Common Transfer Pricing Issues and How to Rectify Them

Posted by Written by Thang Vu Reading Time: 13 minutes

It goes without saying that foreign invested companies (hereafter FDI companies) significantly contribute to Vietnam’s economic development, create jobs, and substantially improve the living standards of Vietnamese citizens. However, Vietnam’s tax authorities have observed and identified several transfer pricing (TP) and tax evasion issues over the years and have undertaken to implement and enhance tax administration and governance to address these issues.

Specifically, historical statistics reveal that approximately 50 percent of FDI companies made losses and many of them had continuously reported losses for many consecutive financial years.

Reports from the provincial tax departments also showed that loss-reporting FDI companies were typically operating in garment and footwear processing and production and cost centres. Despite suffering continuous losses, these FDI companies still invested significantly in expanding their production capabilities and business operations. Such observations caught the attention of the tax authorities because most domestic companies in the exact same industries were profitable.

One typical example that went viral in late 2019 was Coca-Cola Beverages Vietnam Ltd. In summary, Coca-Cola had continuously reported losses after more than 20 years of operating in Vietnam. Their accumulated losses as of September 30, 2011, reached around US$160,340,425, exceeding the initial investment capital of US$125 million, despite the regular 20 to 30 percent increase in annual turnover. Although there was no corporate income tax (“CIT”) to be paid due to such consistent losses, Coca-Cola Group still had plans to make another US$300-million-investment in Vietnam. Long story short, Coca-Cola Beverages Vietnam had to remit almost US$35 million, including tax remedy and interest penalties to the State Budget.

Other FDI companies that caught the TP-related attention of the tax authorities at that point included many household names, such as PepsiCo Vietnam, Nestlé, and Toshiba Asia.

As a result, the Vietnamese tax authorities have significantly increased their focus on TP issues in tax audits and inspections in the last few years.

Previously, TP auditors were organised and maintained in specialized teams at the General Department of Taxation and tax department of large provinces where high-risk FDI businesses were located. Those TP-specialized teams were subsequently dissolved and the auditors from such teams were allocated to tax audit and inspection teams on a national scale. In this respect, the tax authorities made it clear that they would concentrate on TP scrutiny during tax audits and inspection sessions across the country, instead of just a few noteworthy cases.

During recent tax audit/inspection sessions, the Vietnamese tax authorities have asked for increasing amounts of information, including real-time information, during audits, including direct systems interrogations, access to emails, presentations, notes of calls, LinkedIn profiles of employees, etc. In addition, interviews of key personnel have become more like interrogations. Interviews with customers or suppliers of the corporate taxpayer are also more common.

An overview of TP compliance requirements has already been covered in our other article, Transfer Pricing in Vietnam – An Overview.

Therefore, in this article, we only discuss the TP challenges that are typically identified by Vietnam’s tax authorities among FDI companies engaging in intragroup transactions.

Late preparation of TP compliance documentation

While assisting our clients during tax audit and inspection sessions, we have seen situations where the tax authorities rejected TP documentation and enforced adjustments, simply because the TP dossiers were prepared after CIT returns had been submitted.

Decree 132/2020/ND-CP specifically dictates that TP compliance documentation must be prepared on an annual basis and before lodging a company’s annual CIT return (90 days after the financial year ends). Although the tax authority does not require taxpayers to submit their TP documentation annually, the annual CIT returns must be accompanied by TP Appendices, which include:

  • Appendix I: Information on related parties and related-party transactions;
  • Appendix II: Checklist of information and documents required for local file;
  • Appendix III: Checklist of information and documents required for master file; and
  • Appendix IV: Information disclosure reporting national profit.

It is fairly common to see companies that do not meet the conditions for TP documentation exemption, neglect their TP compliance requirements until external auditors or tax advisors raise questions. Many accountants think that TP dossiers are simply supporting documents that will only be provided to the tax authority upon request and can be prepared at any time prior to future tax audits or tax inspections, if the tax declaration forms are submitted on time. Thus, the importance of preparing TP documentation on time is often underestimated until they face rejection from the tax authority.

We have also seen cases where TP compliance dossiers were signed and backdated to show that they were completed prior to annual CIT return lodgement but still got rejected by the tax authorities without even looking at their contents. In this respect, the tax authorities simply requested to review the TP service agreements and look at the dates of search results from commercial databases. This is because the engagement dates on the TP service agreements and dates of search results from commercial databases are very difficult to falsify.

Read: What is a Transfer Pricing Review and Why Do Firms in Vietnam Need It?

Inconsistencies in TP compliance documentation and TP appendices

The information on related-party transactions must be reported consistently between CIT return’s TP Appendices and TP documentation. Such information must also be appropriately accompanied by proper supporting documents, such as the financial statements of the chosen comparable entities, the Group’s transfer pricing policies and cost-sharing arrangements.

In practice, the tax auditing teams challenge the following inconsistencies, which typically result in the rejection of TP compliance dossiers:

  • Inconsistent benchmarking methods between Appendix I of the TP Appendices and the local file.
  • Inappropriate profit level indicator and the reported margin in Appendix I of the TP Appendices does not align with that of the local file.
  • Inconsistent markup margin between the service contracts and the local file.
  • Incorrect disclosures with respect to Appendix II and Appendix III of the TP Appendices which confirm the availability of information that is not covered by the local and master file.

Such inconsistencies are often caused by a lack of coordination between the internal accountants who prepared the TP Appendices and the TP service providers. Many companies do not like the fact that TP service providers often charge a hefty fee for reviewing or preparation of TP Appendices on top of the TP compliance dossiers and thus, they prefer their accountants to do it instead. In such cases, most in-house accountants are unfamiliar with TP disclosure while the TP specialists refuse to assist because such tasks are beyond their scope of work.

Companies that make losses on a continuous basis

Loss-making companies are always on the top of the list for Vietnam’s tax authorities and its inspectors. In practice, the tax authorities give special attention to entities with related-party transactions that generate losses regularly.

If an independent company continuously makes losses over its operating period, its going-concern status will be questioned. On the other hand, if it is a company within an international group, the tax authorities will likely challenge whether such losses should be borne by the other affiliate entities, such as the ultimate parent company or a fully functional entity. The key question in transfer pricing is which companies should bear the loss within the group and which, on the contrary, should be reimbursed for the loss.

By checking the country-by-country (CbC) reporting or the financial data of related parties in the commercial database, if profits are made by an affiliate from one of the tax havens while other affiliates from high-tax jurisdictions keep making losses, it will raise eyebrows among the tax authorities.

A company’s functions and risks should be reasonably aligned from a TP point of view.

In a nutshell, a company that performs limited functions should not bear significant risks. For instance, a garment processing facility or an outsourcing office (cost centre) of a software development corporation should not be exposed to direct and high market risks, intellectual property risks, and reputational risks. From the tax authority’s perspective, companies with limited functions are often expected to generate a consistent profitability level regardless of the economic condition.

Ideally, all involved related parties should be making profits. Otherwise, Special Factor Analyses might need to be prepared to argue that the loss results are not caused by the transfer pricing policies but caused by other business factors.

Low profitability

Companies that prepare TP documentation on an annual basis usually know if their performance is within the arm’s length range and can make adjustments accordingly. However, many companies that fall below the threshold for mandatory TP compliance documentation often underestimate the importance of benchmarking their performance.

We have seen a lot of clients, especially cost-centred entities of global software development and IT solution firms, who have the erroneous assumption that if their companies generate a small amount of profit and pay tax on such profits, the tax authority should have absolutely no reason to give them a hard time in future tax audits.

As mentioned above, the tax authorities often expect companies with limited functions to generate a consistent profitability level regardless of the economic conditions. This is especially true in the case where such companies are the Group’s cost centres and only earn revenue from their parent companies or other affiliates within the Group.

However, in normal business conditions and based on the arm’s length principle, the cost-centred entities are expected to independently try to take on more value-adding functions and control more risks to increase their own profit level. The control of the Group on the profitability of the cost-centred entities is against the arm’s length principle. Hence, an economic analysis comparing the profitability of the cost-centred entities with the profitability of the comparable companies could help to test whether the business result of the cost-centred entities is at arm’s length or not. Such companies’ profits should be consistent and fall within an arm’s length range that can be substantiated in the form of economic analysis.

The current arm’s length range is from the 35th percentile to the 75th percentile (tightened from the 25th to the 75th interquartile range under Decree 20/2017/ND-CP).

Dubious adjustments of profit markup and fluctuations

Case study

A software company in France established a subsidiary in Vietnam for the purpose of outsourcing its manual software development and testing works. The outsourcing office in Vietnam had only one customer, which was its own parent company in France. Both parties entered a service agreement dictating that the back office in Vietnam would charge the French company all of its operating expenses plus a Net Cost Plus (NCP) markup rate of 10 percent. After two years of operation, the French parent company decided that a 10 percent markup was considerably high and decided to reduce the markup rate to 5 per cent via an addendum to the original service agreement.
What would be the potential underlying exposure of such a sudden cut in the markup rate?

From our evolving experience working in controversial assignments and professional surveys, loss-making entities and service agreements are the top two most common areas covered by tax audits. From a TP perspective, a lower markup rate negatively affects the Vietnamese entity, but it would benefit its French headquarters, in this case, the tax authorities in Vietnam may challenge the basis of such a rate reduction.

When there is any change in the value added by an entity, a value analysis should be prepared to substantiate the change in the pricing policy. The value chain analysis would provide an argument from a business perspective on why the change of the function, risk, and asset of the relevant parties is necessary to grow the whole Group. Any reduction of profitability of any entity is the result of fewer functions performed, risk assumed, and assets utilized.

In short, the higher the rate, the less risk for the Vietnamese entity but the higher the risk for the parent company in France and vice versa. Companies should consider this in order to justify the nature of the transactions, make management decisions so that the intragroup transactions are conducted at arm’s length, and prepare sufficient economic analyses to substantiate such decisions.

Read: SBV Issues Guidance on Anti-Money Laundering Law

Challenges in the selection of comparable entities

The process of choosing comparable entities in a commercial database is quite complicated and requires the careful selection of the criteria used. The shortlisted pool must then also be put through the screening process, both quantitative and qualitative, to include companies that are likely to be comparable to the tested party.

While challenging taxpayers on the selection of criteria, the tax authorities often assert that the chosen comparable entities should be picked from the same geographical area and should have preferably, identical principal business activities, product lines and services to the tested party.

From a practical point of view, it is almost impossible to find enough comparable companies with identical primary business activities, selling the exact same products/services and in the same geographic region at the same time. In this respect, companies should always shortlist data by selecting comparable entities based on business codes, availability of selected financial criteria, and geographic region, respectively. If there are not enough comparable entities within a specific region (for example, Vietnam), the location search can be expanded into ASEAN, far east, and central Asia, accordingly. In this respect, regions with similar economic conditions can be used for comparable purposes, regardless of political and cultural differences. The guidelines for the expansion of the comparability analysis scope can be found in Article 9 of Decree 132/2020/ND-CP.

Loss-making comparable entities are often questioned by tax authorities. However, it is unfair to reject a comparable entity that meets the conditions of comparability analysis, simply because it made a loss in one single year. In practice, only shortlisted companies with insufficient financial data and incurred operating losses in three consecutive years during the assessed period are excluded from the chosen comparable entities by quantitative screening.

Moreover, Decree 132/2020/ND-CP allows the use of commercial databases with standard and continuously updated financial data. In the sharing sessions of the tax authorities, the tax authorities in large provinces have requested the General Department of Taxation to subscribe more accounts so that many teams in each province can use the commercial database (for example, TP Catalyst (Orbis-Osiris) of BvD) in tax audit/inspection. Thus, the systematized and consistent commercial database would be helpful for companies operating in Vietnam in upholding their economic analysis against the tax authorities’ scrutiny.

Lack of benchmarking study

Theoretically speaking, taxpayers that fall below the thresholds for mandatory TP compliance documentation just need to prepare Appendix I, which is a TP disclosure form, to be declared and submitted together with their annual CIT return. But it does not mean that they don’t have to justify their positions to the tax authority in future tax audits and inspections regarding:

  • The basis for determining profit markup rates of cost-centered entities.
  • NCP markup rate of intragroup service charges.
  • Interest and royalty rate.

No supporting documents to substantiate the basis for determining intragroup charges may lead to significant tax adjustments down the track. In this respect, the tax authorities often use secret databases, that are not publicly available, for analysis purposes and they are not obligated to present their detailed findings to the audited taxpayers.

Ideally, royalty and interest transactions should be benchmarked using the Comparable Uncontrolled Price (CUP) methodology as the most appropriate TP benchmarking method. On the other hand, a benchmarking study should be prepared separately for intragroup services.

In a nutshell, a benchmarking study is an economic analysis performed using a methodology to substantiate the pricing policy used in a transaction between international related parties. It is considered the backbone of TP compliance because it helps to substantiate the taxpayers’ positions with reliable economic data by comparing the tested intercompany transaction with ones entered between third parties in the same or similar scenarios.

A reliable benchmarking study helps to mitigate the risks of a transfer pricing adjustment as the data contained in the benchmarking analysis will be the basis to defend a taxpayer’s position in front of the tax authorities in the future.

Issues with intragroup royalty and service fee payments

Intragroup royalty and service arrangements have been persistent disputes between the taxpayers and tax authorities in Vietnam. In this respect, we will revisit one of the infamous cases in Vietnam a few years ago, which was the intragroup expenses of Adidas Vietnam.

Adidas is one of the leading sports manufacturers in the world and established its subsidiary in Vietnam in 2009, 100 per cent owned by Adidas International B.V. (Amsterdam, the Netherlands). Despite making billions of US dollars from the Vietnam market in the first few years, Adidas Vietnam consistently reported losses because their operating expenses always outweighed their turnover. Obviously, it caught the Vietnamese tax authorities’ attention and triggered multiple taxes and TP inspections to review the company’s TP compliance status. The inspection result did not say that Adidas Vietnam attempted tax evasion but revealed a substantial amount of dubious transactions with other Adidas affiliates, including international marketing expenses, management fees and royalty payments. Specifically:

  • Adidas AG (Germany) photographed models and celebrities to promote Adidas’s products. To display such promotional photos in the stores, Adidas Vietnam had to pay international marketing costs of 4 percent of their net turnover to Adidas AG.
  • Adidas Vietnam was not a manufacturer, but it had to pay a royalty fee of 6 percent of its net turnover for sales of products sold and the value of licensed products to Adidas AG.
  • Adidas Vietnam was registered as an importer and distributor of sports shoes and clothing, which means that it had all the rights and capacity to import products. However, Adidas Vietnam hired its parent company, which was Adidas International B.V., to carry out purchasing activities on its behalf and Adidas International B.V. charged 8.25 per cent on each purchasing transaction’s value.
  • Under the Southeast Asian Master Service Agreement between Adidas Singapore and other SEA entities, including Adidas Vietnam, Adidas Vietnam not only had to pay remunerations to the management team in Vietnam but also to regional management in Singapore and Adidas AG. Moreover, it was subsequently discovered that such management teams were closely related.

Such intragroup charges significantly boosted Adidas Vietnam’s operating expenses and products’ costs of goods sold as a result. Thus, Adidas Vietnam reported losses consecutively and did not pay CIT during such loss-reporting periods. Although the Tax Department of Ho Chi Minh City announced that they would strengthen tax governance and continue investigating such TP suspicions, there have not been any further official updates since then.

As an observation from Adidas’s case and other similar circumstances, it is vital that FDI companies should be able to justify their grounds when entering intercompany transactions with their foreign affiliate within the Group.

After the release of the new Tax Administration Law in 2019, the tax authorities in Vietnam have been given more powers in tax governance and it was observed that they have been highly concentrated in companies with intercompany royalty and service charges. Such charges are often scrutinized using ‘economic benefit’ and ‘substance-over-form’ tests to evaluate the authenticity of benefits received by the paying parties. Failure to justify and provide supporting evidence of benefits received will instantly result in such intercompany charges being rejected immediately, along with administrative fines and interest penalties. Detailed guidance on the determination of deductible costs for assessment of taxes on enterprises engaged in related party transactions can be found in Article 16 of Decree 132/2020/ND-CP.

In light of the above, FDI companies can use the following evaluation model to assess the risks of their intercompany royalty and service charges and make management decisions from a tax and TP point of view accordingly.

Evaluation Approach for Intercompany Royalty and Service Charges Recommendations
Step 1: Evaluation of the commercial benefits received
  • Maintain appropriate evidence to substantiate the genuineness and benefits of the intragroup royalty and service charges.
  • Prepare separate benchmarking studies to determine the arm’s length basis for each intragroup royalty and service charge.
  • Review the approaches for fee estimates and allocation of intragroup royalty and service charges. The intra group agreements should be reviewed from the local legal and tax perspectives.
  • Consider disallowing fee payments to other affiliates within the Group that are from tax-haven jurisdictions.
Were the services actually provided or the intellectual property genuinely transferred? (Substance-over-form analysis)
What are the economic benefits of the intangible assets and services provided?
How are such benefits directly related to the income-earning activities of the taxpayers?
Are the provisions of intragroup services duplicated?
Step 2: Evaluation of ownership
Did the transferors register the legal ownership of IPs in their respective jurisdictions?
Were the agreements for royalty usage registered?
Were the patents or trademarks registered with the competent authorities in Vietnam?
Step 3: Evaluation of transfer pricing policies and arm’s length principles
Were the royalty and service charges evaluated by any comparability analysis or benchmarking study?
Are the service charges comparable to those of other independent service providers?
Are independent parties willing to pay for such services?
Are copyrights, IP transfers and patents separated?
Why are royalty fees paid for the purposes of trading with related affiliates?
Step 4: Evaluation of available supporting documents
Are the supporting documents, which substantiate the following points, sufficiently prepared and maintained?
– Genuine provisions of services or transfers of IPs
– Analysis of benefits received
– Approach for estimating intra group charges
– Benchmarking studies

In conclusion, FDI companies doing business in Vietnam are highly recommended to understand TP compliance requirements and tax audit process, assess their TP and tax positions from a skeptical point of view, as well as prepare strategies to improve weak areas to strengthen their TP and tax positions.

Moreover, it is also recommended that FDI companies should properly conduct periodic reviews and consult with TP specialists on a regular basis to safeguard themselves from potential tax and TP exposures. There is no such thing as a free lunch—saving money on compliance costs now can expose you to significant tax adjustments and hefty penalties in future tax audits and inspections.

We offer differentiated service packages at Dezan Shira & Associates to accommodate our client’s business needs in enhancing their TP compliance status and mitigate exposure in future tax audits and tax inspections, such as:

  • Prepare, update, and review the TP Appendices I, II, III, and IV of the annual CIT returns.
  • Prepare and update the Benchmarking studies.
  • Prepare the Value Chain Analysis.
  • Prepare, update, review, and translate the TP compliance documentation (i.e., Local File, Master File, Country-by-Country Report).

For further information, please contact us at

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