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Published by Vietnam Investment Review

“Substance over form” in transfer pricing – facts and risks

New principles for determining transfer prices in related party transactions (RPTs) were issued for transfer pricing audits and inspections. However, taxpayers applying the principle of called “substance-over-form” are facing some common circumstances and risks.

Decree No.20/2017/ND-CP issued by the government (Decree 20) prescribing tax administration for taxpayers engaging in RPTs and Circular No.41/2017/TT-BTC issued by the Ministry of Finance (Circular 41) providing guidelines for implementing some provisions of Decree 20 have been in effect for nearly two years. These prevailing regulations introduced some new principles to determine transfer prices in RPTs, contributing to certain achievements in conducting transfer pricing audits and inspections, especially a minimisation of tax losses and avoidance of base erosion and profit shifting in companies.

There is a principle, which has been perceived for years by taxpayers but has only been recently legalised, for assessing the arm’s length nature of RPTs, namely “substance-over-form.” In the followings some common circumstances and risks typically faced by taxpayers applying this principle will be highlighted.

The most witnessed issue would be the fact that local enterprises engage in transactions with related parties, but the substance as well as the terms and conditions of these transactions might not be fully documented in related contracts and supporting documents. Naturally, being intra-group transactions, the contracts and supporting documents for these RPTs are normally quite straightforward and simplified for the purpose of time and cost savings.

Accordingly, they merely focus on order descriptions, that is, product categories, volume, value, delivery terms, but lack provisions for the treatment of potential exposures, such as goods return, compensation, replacement, and the responsibilities of the parties during and after warranty terms. Thus, when incurring costs related to the above-mentioned risks, in spite of the nature of the transaction, these expenses can be considered reasonable, but tax administrative requirements might not be fully observed to ensure their deductibility when determining Corporate Tax Income (CIT) obligations.

Furthermore, enterprises are not yet guaranteed to exclude their non-deductible expenses from determining the profit level indicator(s) when performing benchmarking analysis to determine the appropriate arm’s length range.

Another typical circumstance is that a significant part of foreign-invested enterprises in Vietnam plays a role of “manufacturing/processing centre” of goods or services for a value chain they are part of. However, functions of market development, marketing, sales support, and degree of market risks assumed are not covered adequately in written agreements with related parties.

Consequently, in case enterprises suffer parts of losses incurred for the entire value chain, such as decrease in selling prices to related parties due to adverse sales conditions in the market place of the importers, enterprises having “manufacturing/processing centres” may face difficulties in defending their positions during a transfer pricing audit/inspection. Applying the principle of “substance-over-form,” the above-mentioned sharing of market risks may be considered unreasonable. Then, the loss reported would easily be adjusted, or even eliminated, in accordance with the functional profile and characteristics of enterprises.

The third issue commonly faced by enterprises is that group subsidiaries jointly share the overall costs for the development and operation of a system which provides services for the whole value chain, is run by an internal party of the value chain, and brings in benefits as a whole to the entire value chain. To be specific, such services could be sales support, business and brand development, strategic orientation, and resource management.

The number of companies and subsidiaries in Vietnam hardly demonstrates the nature of and benefits received from the share of these support services, though they can evidence the works performed. As a result, purely from a perspective of regulations on tax administration, expenses incurred by enterprises for such shared services can be accepted as deductible for corporate income tax purposes.

However, when applying the principle of “substance-over-form,” competent authorities possibly assume that, in substance, these transactions generate no “close” benefits to enterprises or subsidiaries, and thus certain adjustments should be required when performing benchmarking analysis, although it is quite difficult and arguable to quantify.

From a risk management perspective, in applying this new principle, we are of the opinion that enterprises, if engaging in transactions with related parties, should review whether the engaged contracts fully stipulate (i) required dealings with any potential risks and financial obligations of related parties in such circumstances, (ii) appropriate correlation between risks and liabilities assumed, roles and functions performed given the big picture of the whole value chain, and (iii) specified economic benefits received from payments for the costs of services shared among related parties.

Overcoming these concerns will help enterprises manage and mitigate potential risks of being exposed to transfer price adjustments, avoid management shocks, and assure their flexibility in the market, while maintaining full compliance with Vietnamese laws and regulations.


Source: Vietnam Investment Review