Improving Tax Management of Transfer Pricing Activities of Multinational Enterprises in Vietnam (LV thạc sĩ)

MINISTRY OF EDUCATION AND TRAINING
FOREIGN TRADE UNIVERSITY

DISSERTATION

IMPROVING TAX MANAGEMENT OF TRANSFER PRICING
ACTIVITIES OF MULTINATIONAL ENTERPRISES IN VIETNAM

Major: The master of International Trade Policy and Law

Full name: Le Thi Thuong

Ha Noi - 2017


MINISTRY OF EDUCATION AND TRAINING
FOREIGN TRADE UNIVERSITY

DISSERTATION

Improving Tax Management Of Transfer Pricing Activities Of
Multinational Enterprises In Vietnam

Major: The master of International Trade Policy and Law

Full Name

: Le Thi Thuong

SUPERVISOR : Assoc. Prof. Ph.D Nguyen Viet Dung

Ha Noi - 2017


i

CERTIFICATION

I hereby certify that the thesis with the title: "Improving Tax Management of
Transfer Pricing Activities of Multinational Enterprises in Vietnam" is my own
research and does not reproduce any other materials. The data indicated in the thesis
is clear, accurate and are collected from the confident sources of information.
The Author

Le Thi Thuong


ii

ACKNOWLEDGMENTS
In order to complete this thesis, besides the efforts of myself, I have received
the help, encouragement and guidance of my teachers, friends, colleagues and
family throughout the course as well as in the period of the thesis research.
Special thanks to Assoc. Prof. Ph.D. Nguyen Viet Dung, who was dedicated to
guide and help me in the process of researching and writing this thesis.
I am grateful to the teachers in the Council of Assessment who gave me the
valuable insights and comments, supporting me to complete the thesis.
I am grateful to the teachers teaching at the Faculty of Postgraduate Education
of the Foreign Trade University for the interesting and useful lectures, for the
enthusiastic transmission of the valuable knowledge and for the best conditions
offering in the process of the course.

I want to say many thanks to my colleagues working on tax department who
support me with a lot of data and information related to tax management of transfer
pricing in Vietnam and other countries.
I am grateful to my family and my colleagues for their encouragement and
supports during the course and the period of thesis research.
This thesis studies on the tax management of transfer pricing – not a new but a
very complicated issues required various knowledge, skills and practical
experiences. Thus, the thesis has the inevitable shortcomings and limitations. I look
forward to receiving valuable comments for improving the thesis.
Sincerely,
Hanoi 2017
The Author

Le Thi Thuong


iii

TABLE OF CONTENTS
LIST OF ABBREVIATIONS ............................................................................................ vi
INTRODUCTION ............................................................................................................... 1
CHAPTER 1: THEORETICAL BASIS FOR TAX MANAGEMENT OF TRANSFER
PRICING .............................................................................................................................. 8

1.1. Transfer Pricing................................................................................................8
1.1.1. The concept of transfer pricing ..................................................................8
1.1.2. Multinational enterprises and associated enterprises .............................10
1.1.2.1. Multinational enterprises ....................................................................10
1.1.2.2. Associated enterprises .........................................................................11
1.1.3. The arm’s length principle .......................................................................12

1.1.4. Transfer pricing methods .........................................................................13
1.1.5. Impact of transfer pricing .........................................................................18
1.2. Tax management of transfer pricing ............................................................20
1.2.1. The concept of tax management of transfer pricing ...............................20
1.2.2. History of tax management of transfer pricing in the world ..................20
1.2.3. Factors of tax management of transfer pricing .......................................21
1.2.3.1. Managing entities ................................................................................21
1.2.3.2. Managed objects .................................................................................22
1.2.3.3. Management tools ...............................................................................22
1.3. Experience of Some Countries in Tax Management of Transfer Pricing .23
1.3.1. China .........................................................................................................23
1.3.2. India ...........................................................................................................28
CHAPTER 2: PRACTICAL SITUATION OF TAX MANAGEMENT OF
TRANSFER PRICING OF MULTINATIONAL ENTERPRISES IN VIETNAM .... 33

2.1. Transfer pricing of multinational enterprises in Vietnam .........................33
2.1.1. The establishment and operation of multinational enterprises in
Vietnam ................................................................................................................33
2.1.2. The motives for formation of transfer pricing in Vietnam .....................36
2.1.2.1. The tax policy and incentives for enterprises with foreign direct
investment .........................................................................................................36
2.1.2.2. The difference in the tax base between Vietnam and other countries .38
2.1.2.3. The Operation Purpose and Policy of Multinational Enterprises ......39
2.2. History of formation and development of tax management of transfer
pricing in Vietnam...................................................................................................39


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2.3. Practical situation of tax management of transfer pricing in Vietnam.....42

2.3.1. Managing entities......................................................................................42
2.3.2. Managed object .........................................................................................45
2.3.3. Management tools .....................................................................................47
2.3.3.1. Legal legislation ..................................................................................47
2.3.3.2. Tax examination and audit ..................................................................53
2.3.3.3. Database used for transfer pricing analysis .......................................57
2.3.3.4. Economic development and international cooperation on transfer
pricing management .........................................................................................57
2.4. Tax Transfer Pricing Outstanding Cases in Vietnam.................................58
2.4.1. Keangnam Vina ........................................................................................58
2.4.2. Metro Cash & Carry .................................................................................60
2.4.3. Coca-Cola Beverages Vietnam Co., Ltd. ..................................................61
2.4.4. Hualon Corporation..................................................................................62
2.5. Evaluation of tax management of transfer pricing in Vietnam .................63
2.5.1 Achievements.............................................................................................63
2.5.1.1. Sufficient regulations on transfer pricing ...........................................63
2.5.1.2. Certain achievement in tax examination and audit .............................64
2.5.1.3. Training for tax officers ......................................................................64
2.5.2 Limitations.................................................................................................66
2.5.2.1. Lack of comprehensive legal framework .............................................66
2.5.2.2. Lack of comparables for determination of arm’s length price ...........67
2.5.2.3. Lack of knowledgeable and experienced human resources in tax
authorities .........................................................................................................68
2.5.2.4. Lack of database on prices and average profit margins for
comparability analysis .....................................................................................69
2.5.2.5. Vietnam position in international arena .............................................69
2.5.2.6. Insufficient application of arrangements on transfer pricing .............70
CHAPTER 3: RECOMMENDATIONS FOR IMPROVING TAX MANAGEMENT
OF TRANSFER PRICING OF MULTINATIONAL ENTERPRISES IN VIETNAM
............................................................................................................................................. 71

3.1. Orientation for recommendations ..................................................................71
3.2. Recommendations for Improving Tax Management of Transfer Pricing of
Multinational Enterprises in Vietnam ..................................................................73
3.2.1. Improving legal regulations on transfer pricing .....................................73
3.2.2. Forming database for comparability analysis .........................................75
3.2.3. Improving risk assessment in selecting enterprises subject to tax


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examination and audit .........................................................................................78
3.2.4. Establishing separate procedures for tax examination and audit of
transfer pricing.....................................................................................................79
3.2.5. Training for tax officers and tax experts on transfer pricing issues ......81
3.2.6. Coordinating between related authorities in Vietnam.............................83
3.2.7. Enhancing dissemination of transfer pricing regulations to taxpayers .85
3.2.8. Participating in international organizations on transfer pricing
management .........................................................................................................87
CONCLUSION .................................................................................................................. 89
REFERENCES................................................................................................................... 91


vi

LIST OF ABBREVIATIONS
ABBREVIATIONS
AL

MEANING

Arm’s Length

APA

Advance Pricing Agreement

CbC

Country-by-Country

CIT

Corporate Income Tax

CP

Cost Plus Method

CPM

Comparable Profits Method

CUP

Comparable uncontrolled price method

EU

European Union

GDT

the General Department of Taxation of Vietnam

GSO

General Statistics Office Of Vietnam

MNE

Multinational Enterprise

MOF

Ministry of Finance of Vietnam

OECD

the Organization for Economic Co-operation and
Development

TNMM

Transactional Net Margin Method

TP

Transfer Pricing

UN

United Nations

USD

The United State Dollar

PWC

PricewaterhouseCoopers

R&D

Research and Development

RPM

Resale price method

VND

Vietnamese dong


1

INTRODUCTION
I. The necessity of the research
Globalization gives opportunities for domestic companies to trade and invest
internationally. It is also a prerequisite for the establishment of multinational

enterprises (MNEs) with business operation of increasing diversity and complexity.
Taking advantages of preferential policies, especially tax incentives, of many
countries in attracting foreign investment, MNEs have performed a range of tricks
to maximize overall profits. In which, transfer pricing (TP) is a trick of shifting
profits among related parties of a MNE through associated transactions. TP has
become popular in the world with growingly complex and sophisticated forms,
causing tax losses and affecting the social-economic development. As a
consequence, governments always pay special attention to TP management, notably
tax management. Tax management of TP is one of the hottest issues which have
been discussed on regional and global forums. International organizations,
consisting of the Organization for Economic Co-operation and Development
(OECD) and the United Nations (UN), have provided several publications like
guidelines or model tax conventions on this issue.
In Vietnam, after approximately 30 years from “Doi Moi”, there are certain
achievements in attracting foreign investment. Registered and implemented capital
of FDI in 2016 reached USD 24.3 billion and 15.8 billion respectively, which are
the highest ever, with more than 2,500 new projects. For the first seven months of
year 2017, the sum of registered capital from new projects, additional funding and
investment in the form of capital contribution and share purchasing reached USD
21.93 billion, increasing 52 percent in comparison to the same period of 2016. To
the date of 20 July 2017, there are 23,737 effective projects with total registered
capital of USD 307.86 billion. The accumulated implemented capital of foreign
investment’s projects is estimated to reach USD 163.9 billion, equaling to 53.2
percent of total effective registered capital. Foreign invested sector also contributes
a large portion of imports and exports, accounting for more than 70 percent of total


2

export turnover and around 60 percent of total import turnover in the previous two

years. [MPI, 2017]
Although substantial amount of total invested capital, contribution of this area
to state budget is only a small proportion. According to data from General Statistics
Office of Vietnam (GSO), for the first four months of 2017, national revenue from
foreign invested sector (crude oil excluded) achieved VND 47.3 million billion,
contributing to around 23.5 percent of estimation, while the figures for private
sector and state sector are VND 52.1 and 49.4 million billion. In 2016, domestic
income from foreign invested enterprises is VND 147.7 million billion out of the
total income of VND 744.9 million billion, accounting for around 19.83 percent.
That of year 2015 is 19.06 percent [GSO, 2016]. In addition, a large part of foreign
invested enterprises report losses over the past years but still expand their business
operation. Coca-Cola is one outstanding example. Coca-Cola consistently reported a
loss, as of the end of 2011, reaching VND 3,768 million, which exceed the total
initial invested capital. Despite such losses, its revenue gradually grew from 20 to
30 percent annually.
This situation raises questions about the compliance of foreign enterprises
with tax laws and regulations of Vietnam. Vietnam government has given concerns
of tax management of foreign investment, especially TP, since the 1990s, but there
is no legal documents regulating this activity until the year 1997. At present, after
several times of amendments and supplements, Decree No. 20/2017/ND-CP dated
24 February, 2017 and effected 1 May, 2017 (Decree 20) is the document with
highest legal effectiveness governing TP. Based on such regulations and action plan
proposed by Ministry of Finance (MOF), tax examination and audit of TP have
been seriously implemented in recent years. In the year 2015, the General
Department of Taxation of Vietnam (GDT) established official Transfer Pricing
audit teams in the GDT and in four major provinces: Hanoi, Ho Chi Minh City,
Binh Duong and Dong Nai in order to conduct specialized tax examination and tax
audit.
However, up to now, legal regulations on TP have not yet completed with

3

many blind spots of policy. Besides, tax examination and tax audit of TP are limited
due to lack of practical experiences and qualifications.
From the above-mentioned reasons, the author chooses the topic “Improving
Tax Management of Transfer Pricing Activities of Multinational Enterprises in
Vietnam” for the research. Starting from theoretical basis and actual situation of TP
tax

management

in

Vietnam,

the

author

shall

make

some

necessary

recommendations on policy and practical action aiming at efficient tax management
of TP, contributing to sustainable development of the country.

II. Research situation in the world and in Vietnam
Tax management of TP is not a new issue on the research of individuals and
organizations in the world.
TP rules were introduced in domestic legislation by the United Kingdom in
1915 and by the United States (US) in 1917. The US developed TP regulations in
the Internal Revenue Code (IRC) in 1930 and TP law dated 1st July 1994. The
OECD and UN have also publications concerning this issue.
The OECD first issued The OECD Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administration (OECD guidelines) in 1995,
which was then amended and updated in 1979 and 1984. The guidelines not only
represent a consensus among OECD members on dealing with TP issues, but also a
basis for developing countries to establish their own TP regulation.
“International Income Taxation and Developing Countries” in 1988 was the
first publication of the UN on TP, which followed by a report on Transfer Pricing of
The United Nations Conference on Trade and Development (UNCTAD) in 1999.
The guideline named the United Nations Practice Manual on Transfer Pricing for
developing countries (UN Manual) which was first introduced in 2013 and revised
in 2017 by the United Nations, is one of the most important publications which
updates all TP guidance used for establishing TP regulations for countries
worldwide.
The European Council (EC) also pay attention to this phenomenon, on 17 May


4

2011, they issued guidelines on low-value-adding intra-group services. They are
endorsed on the basis that their implementation should contribute to reducing tax
disputes.
The European Commission adopts several measures which consist of the
possibility of a “common consolidated corporate tax base (CCTB)” and “home state

taxation”, using apportionment to calculate the amount of taxes to pay in one
operating country of an MNE. Apportionment would be followed an agreed
formula, based upon some criteria of business activity such as some combination of
sales, payroll, and assets. Recently, EU has also developed projects to enhance TP
dispute resolution and harmonize TP documentation requirements. In May 2011,
EC published some guidelines on low-value-adding intra-group services.
The research of Hongren, Charles and partners in the book Cost Accounting:
A management Emphasis, 12th Edition in 2006 analyzed TP management of the IRS
as well as of competent authorities in Japan and Korea. In 2013, Richardson,
Taylor and Lanis introduced the research Determinants of transfer pricing
aggressiveness: Empirical evidence from Australian firms which reported factors
affecting TP of Australian firms going online. There are a lot of researches
regarding TP and related issues of Weicenrieder, Hatem Elsharawy, Duran Timms
and other authors.
Besides, some large international independent auditing firms like KPMG,
Earn&Young, Dellotte. and PriceWaterHouseCooper provide analysis and review
on TP every year to update the actual situation and make forecast for the future.
In Vietnam, the author Nguyen Van Phuong did the research “Kiểm soát nhà
nước đối với gian lận chuyển giá tại Việt Nam” (Control of State for transfer
pricing fraud in Vietnam) in 2015. In which, the author specified the principles of
and factors contributing to controlling TP in associated enterprises, then gave
solutions to prevent TP in Vietnam. In 2012, the author Nguyen Thi Phuong Hoa
did a ministerial research project called “Tăng cường kiểm soát nhà nước đối với
hoạt động chuyển giá trong doanh nghiệp trong điều kiện hội nhập kinh tế ở Việt
Nam” (Strengthen the control of the State for transfer pricing activities of


5

enterprises in Vietnam in terms of economic integration) which systemized

theoretical basis of nature, meaning and content of state control of TP and
determined directions and measures to strengthen state control of TP in
international integration. The researcher Phan Thi Thanh Duong chose the topic
“Pháp luật về kiểm soát chuyển giá ở Việt Nam” (Vietnam legislation of
controlling transfer pricing) for her doctoral thesis, which analyzed and explained
the relationship between domestic law and international law in TP adjustment. In
2011, the GDT introduced the book “Hướng dẫn kê khai giao dịch liên kết khi
quyết toán thuế TNDN và chống chuyển giá” (Guidance on declaration of the
associated transactions in corporate income tax finalization and anti-transfer
pricing) specifying expression of TP and guiding declaration on associated
transactions. In addition, there are a wide range of books and articles of many
authors regarding TP management.
In short, there are various researches on TP management, specifically on tax
management, in Vietnam and in over the world. However, there is no work
analyzing the determinants of tax management of TP of MNEs in a systematic
manner.
III.

Object and scope of research
The object of research is tax management of TP of MNEs in Vietnam. Tax

management of TP is constituted by managing entities, object of management and
content of management.
In Vietnam, managing entities of TP include Ministry of Planning and
Investment (MPI), the MOF, including the GDT and its branches, the State Bank of
Vietnam, the State Audit Office of Vietnam, etc. However, in this research, the
author shall concentrate on the administration of the GDT and its branches on TP.
TP is formed by associated transactions among related companies domestically or
internationally, but in this thesis, only international associated transactions for
purpose of tax avoidance are analyzed. Management content in this research shall

be studied on three broad factors: legal regulations, tax examination and audit as
well as other factors.


6

IV. Research objectives
The objectives of the thesis is building the rationale for TP management,
analyzing the practical situation of TP tax management in Vietnam and
determining all factors which affect tax management of TP in Vietnam. From
above analysis and synthesis, the thesis shall make several appropriate
recommendations for improvement of tax management of TP in Vietnam. To
achieve the objectives of the thesis, following specific task shall be performed:
Specifying the rationale of transfer pricing to determine the scope and object
of transfer pricing, classify different methods of TP as well as recognize its impacts
in reality.
Studying the situation of TP management in the world, categorizing the factors
which affect TP management and analyzing how such factors have impacts on TP
management.
Investigating the practical situation of TP in Vietnam, from that evaluating the
achievement and limitations of TP management in Vietnam.
Making recommendations to enhance the achievements and overcome the
limitations of TP management in Vietnam.
V. Research methods
The research is conducted based on the methods of collecting, analyzing and
synthesizing information, processing statistical data and evaluating actual situation
of Vietnam in comparison with that of other countries in the world. The thesis also
uses case study method to have a realistic view of the issues by generating the
experience of other countries in TP management and analyzing some outstanding
TP cases in Vietnam.

VI. Expected results
The research is expected to make several contributions to theoretical and
practical basis as follows:
-

Generating theoretical base for tax management of TP of MNEs


7

-

Determining factors contributing to tax management of TP of MNEs

-

Analyzing TP activities of MNEs in Vietnam

-

Analyzing and evaluating practical tax management on TP of MNEs in Vietnam

-

Making recommendations on improving tax management of TP of MNEs in
Vietnam

VII. Structure of the research
A part from the Introduction and the Conclusion, the research is divided into
three chapters as follows:

Chapter 1: Theoretical basis for Tax Management of Transfer Pricing
Chapter 2: Practical situation of Tax Management of Transfer Pricing of
MNEs in Vietnam
Chapter 3: Recommendations for Improving Tax Management of Transfer
Pricing of MNEs in Vietnam


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CHAPTER 1: THEORETICAL BASIS FOR TAX MANAGEMENT OF
TRANSFER PRICING

1.1.

Transfer Pricing

1.1.1. The concept of transfer pricing
International trade and investment are formed and developed on the basis of
comparative advantage. A country shall specialize in producing and exporting only
those goods and services which it can produce more efficiently or, in other word, at
lower opportunity cost than other goods and services which it should import.
Comparative advantage results from different endowments of the factors of
production such as capital, land, labor) entrepreneurial skill, power resources,
technology, etc.. This is the base for domestic companies eager to invest and run
business internationally.
Globalization creates opportunity for international trade and for companies to
expand its business operation by investing to other countries. Such companies often
established legal structures such as subsidiaries, branches, joint ventures or
partnerships to operate in the recipient countries and conduct transactions with one
another and with the parent company. All legal structures as well as the parent

company are separately called associated party and together called an MNE and
transactions between them are called intra-group transactions.
According to the statistic of OECD, around sixty percent of world trade takes
place within MNEs, consisting of international transfers of goods and services,
capital and intangibles [OECD, 2012]. Those transfers are not only governed by
market forces but also by operation forces of the MNE. Therefore, in many cases,
the transfer prices of transactions between associated parties of MNEs are different
from prices set up in transactions between independent companies.
There is no official concept of TP, but several definitions are given by some
specialists and organizations. In the book of The International Taxation System by
Andrew Lymer and John Hasseldine, TP were defined as the pricing policies and


9

practices that are established when physical goods as well as services and intangible
property are charged between associated business entities [Andrew Lymer and John
Hasseldine, 2012, page 159].
According to Dezan Shira & Associates, TP referred to all types and manners
of inter-company pricing arrangements between related business organizations,
generally across international borders. These include transfers of intellectual
property, tangible goods, services, loans, and other financial transactions [Dezan
Shira & Associates, 2010].
In the view of the UN, TP is the general term for the pricing of cross-border,
intra-firm transactions between related parties. TP therefor refers to the setting of
prices at which transactions occur involving the transfer of property or services
between associated enterprises, forming part of an MNE [UN, 2013].
The OECD has not given the definition of TP, however they provide the
definition of a transfer price as a price, adopted for book- keeping purposes, which
is used to value transactions between affiliated enterprises integrated under the same

management at artificially high or low levels in order to effect an unspecified
income payment or capital transfer between those enterprises.
The OECD guidelines make it clear that the concept of TP should not be
confused with tax fraud, or tax avoidance, even though TP transactions may be used
for such purposes [Michelle Markham, 2004].
In the scope of research in this thesis, the Author supposes that: “Transfer
pricing activities or transfer pricing (transfer pricing) is the establishment of
transfer prices for properties, regardless of tangibles or intangibles, which are
different from market prices of such properties, between associated enterprises of
an MNE for the purposes of tax avoidance, which contributes to maximum the
overall profits.”
From the above definition, TP is occurred in case of (i) transactions between
associated enterprises of an MNE, (ii) transfer price different from market price,
and (iii) for the purpose of tax avoidance.


10

TP can be occurred in the transactions between associated enterprises of an
MNE, this is because such transactions are governed by both market force and
MNE operation force, in which operation force is outweigh the market force.
One of the bases for evaluating the TP of associated enterprises is market
price, also called AL price. Transfer price in TP is different from market price, it
may be lower or higher than market price. Establishment of such prices shall
significantly reduce tax liability in country with higher tax rate but marginally
increase tax liability in other country with lower tax rate. This leads to substantial
decrease in overall payable tax amount of MNE. In some cases, maybe the transfer
price set up within an MNE is in accordance with AL price. In such cases, the MNE
is considered as not doing TP and their transactions are not included in the scope of
this research.

1.1.2. Multinational enterprises and associated enterprises
1.1.2.1. Multinational enterprises
According to the OECD in the publication “OECD transfer pricing guidelines
for Multinational enterprises and Tax administrations”, MNE is a group of two or
more associated parties operating in more than one law jurisdiction [OECD, 2010].
Why MNEs implement transfer pricing
Since the relationship between associated parties comes from overall interests,
the concern of an MNE is overall benefit but not separate benefit of each associated
parties. By utilization advantages of operation in different countries, MNE is able to
relocate the revenue and cost for all associated parties to minimize overall tax
liability, or in other words, maximize gross profit of the group. The adjustment of
revenue and cost results in the establishment of intra-group prices for transactions
between associated parties which are not priced on the demand and supply basis.
Further, thank to operating in different countries, MNEs can detect the
countries with favorable business environment, policy incentives, especially
incentives on taxes. In addition, each entity has its right to freely make decision on
any matter of business operation within legal framework. Therefore, they can decide


11

the transacted price of products or services with the others in certain transactions.
The establishment of price policy within the group keeps the overall interests
unchanged, but it may alter their overall tax liability. Through pricing arrangement,
tax liability is moved from the countries with higher tax burden to that with lower
tax burden. Based on specific social – economic policy, the tax policy and tax
incentives for enterprise with foreign capital are often different.
Another motive for MNE can do TP is the transfer of intangible properties.
The intellectual properties such as the monopoly of technology or know-how of the
mother company are secured while expanding its business to different countries. It

is better to transfer its business secrets within the group than to another independent
company. With the aim of expansion, other intellectual rights, for example, the use
of license, trademark, trade name, consultancy, are also transferred to associated
parties. It is difficult to estimate the real value of such transferred property.
Therefore, an MNE can change the transferred value of intangibles to shift profits
from one party to others to achieve the goals of increasing gross profit.
1.1.2.2. Associated enterprises
In common, the word “associated” means connected or amalgamated with
another company or companies. 1
The “associated enterprises” (AE) was defined in OECD Model Tax
Convention article 9 as an enterprise of a country participates directly or indirectly
in the management, control or capital of an enterprise of the other country, or the
same persons participate directly or indirectly in the management, control or capital
of two enterprises in different countries.
There is no specific common guidance on associated enterprises both in the
Commentaries on Article 9 in the UN and OECD Models and in the OECD
guidelines. This is mainly because TP issues are relevant only if special conditions
have been made or imposed between two parties.

1

Longman Dictionary


12

Management, operating or capital contribution factors are conditions which
affect the harmony of interests of those enterprises and also the basis for
determining the associated relationship. Thus, associated enterprises can be formed
in the same country or maybe in many different countries. From there, TP is not

only taking place in international transactions that can both in domestic
transactions. In fact, the transfer of interest rates is usually assessed for international
transactions due to significant differences in tax policies between countries.
Meanwhile, because all companies have to comply with national treatment, the tax
liability resulting from domestic transactions is almost the same.
In the scope of this thesis, TP is researched in international transactions
between associated parties of an MNE.
The definition of an “associated enterprise” is based on domestic
circumstances and hence the concept of one country differs from, to some extent,
the concept of other countries. However, all of them are established under the
relationship of capital, management or control.
Associated transactions are understood as transactions which are concluded by
associated enterprises.
1.1.3. The arm’s length principle
The arm’s length (AL) principle is promulgated by the OECD in Article 9 of
The OECD Model Tax Convention on Tax and on Capital. It is also mentioned in
OECD guidelines. According to the Guidelines, conditions to determination of TP
are made or imposed between the two enterprises in their commercial or financial
relations which differ from those which would be made between independent
enterprises, then any profits which would, but for those conditions, have accrued to
one of the enterprises, but, by reason of those conditions, have not so accrued, may
be included in the profits of that enterprise and taxed accordingly. [OECD, 2010]
In the Manual of the UN, the AL principle is seemed as an international
standard that compares the price in transactions between related entities with the
price in similar transactions conducted by independent entities. The transfer price


13

between unrelated parties is often called AL price. All different values of AL prices

constitute an AL range. If the price established between associated parties is not
outside the AL range, it may be directed to a TP action. Therefore, in certain
circumstances, the market consisting of unrelated parties is the measure for
verifying transfer prices for transactions between associated entities.
However, in reality, it is rare to have two identical transactions. Therefore, to
determine whether a controlled transactions complies with AL principle or not, it is
necessary to use comparable transactions with certain differences which can be
reasonably adjusted to eliminate such differences.
1.1.4. Transfer pricing methods
To assess whether a price compliance with the AL principle or not, several
approaches are applied, called “transfer pricing methods”. According to the OECD
classification in the OECD guidelines, TP methods can be divided into two broad
groups: transaction-based methods and profit-based methods.
Transaction-based methods:
Comparable Uncontrolled Price (CUP): This method is used to determine
whether an transactions is controlled or not by comparing price for transaction
between related parties (controlled transaction) to price for transaction between
unrelated parties (uncontrolled transaction) in comparable circumstances.

Associated enterprise 1

Unrelated Entity A

Associated Enterprise 2

External

Unrelated Entity B

Figure 1: Comparable Uncontrolled Price Method

Transaction between two Associated Enterprises is controlled transaction.


14

Transaction between Associated Enterprise and unrelated party or between two
unrelated parties called uncontrolled transaction.
Comparable circumstances of two transactions can be made if there are no
differences in transactions being compared that would materially affect the price or
material differences can be reasonably adjusted.
Reasonable adjustments may be possible for several differences such as the
type and quality of the product, delivery terms, volumes of sales and related
discounts, product characteristics, contractual terms, geographical factors. Unique
and valuable trademarks or fundamental differences in the products are features
which cannot be reasonably adjusted in this method.
This method is a direct measure of determining AL price through involving a
direct transactional comparison. The content of this method is clear and easy to
understand and the result is reliable. However, in many cases, it is hard to find
comparable uncontrolled transactions in accordance with comparability standards,
especially transacting intangibles such as services or intellectual properties.
Therefore, this method should be applied when one of the associated entities of the
transaction is involved in uncontrolled transactions with an independent party or in
the transactions of tangible commodity with minor differences between different
types.
Resale Price Method (RPM:) This method is used to determine the price to be
paid by a reseller for a product purchased from an associated enterprise and resold
to an independent enterprise. The purchase price is established so that the margin
earned by the reseller is sufficient to allow it to cover its selling and operating
expenses and make an appropriate profit corresponding to its performs and the risks
it incurs.

Associated
Enterprise 1

Arm’s length
Price?

Associated
Enterprise 2

Given Price

Figure 2: Resale Price Method

Independent
Enterprise


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If the given price is USD 10 and the resale price margin (gross profit margin)
is 20 percent, the AL price shall be USD 8.
The factor needs to consider in this method is gross profit margin. Comparison
can be made if there are no differences between the transactions being compared
that materially affect the gross margin or the differences can be reasonably adjusted.
In this method, it is functional comparison more than transactional
comparison. Therefore, product differences are less important in this method than in
CUP method. In determination of AL price in this method, several issues need to
take into account including how substantial value the reseller add to the product, the
level of activities performed by the reseller, how significant the seller perform in
commercial activity in relation to the resale activity, whether the reseller has the

exclusive right to resell the goods, the differences in accounting practices.
This method should be used to determine the gross margin of full range of
products of a sales company, not only separate product type. It is more appropriate
for situations where is a weak relationship between the costs incurred and the sales
price of the goods. However, this method is not a direct transactional comparison
and it is difficult to find comparable data due to accounting inconsistencies.
Therefore, it is applied when CUP method is not applicable or the sales company do
not own valuable intangible properties.
Cost Plus (C+ or CP): This method analyzes appropriate prices of properties
charged by supplier to a related buyer by adding to costs of the supplier an suitable
gross margin, so that the supplier can make an appropriate profit in accordance with
market conditions and functions performed.
For example, if the cost of Associated Enterprise 1 is USD 500, and the gross
profit markup is 50 percent, the AL price is USD 750.
The critical factor in this method is determining gross profit margin.
Comparison can be made if there are no differences between the transactions being
compared that materially affect the gross profit markup or the differences can be


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reasonably adjusted.
To use this method in determining AL range, a number of potential difficulties
need to consider, for example, the link between costs incurred and the market price,
the differences in the level and types of expenses in connection with the functions
performed and risks assumed between controlled and uncontrolled transactions,
costs should be excluded from the cost basis.
This method is based on internal costs of the MNE, so the information is
available for applying this method. However, there are some obstacles when using
this method, for instance, weak link between costs and market price, no comparable

data on gross margin due to accounting inconsistencies.
The method is based on the cost of associated enterprise and its gross profit
mark up, so it is appropriate for manufacturing or assembling company or relatively
simple service providers.
Profit-based methods:
Two classes of transactional profit methods are recognized including profitcomparison methods (Transactional Net Margin Method or TNMM/Comparable
Profits Method or CPM) and profit-split methods.
Profit comparison methods (TNMM/CPM):
The TNMM determines the net profit margin relative to an appropriate base
realized from the controlled transactions by reference to the net profit margin
relative to the same appropriate base realized from uncontrolled transactions.
Ideally, operating margin should be compared to operating margin earned by
same enterprise on uncontrolled transaction. This method is applicable for any type
of transaction and often used to supplement analysis under other methods.
TNMM has almost become the ‘default’ method for taxpayers in recent years.
The key advantage of the TNMM is that there is often available data in the public
domain about the net profits that comparable independent businesses earn from their
trading activities in comparable markets with other third parties. As such, the


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TNMM often proves easier to apply than the CP or RPM methods, and TNMM is
less sensitive to minor differences in the products being sold.
The main disadvantage of the TNMM is that because there is typically
insufficient information in the public domain to be certain, the comparable
companies are truly comparable to the tested party.
Profit Split Method (PSM)
This method seeks to determine the way that a profit arising from a particular
transaction would have been split between the independent businesses that were

party to the transaction. The PSM divides the profit based upon the relative
contribution of each related party business to the transactions enterprise as
determined by their functional profile and, where possible, external market data.
Over recent years we have increasingly seen multinational groups apply a
profit split as the basis of their TP policies. For many it is because globalization
requires that they manage their business along divisional lines with the consequent
scant regard to the profit profile of the underlying legal entities.
In many cases, the increasing importance and value of a group’s Intellectual
Property (IP) and the often shared nature of the development of that IP, and the
attached business risks, may lead taxpayers to the PSM.
Despite the advantages of the PSM, there are significant difficulties in
applying it in practice. The simplicity of the requirement in the OECD Transfer
Pricing Guidelines to split the profit between the parties, ‘on an economically valid
basis that approximates the division of profits that would have been anticipated and
reflected at AL’ reduces the difficulty in working out what profit should be shared
and the relative contribution of each participant to the profit share.
Profits arising today may have been the result of work undertaken by one of
the businesses many years in the past. Conversely, including all costs in the profit to
be shared could allow some participants to ‘export’ the cost of their own
inefficiency to others.