Under the influence of the period globalizationNowadays, countries tend to open their markets and attract foreign investors, especially multinational corporations, in order to develop their domestic economies.
However, when participating in the market, investors always try to utilize various methods to maximize their benefits, causing erosion of the tax base and shifting profits through transfer pricing. So, what is tax base erosion? What is transfer pricing? What are the different forms of transfer pricing?
1. Challenges from tax base erosion and profit shifting
Base erosion and profit shifting (BEPS) is a practice used by multinational corporations to shift profits from high-tax jurisdictions to low-tax jurisdictions. BEPS is becoming increasingly common through transfer pricing, e-commerce, thin capitalization, tax havens, etc. According to financial experts, BEPS is a form of tax evasion by taxpayers.
Many businesses have exploited loopholes and limitations in tax policies in the countries where they operate to transfer profits to countries or territories with lower or zero tax rates.
According to statistics from the Organization for Economic Cooperation and Development (OECD), the loss of state revenue from corporate income tax is approximately 4%–10% of global corporate income tax revenue, equivalent to $100–240 billion per year. This shows that BEPS (Business Performance Permit System) is becoming a worrying trend, significantly impacting the investment and business environment, undermining the transparency of the tax system, leading to unfair tax competition between countries, and increasing the risk of tax compliance for taxpayers.
Undeniably, BEPS is now a global issue, with reciprocal impacts between countries (between investing and host countries), and has become a major challenge for governments, especially developing countries. According to the OECD, BEPS is particularly important for developing countries because taxes are the main source of government revenue, especially corporate income tax.
However, recently, the most evident manifestation of "tax evasion/tax avoidance" has been "transfer pricing" by businesses, primarily focusing on FDI enterprises and cross-border transactions in the e-commerce sector. Some foreign businesses with e-commerce operations and income generated in Vietnam have not fully fulfilled their tax obligations.
2. Actions of the Vietnamese Government
To ensure the effective and efficient implementation of BEPS solutions, and to further refine these solutions during implementation, the OECD has established a Joint Cooperation Forum comprising OECD and non-OECD member countries and the G20 to jointly implement the BEPS Joint Cooperation Forum globally, including developing countries. Participation in the Joint Cooperation Forum will provide countries with the necessary support to implement effective BEPS prevention solutions, helping to protect revenue and the tax base.
Recognizing this, and in order to proactively prevent BEPS, Vietnam has taken relatively strong measures to address the abuse of its tax agreements with other countries. Accordingly, since 2015, the Ministry of Finance has coordinated with international experts to conduct a preliminary review of the contents of the Action Program against BEPS and has identified the most high-risk and urgent issues related to BEPS for Vietnam.
Vietnam is committed to implementing at least four actions within the overall 15-action package aimed at preventing BEPS (with timelines and roadmaps depending on Vietnam's economic development and international integration requirements). Essentially, these standards align with the key tasks that the Vietnamese Ministry of Finance is implementing during the 2016-2020 period. Specifically:
firstIn the field of e-commerce: The Ministry of Finance will draft general guiding legal documents based on international practices regarding management methods and applicable policies, especially for cross-border business transactions; applicable tax rates for electronic products and services; and consider and study the application of regulations on the conditions for establishing a permanent establishment in the field of e-commerce in accordance with international practices.
MondayIn the field of tax agreements: Review, amend, and supplement regulations to combat tax evasion/avoidance under the Agreement; Research and apply mechanisms for resolving disputes through bilateral agreements; Propose the signing and negotiation of multilateral tax agreements; Report to the Government on participation in international multilateral tax agreements and participation in multilateral forums on tax administration and information exchange.
Tuesday, In the area of transfer pricing: On November 5, 2020, the Government issued Decree 132/2020/ND-CP regulating tax management for enterprises with related-party transactions, replacing Decree 20/2017/ND-CP dated February 22, 2017, which regulated tax management for enterprises with related-party transactions. The timely issuance of these documents provides tax authorities with "more powerful and flexible" management tools to improve the effectiveness of tax management for enterprises with related-party transactions.
Wednesday, In the field of taxation: Review regulations on tax incentives and exemptions, consider and supplement regulations on the ratio of interest expense to equity that can be included as a deductible expense when calculating corporate income tax, and include this in the proposed amendments to the Corporate Income Tax Law.
3. What is transfer pricing?
Transfer pricing is the practice by which business entities (primarily multinational corporations – MNCs) and affiliated companies implement pricing policies to alter the exchange value of goods, services, and assets in their relationships with parties within the group or affiliated group, deviating from market prices, with the aim of minimizing the amount of tax payable by the entire group. Other objectives include market dominance and rapid capital recovery in host countries.
Transfer pricing practices erode the tax base and shift profits (BEPS) to countries with lower tax rates.
4. Starbucks is a prime example of transfer pricing.
Starbucks is one of the world's leading coffee brands. Starbucks operates in many countries and generates billions of dollars in revenue. Besides its home country of the United States, the UK is Starbucks' largest market. The UK market alone is capable of generating less than $1 billion annually for Starbucks.
At the end of September 2012, Starbucks had 593 stores. But a year later, that number had dropped to just 549. Despite the decline, the number of Starbucks stores in the UK is still enormous for any coffee brand.
However, sometimes scale of operations and revenue don't correlate with profit. High revenue doesn't necessarily mean high profits. In fact, profits can even be negative. Starbucks' operations in the UK market are a prime example of this.
In 2012, Starbucks announced revenue of £413 million (equivalent to $658 million) in the UK market, a 4% increase from the previous year. This exceptionally high sales figure resulted in a loss of £30 million for Starbucks. This was unusual, but for those interested in Starbucks, this unusual situation turned out to be normal, given that Starbucks' high revenue followed by heavy losses had been a recurring theme for the past 15 years.
Starbucks has clearly explained the reasons for its losses. Although Starbucks in the UK is doing well, revenue doesn't cover costs because Starbucks has to pay a large "royalty fee" to its parent company. This "royalty fee" is determined by the parent company, not by market forces. A similar situation occurred with Coca-Cola in Vietnam, where Coca-Cola had to pay exorbitant prices for exclusive raw materials to its parent company.
To achieve this goal, they established a network of interconnected parent and subsidiary companies, following the principle that the more complex and intricate, the better. The parent company was headquartered in an area with low tax rates.
Subsidiary companies in high-tax countries often lack financial and accounting autonomy, pay exorbitant royalties and brand fees, and even pay interest to the parent company to shift profits out of the high-tax country, eroding the tax base.
5. What are the causes of transfer pricing?
Objective reasons
- Firstly, transfer pricing activities stem from the freedom of self-determination (the right to buy and sell products and services at desired prices) of economic entities in business sectors and product lines permitted by law.
- The strong context of globalization has forced governments to open up their economies. This has created favorable opportunities for multinational corporations (MNCs) to expand their business operations by establishing subsidiaries and branches abroad, forming a "link" in the transfer pricing scheme.
- Objective factors stemming from differences in tax policies, accounting and auditing systems, and foreign direct investment (FDI) attraction strategies of various countries create favorable conditions for multinational corporations to develop transfer pricing strategies.
- Controlling multinational corporations extends beyond the control of a single nation.
Subjective reasons
- The legal framework and policy mechanisms related to controlling transfer pricing activities in many countries (especially in developing and least developed countries) still have many limitations and are incomplete.
- Multinational corporations (MNCs) possess immense economic power and highly advanced corporate and financial management skills. Meanwhile, recipient countries often have significant limitations in the expertise of their tax, financial, and customs officials. This disparity makes it easier for MNCs to conceal their transfer pricing activities.
6. Some signs of transfer pricing
Some key indicators of transfer pricing include:
- Businesses that report losses for two or more consecutive years since their establishment;
- Businesses that experience alternating periods of profit and loss, or unusual profit and loss patterns;
- Businesses engage in transfer transactions with businesses in countries with low tax rates;
- The company has significantly lower profit margins compared to other companies in the same industry or within the same group.
- Businesses with production costs that are significantly lower or higher than the market average;
- The company has major buying and selling transactions, accounting for a high proportion, with affiliated companies;
- FDI enterprises are subject to the control of their parent companies regarding input and output prices.
See more:
- Learn about transfer pricing – Part 2: Transfer pricing practices of multinational companies in Vietnam
- Learn about transfer pricing – Part 3: Classification of related-party transactions and the principle that substance determines form
- Learn about transfer pricing – Part 4: Instructions on some aspects of the application form and documents.