Key aspects of related party transactions

When the parties involved in a transaction have a related, non-independent relationship, the transaction can be considered as the transaction unusual. From a state management perspective, these unusual transactions can potentially allow related parties to avoid tax obligations to the State, so they need to be managed. This type of transaction is called a related party transaction. 

1. What is related party transaction? 

A transaction is considered related party transaction when it meets the following two conditions: 

First, the parties involved in the transaction must be related parties. 

Related parties are parties whose relationship falls into one of the following cases: 

• A party is directly or indirectly involved in the management, control of, contribution of capital to, or investment in, the other party; 

• Parties are directly or indirectly affected by the management, control of, contribution of capital, or investment, from the other party. 

Specifically: 

• One enterprise directly or indirectly holds at least 25% of the equity of the other enterprise; 

• Each of the two enterprises has at least 25% of its equity held, whether directly or indirectly, by a third party; 

• An enterprise is the shareholder having the greatest ownership interest in the other enterprise, or participates directly or indirectly in at least 10% of total share capital of the other enterprise; 

• An enterprise guarantees or lends capital to another enterprise in any form (even including third-party loans guaranteed by financing sources of related parties and financial transactions of same or similar nature) provided that the loan amount is at least equal to 25% of the equity capital of the borrowing enterprise and accounts for more than 50% of the total value of the medium- and long-term debts of the borrowing enterprise; 

• An enterprise appoints a member of the executive board responsible for the leadership or control of another enterprise provided the number of members appointed by the former accounts for more than 50% of total number of members of the executive board responsible for the leadership or control of the latter; or a member appointed by the former has the right to decide financial policies or business activities of the latter;

• Both related enterprises appoint more than 50% of membership of the executive board or have one member of the executive board authorized to decide financial policies or business activities who is appointed by a third party; 

• Both enterprises are managed or controlled in terms of their personnel, financial and business activities by individuals, each of whom is in one of the following relationships with the others such as a wife, husband, natural/foster father, natural/foster child, natural/foster older/younger sibling, brother/sister-in-law, maternal/paternal grandfather/grandmother, maternal/paternal grandchild, and maternal/paternal aunt, uncle and nibling;

• Both business entities have transactions, either between their head offices and permanent establishments or between permanent establishments of overseas entities or individuals; 

• Enterprises are put under control of one individual through either his/her capital participation into that enterprise or his direct involvement in the administration of that enterprise; 

• In other cases where an enterprise has their business activities managed, controlled or decided de facto by the other enterprise; 

• An enterprise performs the disposition or acquisition transaction in at least 25% of their equity within a tax period; the borrowing or lending transaction in at least 10% of their equity performed at the transaction time falling within a tax period with a person holding the executive office or the controlling interest in the enterprise, or with a person in one of the relationships prescribed at Point g of this Clause.

Second, transactions between related parties comprise such transaction activities as purchase, sale, bartering, renting, leasing out, borrowing, lending, transfer or disposal of commodities, provision of services; financial borrowing, lending, financial services, financial guarantee and other financial instruments; purchase, sale, bartering, renting, leasing out, borrowing, lending, transfer or disposition of tangible assets, intangible assets and agreement on purchase, sale and sharing of resources such as assets, capital, labor and sharing of costs between related parties, except business transactions in goods and services subject to price adjustments that the State makes under laws on prices. 

2. In what cases are related party transaction costs not acceptable? 

The costs of related-party transactions will not be accepted by tax authorities as reasonable costs of enterprises and will not be deducted when calculating corporate income tax if this transaction does not match the substance of arm’s length transactions or does not contribute to generating revenue or income for the taxpayer’s production and business activities. This costs of related-party transactions shall not be charged as deductible costs upon determination of the income subject to the corporate income tax within a specified taxable period, specifically including:  

• Costs of payments to a related parties that does not perform any business or production activity relating to a taxpayer’s industries or business lines; that do not have any associated rights and responsibilities to assets, commodities and services provided to the taxpayer. 

• Costs of payments to a related party that performs business or production activities, but has the scale of assets, number of employees and operating functions incommensurate with the transactional value that this related party has obtained from a taxpayer. 

• Costs of payment to a related party that is a resident entity within a country or territory that does not collect the corporate income tax, and that does not contribute to creating sales or added value for the business and production activities of a taxpayer. 

For service costs between related parties, these costs are determined as deductible costs when calculating the taxpayer’s taxable costs. These costs must: 

• Meet the following conditions: 

• The services provided have commercial, financial and economic value and are directly used in their business and production activities of the taxpayer. 

• Services provided by related parties are determined as already supplied only in the same conditions under which unrelated parties are charged for these services. 

• Service fees are paid on the basis of the arm’s length principle and the method of calculating transfer pricing or allocating service fees between related parties must be applied consistently within the entire group to payment of charges of similar services of which the taxpayer must provide a contract, evidencing documents, invoices and information concerning the method of calculation, factors of allocation and pricing policies of the group.

• Not included in the following cases: 

• The Services provided for the sole purpose of providing other related parties with benefits or values. 

• Services of which costs are repeatedly charged due to multiple related parties render the same services, without identifying the added value for the taxpayer. 

• Services which are, in nature, benefits obtained by a taxpayer as a member of a corporation. 

• The cost that a related party adds to a service provided by a third party through a related intermediary without adding any value to these services. 

3. How to limit the risk of excluded related party transaction costs

As analyzed above, it is not easy to get the cost of related party transactions accepted. In consulting practice, the author finds that to limit the risk of this fee being excluded, enterprises need to store documents proving the following issues: 

• Related party transactions are necessary and serve the business’s operations. If there is no related party providing, the business may also have to use an independent third party.

• The cost of payment to the related party is similar to that paid to similar service or goods providers in the market. 

• The related parties actually conduct transactions with each other, for example, there are documents showing that there is a request for service, and that products and services are provided, etc.  

4. Consequences if the costs of related party transactions are not accepted as reasonable and valid costs of the enterprise when calculating tax 

When the costs of related party transactions are eliminated, this reduces costs, increases profits, and leads to an increase in the amount of corporate income tax payable to the State. At that time, the enterprise will be subject to sanctions including: 

• Forced to pay a fine of 20% of the amount of tax under-declared compared to the regulations. 

• Forced to pay the full amount of tax arrears to the state budget. 

• Forced to pay the full amount of late tax payment to the state budget calculated at the rate of 0.03%/day. 

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