Tax and Transfer pricing audits: Why the aggressiveness is heating up now?

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In Vietnam, tax audits usually happen every 3-4 years. Recently, these audits have become more intense, especially when transfer pricing is involved. These audits with transfer pricing matter are not just more detailed but also take longer to complete. The current challenge extends beyond merely possessing transfer pricing documentation; the emphasis is increasingly on the quality and comprehensiveness of that documentation and its supporting evidence.

This evolution in the audit landscape and the intensified scrutiny by tax authorities on intercompany transactions can be explained by two primary factors: internal and external.

1. First of all, internally, the focus is on the quality of the documentation.

Taxpayers must move beyond verbal explanations and provide clear, substantiated evidence to convincingly support their positions before the tax authorities. Essential components of such documentation include:

• Functional profile: The functional profile is crucial in demonstrating the complexity of a business and its contribution to the overall value of the Group. This profile provides insight into the specific functions, assets, and risks associated with the business. The underlying principle is straightforward: entities assuming higher risks should correspondingly earn higher returns, while those with lower risks should expect lower returns. For example, a company identified as a contract manufacturer typically operates with a stable, low profit margin due to its limited risk exposure. Any significant fluctuation in this margin must be clearly justified and documented. On the other hand, a company classified as a full-fledged manufacturer undertakes a higher level of risk, which allows for the potential of substantial profit margins in favorable market conditions, but also exposes it to considerable losses when business conditions deteriorate. This risk-return relationship is fundamental in assessing whether the company’s functional profile accurately reflects its economic reality and contribution to the Group.
• Benchmarking analysis: The benchmarking process is one of the most challenging and subjective aspects of transfer pricing, often involving significant grey areas. This analysis compares a company’s financial performance against that of similar entities to determine if its pricing aligns with market standards. The process consists of two critical steps: quantitative screening, which focuses on numerical data, and qualitative screening, which involves professional judgment to assess the true comparability of the companies. The qualitative screening phase is particularly contentious, as it requires understanding and interpretation, often leading to disputes during audits. Additionally, it’s important to recognize that the databases used by taxpayers and tax authorities may differ, leading to potential discrepancies in selected comparables. Regulations generally require a minimum of five (05) comparable companies to establish the market range, with a preference for Vietnamese companies that share similar industry codes. However, when sufficient Vietnamese comparables are unavailable, it becomes necessary to broaden the search to include foreign companies. This expansion can introduce further complexity and potential areas of disagreement during the audit process.
• Increased scrutiny on the nature of each intragroup transaction: Tax authorities are intensifying their focus on the specific details of individual intragroup transactions, rather than relying solely on the company’s overall profit margin. This increased scrutiny involves a closer examination of the economic benefits purportedly received by the service recipient in each transaction. Taxpayers are required to provide robust evidence that the prices or fees charged in these transactions are consistent with market rates, as if the transactions were conducted with independent third parties. This means that each intragroup transaction must be carefully documented and substantiated to withstand the challenges posed by tax authorities. The emphasis is on ensuring that these transactions reflect genuine economic activities and adhere to the arm’s length principle, thereby minimizing the risk of adjustments during audits.

2. Secondly, external factors also contribute to the increased audit aggressiveness.

• Increased focus on transparency: There is a growing global emphasis on transparency in tax reporting, particularly concerning intercompany transactions. This shift towards greater openness requires companies to provide detailed and accurate documentation that demonstrates the legitimacy and economic substance of their intercompany dealings. Tax authorities are increasingly scrutinizing whether these transactions genuinely reflect real economic activities and whether they align with the arm’s length principle. As a result, companies must ensure that their transfer pricing policies are not only compliant with local regulations but also transparent and defensible on a global stage.
• Concerns about profit shifting: While transfer pricing is often misunderstood as a tool for shifting profits to lower-tax jurisdictions, this perception has led to heightened scrutiny by tax authorities. They are particularly concerning whether the profits reported by a company are commensurate with the risks it assumes, the services it provides, and the assets it holds. Tax officers are closely examining whether service fees are justified based on the actual services rendered and whether assets are accurately valued in accordance with their economic contribution. This increased focus aims to prevent profit shifting and ensure that tax liabilities are fairly apportioned based on genuine economic activity.
• Enhanced expertise among tax officers: The continuous sharing and exchange of technical knowledge in transfer pricing among provincial tax authorities have significantly enhanced the auditing capabilities of tax officers. Through regular training sessions, collaborative discussions, and access to up-to-date technical resources, tax officers have become more adept at identifying and analyzing complex transfer pricing issues. This increased expertise enables them to conduct more thorough and effective audits, ensuring compliance with transfer pricing regulations and minimizing the risk of profit shifting.
• Potential for high tax collection: Transfer pricing is increasingly recognized as a significant area for tax revenue generation. Adjustments to a company’s profit margin, especially when applied to entities with substantial revenues, can result in considerable tax liabilities. Moreover, companies may face additional financial burdens due to administrative penalties of 0.03% per day and a 20% shortfall penalty for underreporting income. This potential for high tax collection underscores the importance for companies to maintain robust and accurate transfer pricing documentation to avoid costly adjustments and penalties during audits.

Given the increasing aggressiveness of audit trends, it is strongly advised that taxpayers involved in related-party transactions take the following proactive measures:

• Review the internal pricing policy: Related-party transactions are central to the operations of any Group, and setting the right price for these transactions is a complex task. It requires a delicate balance between the interests of both the seller and the buyer, while also ensuring compliance with tax regulations in both the home and host countries. Achieving this balance is critical to the Group’s overall success and sustainability. Therefore, companies must regularly review and update their internal pricing policies to ensure they align with current market conditions, regulatory expectations, and the strategic objectives of the Group.
• Ensure full compliance with regulations: Compliance with transfer pricing regulations is non-negotiable. Taxpayers must ensure that the required Appendix disclosing related-party transactions is submitted alongside the Corporate Income Tax (CIT) return within 90 days of the fiscal year-end. Additionally, companies must maintain and be prepared to submit, upon request, the comprehensive transfer pricing documentation, which includes the Local File, Master File, and Country-by-Country Reporting. Failure to comply with these regulatory requirements can lead to significant penalties and increased scrutiny from tax authorities.
• Proactively prepare an audit strategy to mitigate risk: Developing a robust audit strategy is essential to navigating the complexities of a tax audit successfully. This strategy should include thorough preparation of documentation, anticipation of potential areas of challenge, and a clear plan for engaging with tax authorities. By proactively preparing for an audit, companies can mitigate risks, reduce the likelihood of disputes, and ensure that any audit process is handled efficiently and effectively.