Recording loss is a normal event in the operational journey of a company. However, in a transfer pricing analysis, judging a company merely from accounting loss may not be appropriate. One has to delve further and understand the economics behind the numbers and not just the financial outcome of profit or loss.
Multinational enterprises (MNEs) with a global supply chain operating under various tax jurisdictions have the advantage of tax arbitrage. It is possible for an MNE to design a value chain in a cynical way so that loss or low profit is recorded in a higher tax country while profit is recorded in a lower tax country, thereby reducing the overall effective tax rate of the group.
Domestic companies with localized operations are at a competitive disadvantage. However, an MNE with a tax efficient operating structure is not the same as tax avoidance or tax evasion: genuine cases have to be differentiated from transfer pricing manipulated cases.
Analysis of Typical Arrangements
Transfer pricing is based on the principle of the arm’s-length comparison. Circumstances surrounding the company should determine the comparability and not the financial outcome.
Functions, asset and risk (FAR) is at the heart of transfer pricing analysis that helps to delineate the entire value chain of the group company. Judging a comparable based on its ability of making a profit deviates from functional comparability.
It is concerning when an entity consistently realizes losses while the MNE group as a whole is profitable. Also, from a transfer pricing perspective, the loss resulting from non-operating factors such as interest rate, donations or certain non-recurring expenses may be irrelevant.
Therefore, the capital structure of debt or equity does not impact transfer pricing. However, the corresponding interest accruing from such debt needs to be at arm’s length.
The thin capitalization legislation of Vietnam has capped the interest at 20% of earnings before interest, tax, depreciation and amortization (EBITDA). The interest transaction should be benchmarked separately under the comparable uncontrolled price (CUP) method and not on an aggregated basis. However, MNEs in Vietnam use the aggregated approach to benchmark interest transactions.
MNEs should review the pricing policy of cases where contract manufacturers or captive service providers (contracting entities) suffer recurring losses. The contracting entities operate in a ring-fenced setting. Such entities operate on behalf of the principal entity which, in turn, decides what should be produced and how much should be produced by the contracting entities. An entrepreneur in the value chain undertakes significant operational functions, risk and employs significant assets. Therefore, any loss or super normal profit should be attributed to the principal entity; while the contracting entities bears limited risk and is expected to receive guaranteed return on cost and should not incur losses.
Arm’s Length Range
Under the profit method, a structured and comprehensive search method is undertaken to identify comparables. Such an exercise results in a comparable set ranging from loss-making companies to super normal profitable companies. As per the regulation, the margin of the company is considered at arm’s length if the same falls within the inter-quartile range.
Statistics reveal that the results of a particular comparable set of profit level indicator (PLI) will typically depict a normal distribution across the median. Data that cluster on either side of the median value is representative of the overall population as the median value itself. Statistical analysis, taking into account the inter-quartile range, disregards data outliers, i.e. anomalous population, and considers the acceptable population which is close comparable.
If the margin of the assessed company falls outside the inter-quartile range, the revenue authority carries out an adjustment. Decree 20 read with Circular 41 containing the Vietnamese TP Regulations specifies that if the company suo motu agrees to carry out an adjustment and offer tax on the adjusted amount, it can consider any point in the inter-quartile range as the arm’s length margin.
Conversely, if the revenue authority makes the same adjustment at the time of the transfer pricing audit then the authority would consider the median as the arm’s length price.
In an open market scenario there are numerous price points at which a company enters into dealings based on the relative bargaining power of each entity. When the price points are plotted a range of prices is given, and not a single fixed price, whereby different parties agree to enter into a contract.
Therefore, the profit of the company within the inter-quartile range should be arm’s length. Adjusting the pricing to the median over a range of prices disregards the market dynamics of multiple price points. To say that the company should earn exactly at the median position in a dataset would not be logical.
Persistent Loss-Making Comparables
An independent company cannot incur losses indefinitely, unlike a company that is part of a multinational group that can bear such losses if it benefits the MNE as a whole.
A loss-making comparable satisfying the comparability analysis should not be rejected solely because it incurred loss in one year. A year-on-year analysis is necessary to fully understand the reason for the loss.
The three-tier documentation developed by the Organization for Economic Co-operation and Development (local file, master file and country-by-country report) when analyzed harmoniously gives a holistic view of the supply chain for the MNE. It provides an understanding as to whether the value chain confirms with the economic substance.
Usage of Profit as a Quantitative Filter
Operating profit or loss as a factor for elimination in a benchmarking analysis is common practice.
Under the profit method, profit should not be used as the elimination criterion, otherwise it will distort the result. For a comparability analysis, an elimination factor or a combination of elimination factors of revenue, employee, expenses, asset can be used.
In contrast, profit which is a key factor in a profitability analysis should be sacrosanct. In other words, operational similarity should determine the comparability and not the ability of a company to make profit.
Gross Level Comparison and Secret Comparables
In certain types of import of goods and services transactions, the controlled transaction alone should be benchmarked and not on an aggregated basis as there are other factors that can affect net level profitability.
The acceptability of gross level comparison and economic adjustment in Vietnam is low. As a consequence, the gross level method, i.e. the resale price method (RPM) and the cost plus method (CPM) are the least used methods for comparison.
Moreover, the revenue authority insists on comparables from the same geographical area, i.e. Vietnam. Practically, often companies find it difficult to identify close comparables within the same area.
Also, the definition of “geography” in terms of political boundaries may be too narrow. If the economic conditions, irrespective of political boundaries are the same, they should be considered as comparables. In the real world, one could never find identical companies, instead one should look for similar companies. Therefore, companies from neighboring countries like Cambodia, Philippines, Indonesia, Malaysia, etc. may be considered as comparables.
Further, in practice, revenue authorities only consider listed companies as comparable. There is no rationale as to how listed or unlisted company influences the comparability analysis.
The revenue authority often apply secret comparables for the purpose of analysis. The secret comparables are the ones that are not available in the public domain and the revenue authority does not make them available to assessed companies. These comparables may be some private companies or companies that may be known to the revenue authority while auditing other clients. It would be unfair to judge the arm’s length price based on secret comparables if such data is not made available to the assessed company to contest.
Comparability should take precedence over other factors while arriving at final comparables. The company should also carry out economic adjustments to negate the material differences and make the data more comparable.
Economic adjustments improve comparability; however, a high degree of economic adjustments in a comparable could indicate issues with the comparable selection. The economic adjustment may be because of the difference in capacity utilization, market risk, work capital difference, foreign exchange. The most common is working capital differential adjustment that is based on the premise of the difference in time value of money of the tested party vis-à-vis comparables affecting profitability.
Royalty and Management Fee
Transactions of royalties and management fees are vulnerable to adjustment for the loss-making entity. If the company uses certain technical know-how, brand, trademark or specialized services and is still making a loss this will not go well with the revenue authority. Here the transaction should be analyzed and not the profitability outcome as a result of such arrangement.
The ideal approach would be to benchmark royalty transactions using CUP as the most appropriate method and separate benchmarking for management fee. However, continued loss after availing these services may draw the attention of the revenue authority.
The CUP method involves comparing the prices of goods and services. If the CUP method is determined as the most appropriate method then the revenue authority should not be concerned about the loss incurred by an entity as long as the price is comparable.
Foreign Tested Party
The principle of transfer pricing mandates that the company with the simplest function with reliable data that requires the least adjustment should be considered as the tested party. In a value chain, the entity that performs limited functions and operates under a ring-fenced setting may be a tested party.
If facts support that a foreign entity should be the tested party, the company should ideally select the same and carry out benchmarking analysis using foreign comparables. However, the tax authority discounting the characterization of an entity always takes the Vietnam entity as the tested party that defies the principle of transfer pricing. The foreign tested party approach helps in directly benchmarking the controlled transactions while an aggregated basis gives generalized analysis.
The operating profit may be distorted by several factors including management inefficiency, non-recurring legal expenses or provisions. In this context, if the foreign tested party is considered then it will help in benchmarking the international transaction and not the company as a whole.
Company Strategy in a Loss Situation
Subsidiaries in Vietnam typically have smaller operations compared to the overall group operation, therefore, MNEs tend to overlook transfer pricing issues. The pricing policy should not be determined based on the scale of operation.
Under a comparability analysis, the reason for rejection should be based on the cumulative effect of all the factors under consideration. A company which consistently reports losses is at a high risk of a transfer pricing audit. The case may end up with the company not being able to utilize carried forward losses and it may also be liable to additional tax, plus a surcharge and penalty.
The company should record the reason for loss along with economic adjustment carried out in the local file. The company should analyze the risk of acceptance of economic adjustment vis-à-vis potential penalty that can be levied in case of adjustment.
The company should not adopt an aggressive position when the probability of acceptance of loss is low and should consider offering tax upfront as adjustment on taxable income by the revenue authority will have several penal consequences and involve reputational risk. Further, a company can choose the most favorable point in an inter-quartile range to determine the arm’s length price, whereas the revenue authority would consider the median which can increase the tax burden for the assessed company.
Business models and pricing policies should be analyzed over time. Loss is not mispricing but incidental to business and each case, based on economic substance, should be analyzed separately.
Vishwa Sharan is Director and Nguyen Dinh Du is a Partner of Transfer Pricing Services at Grant Thornton, Vietnam