The cost of profit shifting - Is it too expensive?

The cost of profit shifting - Is it too expensive?

Transfer pricing adjustment is often seen simply as a matter of how much tax Multinational enterprises (MNEs) pay if being adjusted by the tax officers in a tax audit. But it’s about so much more than just numbers. Adjusting intercompany prices has a ripple effect that touches various aspects of a business, from regulatory compliance and operational efficiency to strategic planning. It's not just a concern for tax teams; it impacts supply chain consistency, corporate reputation, and overall business growth. In this article, we’ll explore why transfer pricing adjustments matter across the entire organization, highlighting the broader implications that go far beyond taxes.

Transfer Pricing adjustments: more than just about MONEY

MNEs engaged in related-party transactions (RPTs) need to ensure they comply with the arm's length principle. If these transactions are found not to align with this principle or are deemed to be intended for profit shifting, tax authorities have the right to adjust or even deem the transaction price and profit margin of the taxpayer.

The consequences of this adjustment include:

1. The immediate financial hit of Transfer pricing adjustments

One of the most immediate and tangible effects of transfer pricing adjustments is the significant increase in taxes paid by MNEs. In addition, the administrative penalties are also imposed on, including a late payment interest of 0.03% per day and a 20% surcharge on the tax shortfall. This financial strain often arises when tax authorities reassess profit margins using comparable data ranges, leading to unexpected and sometimes substantial tax liabilities. Many companies, understandably, feel apprehensive about these adjustments, as the process can appear unpredictable and subjective.

The issue lies in the selection of comparable data, in other words, the benchmarking data. This task is not straightforward; it demands the understanding of both the business's unique characteristics and the market environment in which it operates. The process involves a high degree of subjectivity, relying heavily on the expertise and judgment of the professionals conducting the analysis. It also depends on the availability and reliability of internal and external databases, which may vary significantly across different regions and industries. Additionally, economic conditions at the time of benchmarking can influence the selection of comparable data, adding another layer of complexity to the process.

Navigating this complex landscape requires not only a deep understanding of transfer pricing principles but also insight into market dynamics to ensure a fair outcome.

2. Loss carryforwards: The unseen casualty of adjustments

In the business world, profitability is the goal, yet losses are an unavoidable reality, particularly in the early stages of a company’s life cycle. In Vietnam, companies are permitted to carry forward losses for up to five years, a vital buffer for those dealing with high fixed costs, adverse market conditions, or inefficient budgeting practices. However, one of the red flags for transfer pricing authorities is continuous loss-making paired with business expansion. This often raises suspicions of transfer pricing manipulation, prompting authorities to take an aggressive stance.

Typically, new businesses need 3 to 5 years to establish operations and achieve profitability. Unfortunately, some authorities do not accommodate this natural business cycle and instead disallow reported losses, forcibly adjusting the company to a profit position. This approach not only eliminates carried-forward losses but also negates the opportunity to offset these losses against future profits within the five-year window. As a result, companies face an increased tax burden and a disrupted financial strategy.

3. Premature incentive periods: A critical issue for Start-ups

This challenge is especially critical for start-ups, as transfer pricing adjustments can significantly disrupt their carefully planned tax incentive timelines. In many cases, tax incentives are a crucial part of a start-up’s financial strategy, offering much-needed relief during their initial, often unprofitable, years. However, when tax authorities step in to adjust reported losses to show a profit, it can trigger the start of these incentives far earlier than anticipated.

For example, a start-up might have planned to utilize tax incentives two or three years into its operations, once it has moved past the initial phase of heavy investment and operational losses. However, a forced adjustment by the authorities may compel the company to start using these incentives immediately, well before it is fully prepared. This premature activation not only prevents the company from carrying forward its early-stage losses, a critical component of its financial buffer, but also derails the entire tax planning strategy.

Moreover, using these incentives sooner than intended diminishes their effectiveness and long-term benefits. These incentives are often structured to provide relief during the growth phase when the company begins generating stable profits. By activating them prematurely, start-ups lose this financial advantage just when they need it the most to support expansion and sustain operations. Consequently, this disruption can significantly impact the start-up’s financial health, growth trajectory, and overall viability in the market.

4. Adjustments that reshape business models

Transfer pricing adjustments can lead to consequences that stretch far beyond immediate tax payments; they often compel companies to rethink their entire business model and transaction flow. When tax authorities impose adjustments, MNEs may be forced to revisit their pricing strategies, reorganize supply chains, or modify intercompany agreements to meet new profit expectations. This process might involve changing the way goods and services are transferred between subsidiaries, reallocating functions, assets, and risks across the organization, or even restructuring entire business operations.

Such adjustments not only create additional administrative burdens but can also disrupt the company's daily operations. For example, supply chain modifications might result in longer lead times or increased costs, while changes in intercompany agreements can affect cash flows and internal pricing policies. The knock-on effects can ripple through various aspects of the business, including financial forecasting, inventory management, and strategic planning.

However, these changes can also present a valuable opportunity for MNEs. If the adjustments reveal underlying weaknesses in the current pricing strategies or transaction flows, this can be a wake-up call to refine the business model. By proactively addressing the issues highlighted during the adjustment process, companies can optimize their pricing strategies, streamline operational flows, and strengthen risk management across intercompany transactions.

This realignment can ultimately lead to a more robust and compliant business framework that not only meets regulatory requirements but also supports long-term growth. In some cases, these forced adjustments may drive innovation and efficiency, positioning the company to operate more effectively in an increasingly complex global market.

5. Reputational risks: The hidden costs of adjustments

Transfer pricing adjustments carry significant reputational risks, particularly for publicly listed MNEs. When tax authorities challenge a company's pricing strategies, it often becomes a high-profile issue, drawing media scrutiny and intense attention from shareholders, investors, and the public. Allegations of tax avoidance or profit shifting can have a damaging effect, as they raise questions about the company's integrity and ethical standards. Such negative perceptions can quickly erode stakeholder trust, leading to a decline in share value and a loss of investor confidence.

The long-term consequences of reputational damage can be even more detrimental than the immediate financial costs. Public skepticism towards the company's practices can alter customer perceptions, affect brand loyalty, and potentially limit future business opportunities. It can also attract closer regulatory scrutiny, creating an environment of ongoing compliance challenges. Furthermore, the reputational fallout can hinder strategic partnerships, discourage investment, and affect the company’s overall market positioning.

Conclusion

Transfer pricing adjustments are not merely a matter of additional tax payments; they impact the very core of how a business operates. From influencing tax planning and financial strategies to altering business models and affecting corporate reputation, these adjustments present complex challenges that require careful navigation.

To mitigate these risks, MNEs must approach transfer pricing with a comprehensive and strategic mindset. Transparency and compliance should be at the forefront of their transfer pricing policies, ensuring that pricing strategies are aligned with both regulatory standards and ethical business practices. Clear communication, both internally and externally, is equally crucial. Companies need to articulate their transfer pricing approach to stakeholders effectively, demonstrating their commitment to fairness and compliance. By proactively managing these aspects, MNEs can safeguard their reputation and maintain the trust and confidence of the public, investors, and regulatory authorities.



Huỳnh Sơn Hà

Accountant at Vietcombank | Ex-EY Vietnam

3mo

You are inspiring!

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Nguyen Van Hung

Tax Intern at Grant Thornton Vietnam | @DAV

3mo

Great insights. Thanks for sharing!

Le Do

The Fool from Easy Knowledge Channel | #6 Digital Marketing Vietnam| Bringing Digital Growth Solution | Digital Marketing Strategy Planner and Advisor | Issues of Enterprises Consultant (Connecting Other Fields Mentors)

3mo

Very helpful

Huynh Nhu Nguyen

Marketing is planning to bring the product to market and I always love to do that

3mo

This is insightful!

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