April 5, 1986 REVENUE AUDIT MEMORANDUM ORDER NO.

04-86 SUBJECT : Audit Guidelines in the Allocation of Home Office Overhead Expenses Under Section 37(b) of the National Internal Revenue Code. TO : All Internal Revenue Officers and Others Concerned

In order to avoid delay and conflict in the determination of Philippine sources taxable net income of foreign taxpayers for purposes of Philippine income tax, this Revenue Audit Memorandum is issued. 1. Background

1.1 In computing net income from sources within the Philippines, Section 37(b) provides that from the gross income from sources within the Philippines ". . . there shall be deducted the expenses, losses and other deductions properly allocated thereto and a ratable part of any expenses, interests and losses and other deductions effectively connected with the business or trade conducted exclusively within the Philippines which cannot be definitely allocated to some items or class of gross income . . . " casia 1.2 These deductions are difficult to verify because substantial amounts thereof are incurred in the head office or elsewhere and the corresponding supporting documents and books of accounts are not accessible to local taxing authorities. 1.3 Heretofore only an audit certificate is presented to substantiate the deductions incurred abroad which are allocated and pro-rated to Philippine source gross income. 1.4 In implementing the above provision of the National Internal Revenue Code, there is a need for adequate and satisfactory proof and explanations in order that the claimed deductions of the foreign taxpayer may be allowed for income tax purposes. 2. Audit Procedure

2.1 Functional analysis At the start of investigation there should be a detailed examination of the functions performed both by the Home Office and the Local Branch. For this purpose, an organization and functional chart of the home office and local branch should be secured. 2.11 The functions should be determined and then listed. Who does what? What is required to do it? Who needs whom for what? 2.12 After having listed the functions performed by each entity, the functions themselves must be analyzed. Could anyone else perform these functions? How difficult are they? What skill, equipment and processes are needed? cd i

2.2 On the basis of the functional analysis, the claimed deduction properly allocable can now be determined by applying the tests of (a) relevance (necessary) to the local branch and (b) reasonable (ordinary) charges keeping always in mind the arm's length principle in transactions between related parties. 2.3 As to the deductions which cannot be definitely allocated, the following are required: 2.31 Breakdown or Schedule of Home or Foreign Office expenses being prorated, together with an explanation of the nature of each expense. Take note of deductions which are directly allocable to income earned outside the Philippines. 2.32 Basis of pro-ration (a) Determine if the basis and method of pro-ration are being applied consistently from year to year. (b) Is the same amount of Home Office expenses being allocated world-wide? 3. In all instances, be on the lookout for:

a. Charges applicable to newly opened foreign branches but are being claimed as deductions by the Philippine branch; b. Functions are being performed for some branches but not for others, and yet no adjustments are made on the allocation; c. or any other scheme of over-allocating costs to the Philippine branch. cdasia 4. All pertinent provisions of these Audit Guidelines applicable in the investigations of subsidiaries by multi-national companies should be observed by all internal revenue officers concerned. (SGD.) BIENVENIDO A. TAN, JR. Commissioner