Transactions between related parties are a common feature of business operations. Companies often engage in dealings with shareholders, subsidiaries, affiliates, or other entities under common ownership for legitimate commercial purposes such as financing arrangements, operational support, or asset transfers within a corporate group.
While these transactions may be valid from a business standpoint, they can raise tax issues if the applicable rules under the National Internal Revenue Code (NIRC), as amended, are not carefully considered. In particular, certain expenses arising from related-party transactions such as losses on asset transfers, bad debts, and interest expenses may not be deductible for income tax purposes. Corporations that overlook these limitations may face disallowances during tax examinations, potentially resulting in deficiency income tax assessments, surcharges, and interest.
Understanding the tax treatment of related-party transactions is therefore an important aspect of corporate tax compliance.
Who are considered related parties?
In general, a related party refers to individuals or entities that have relationships allowing them to exercise control or significant influence over the financial and operating decisions of another party. Because these relationships may allow transactions to be structured differently from those between independent entities, tax laws impose safeguards to prevent the manipulation of taxable income.
Section 36(B) of the NIRC identifies several relationships that may give rise to related-party transactions. These include members of a family, which for tax purposes covers brothers and sisters (whether whole or half-blood), spouses, ancestors, and lineal descendants. The law likewise considers an individual and a corporation as related parties when the individual owns, directly or indirectly, more than fifty percent of the outstanding stock of the corporation.
Related-party relationships may also exist between two corporations where more than fifty percent of the value of the outstanding stock of each corporation is owned by the same individual or group of individuals. In addition, certain relationships involving fiduciaries and beneficiaries may fall within the related-party rules.
These relationships are important because transactions between such parties may be subject to limitations under the tax code.
Losses from related-party sales
One of the most explicit restrictions under the NIRC involves losses arising from sales or exchanges of property between related taxpayers. Section 36(B) specifically provides that losses from such transactions are not deductible for income tax purposes.
The rationale behind this rule is to prevent taxpayers from generating artificial losses by transferring assets within a controlled group.
For instance, assume that Corporation A sells machinery to Corporation B, a sister company owned by the same shareholders. The machinery has a book value of ₱2,000,000 but is sold for ₱1,500,000, resulting in a loss of ₱500,000.
Bad debts involving related parties
Bad debts may generally be deductible under Section 34(E) of the NIRC, provided certain conditions are met. Among others, the debt must be valid and legally demandable, connected with the taxpayer’s trade or business, ascertained to be worthless, and charged off within the taxable year.
However, an important limitation applies when the debt arises from a transaction between related parties. In such cases, the deduction may not be allowed for income tax purposes.
Consider a situation where a corporation advances funds to an affiliated company to support its operations. If the affiliate subsequently becomes insolvent and the receivable is written off as a bad debt, the amount may be recognized as an expense in the financial statements. Nevertheless, the deduction may be disallowed for tax purposes if the parties fall within the related-party relationships identified in Section 36(B).
Interest on loans between related parties
Interest expense is generally deductible under Section 34(B) of the NIRC if it is paid or incurred in connection with the taxpayer’s trade or business. However, loans involving related parties are often subject to closer scrutiny by the tax authorities.
In practice, issues may arise when loans between related parties lack proper documentation or when the terms of the loan do not reflect arm’s-length conditions. For example, the absence of a written loan agreement, the lack of a defined repayment schedule, or interest rates that are inconsistent with market conditions may lead tax authorities to question the nature of the transaction.
In some cases, what is recorded as a loan may actually resemble a capital contribution. When this occurs, the interest expense claimed by the corporation may be disallowed.
These issues are also relevant under the Bureau of Internal Revenue’s transfer pricing regulations, which require related-party transactions to comply with the arm’s-length principle. This means that the terms of transactions between related parties should be comparable to those that would have been agreed upon between independent parties under similar circumstances.
A reminder on tax deductions
It bears emphasizing that deductions are not automatically granted. Under established tax principles, deductions are considered a matter of legislative grace, and taxpayers claiming them must be able to clearly establish their entitlement under the law.
For this reason, expenses arising from related-party transactions are often carefully examined during tax audits. Taxpayers should therefore ensure that their transactions are properly documented and that the tax implications are carefully evaluated before claiming deductions.
Conclusion
Related-party transactions are a practical reality in many businesses, particularly within corporate groups. However, taxpayers should be mindful that certain expenses arising from these transactions such as losses on asset transfers, bad debts, and interest payments may not be deductible under the NIRC.
By understanding these limitations and ensuring proper documentation of related-party dealings, corporations can better manage potential tax risks and avoid unexpected adjustments during tax examinations.
References:
- Section 34(B), National Internal Revenue Code (NIRC), as amended
- Section 34(E), National Internal Revenue Code (NIRC), as amended
- Section 36(B), National Internal Revenue Code (NIRC), as amended
- Section 50, National Internal Revenue Code (NIRC), as amended
Article written by: Rhea Pelayo, CPA
