Non-recognition of related-party transactions reduces tax liability: Mechanisms and legal consequences.

In the context of a globalized economy, multinational corporations and affiliated companies are increasingly expanding their operations in Vietnam. However, this development is accompanied by challenges in tax management, particularly the phenomenon of transfer pricing. To ensure fairness and prevent revenue losses, the State has issued strict regulations, emphasizing the authority of tax authorities to disallow related-party transactions that reduce a company's tax obligations.

This article will analyze in detail the principles, processes, and consequences when businesses conduct transactions that do not comply with the arm's length principle, while clarifying the management mechanism based on the nature of business operations.

What does it mean to not recognize related-party transactions to reduce tax liability?

According to the provisions of Decree 132/2020/ND-CP, The tax authorities have the power to manage, inspect, and audit the related-party transaction prices of taxpayers. The phrase "not recognizing related-party transactions that reduce tax liability" means that the regulatory authority will eliminate or adjust transactions between related parties if those transactions are not based on market prices.

The core objective of not recognizing related-party transactions to reduce tax obligations is to prevent profits from being transferred abroad or to member entities enjoying tax incentives, resulting in revenue losses for the state budget. When a transaction is deemed to lack objectivity, the tax authorities will exercise their right to determine the price based on comparative market data.

The core principle: "Substance determines form."“

The tax authorities will not rely solely on contracts or documents provided by businesses. Instead, they will consider the "nature of the activity and transaction." If a transaction has complete legal documentation but lacks actual economic substance, or the value created is disproportionate to the capacity to perform it, the tax authorities have the right to reject the related-party transaction, thereby reducing the tax liability. This ensures that every dollar of tax paid is commensurate with the actual value that the business creates in Vietnam. To address these technical issues, many businesses have sought assistance from tax authorities. related party transaction advisory services Professionals like MAN – Master Accountant Network – ensure compliance right from the start.

Two pillars in managing related-party transaction taxes.

To determine whether a business is complying with regulations, the regulatory authority relies on the following two main pillars to enforce the policy of not recognizing related-party transactions that reduce tax obligations:

Arm's Length Principle

This is an international standard initiated by the OECD and fully implemented by Vietnam. This principle requires that the value of transactions between related parties must be equivalent to the value of transactions between independent parties under similar conditions.

If a business purchases goods from its parent company at an unusually high price or sells to its subsidiary at an unusually low price, causing a decrease in profits in Vietnam, the tax authorities will immediately apply measures to disallow the related-party transaction that reduces tax liability and adjust the transaction price to the market price.

The nature of the activity and the value created determine tax obligations.

Tax obligations must correspond to the value generated from the nature of the transaction. A business in Vietnam cannot consistently record low profits if it holds critical functions such as manufacturing, warehousing, and is subject to significant market risks. Value chain analysis helps tax authorities determine whether profit allocation is fair. If there is a large discrepancy between profit and actual contribution, tax authorities will not recognize related-party transactions that reduce tax obligations in order to protect revenue sources.

Typical cases that lead to the non-recognition of related-party transactions.

The non-recognition of related-party transactions that reduce tax obligations often occurs in the following sensitive cases:

• Related-party transactions lacking economic substance: Businesses enter into consulting, technical support, or management contracts with their parent company but cannot demonstrate that these services are actually necessary for their business operations. In this case, these costs will be completely disallowed because the related-party transaction is not recognized, thus reducing tax obligations based on inflated value.
• Non-business transactions: Expenses incurred for personal purposes or for the benefit of the parent company that do not contribute to revenue in Vietnam will be scrutinized by the tax authorities. In such cases, the non-recognition of related-party transactions that reduce tax liability is mandatory to ensure transparency.
• Excessive interest expense (Thin capitalization): This is the most common problem. Businesses borrow capital from related parties at high interest rates. According to Decree 132, interest expense is capped at 30% EBITDA. Any amount exceeding this limit is considered profit shifting, and the tax authorities will not recognize the related-party transaction that reduces the tax liability for the portion of interest expense exceeding this threshold.
• Unreasonable transfer of intangible assets: Paying royalties to brands that a Vietnamese business has actually built its own reputation for in the local market is a basis for regulatory authorities to not recognize related-party transactions that reduce tax obligations.

Detailed analysis of methods for determining transfer pricing.

To avoid the tax authorities rejecting related-party transactions that reduce tax liability, businesses must use one of the following comparative methods to demonstrate the reasonableness of the transaction price:

Independent transaction price comparison method

This is the preferred method. Businesses directly compare the price of products in related-party transactions with the price of similar products in transactions with independent parties. If the selling price to the related party is lower than the selling price to external customers, the tax authorities will not recognize the related-party transaction, thus reducing tax liability and adjusting revenue upwards.

Resale price method

This typically applies to distribution units. The purchase price from the related party is determined by the resale price minus a reasonable gross profit. If the distributor's gross profit is lower than the market average, the tax authorities may not recognize the related-party transaction, thereby reducing the tax liability and adjusting the cost of goods sold downwards.

Cost plus profit method

This applies to contract manufacturing units. The selling price to the related party is equal to the production cost plus a gross profit margin on the cost of goods sold. If this profit margin is lower than that of independent contract manufacturers, the risk of the related-party transaction being disqualified, resulting in reduced tax liability, is very high.

Net Profit Margin Comparison Method

Based on profit margin on revenue, expenses, or assets. This is the most common method in Vietnam due to the ease of finding comparative data. However, if the profit margin falls outside the market range, the tax authorities will exercise their right to disallow the related-party transaction, thereby reducing tax liability.

Profit allocation method

This applies to complex transactions where parties jointly contribute unique intangible assets. If the allocation does not accurately reflect the contribution ratio, the tax authorities will adjust each party's profit and disallow the related-party transaction that reduces tax liability by the original ratio of the discrepancy.

The tax authority's price inspection and adjustment process.

The tax authorities follow this process to ensure that no cases requiring the non-recognition of related-party transactions that reduce tax liability are overlooked:

• Risk analysis: Using artificial intelligence and big data to filter out businesses with unusually volatile profit margins or those experiencing losses for many consecutive years while still expanding production. This is the first sign that related-party transactions may not be recognized, potentially reducing tax obligations.
• On-site inspection: A physical examination of the production line, warehouse, and the function of each department to determine the "nature of the operation".
• Selecting comparison targets: Find 3-5 independent businesses with the most similar functions and risks.
• Price range adjustment: If a company's price falls outside the range of the first to third quartiles of the market, the tax authorities will disallow the related-party transaction, thereby reducing the tax liability, and adjust it to the median value.

Consequences of having a transaction rejected by the tax authorities.

The consequences of not recognizing related-party transactions that reduce tax obligations are extremely severe for businesses' finances:

Collection of back taxes and late payment interest.

When tax authorities do not recognize related-party transactions as reducing tax liability, taxable income will be recalculated from scratch. The amount of back taxes collected can reach tens or hundreds of billions of VND for large corporations. This is accompanied by late payment penalties calculated daily, further exacerbating the financial burden.

Loss of tax benefits

In some cases, if the non-recognition of related-party transactions reduces tax obligations, leading to the conclusion that the business has committed tax fraud, the business may be stripped of applicable tax rate incentives or tax exemption periods.

Compliance costs are increasing.

After being penalized for failing to recognize related-party transactions that reduced tax obligations, businesses will have to invest significant costs in hiring consultants, re-filing documents, and providing explanations to regulatory authorities in subsequent periods. The use of Transfer pricing advisory services It has now become crucial to minimize damage and get tax operations back on a safe track.

Solutions to protect businesses from tax risks.

To avoid having related-party transactions disqualified by the tax authorities, which could reduce tax obligations, businesses need to develop a well-structured compliance strategy:

Complete the application dossier for all three levels.

Businesses must proactively establish:

• Country profile: Demonstrates that the nature of transactions in Vietnam complies with the principle of independence.
• Global profile: Shows consistency of pricing policy across the entire group.
• Country-by-County Profit Reporting: Ensure profits are allocated proportionally to operations in each country. Thorough documentation is the best way to avoid disallowance of related-party transactions, which can reduce tax liability.

Many businesses choose this solution. hire someone to prepare related party transaction documents. To ensure these reports fully meet the stringent criteria of the regulatory authority, avoiding the risk of disallowing related-party transactions and reducing tax obligations.

Develop pricing policies based on operational realities.

Transfer pricing should not be imposed by the parent company but should be calculated based on the actual functions, assets, and risks in Vietnam. When the nature of the operations is clear, the tax authorities will have no basis to disallow the transfer transaction that reduces tax liability.

Advance Pricing Agreement (APA)

If possible, businesses should participate in an APA program with the tax authorities. This is a pre-determined commitment regarding the pricing method, giving businesses complete peace of mind that their related-party transactions will not be disqualified, thus reducing their tax obligations throughout the term of the agreement.

Conclusion: Transparency is the foundation for sustainability.

The regulation regarding the non-recognition of related-party transactions that reduce tax obligations is not intended to create difficulties for businesses, but rather to build a fair and healthy business environment. Businesses need to understand that tax obligations must be commensurate with the actual economic value created.

By strictly adhering to the arm's length principle and focusing on the essence of their business operations, companies will no longer have to worry about disallowing related-party transactions that reduce their tax obligations. In the digital economy era, transparency is the most valuable asset that helps businesses establish credibility and achieve sustainable growth in the Vietnamese market.

Contact Contact MAN – Master Accountant Network for timely advice and support!

Contact information MAN – Master Accountant Network

• Address: No. 19A, Street 43, Tan Thuan Ward, Ho Chi Minh City
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• Email: man@man.net.vn

Content is moderated by: Mr. Le Hoang Tuyen – Founder & CEO of Man, CPA Vietnam Auditor with over 30 years of experience in Accounting, Auditing and Financial Consulting.

Frequently Asked Questions: Does not recognizing related-party transactions reduce tax liability?