Transfer pricing solutions in China.

Imagine a cake with pieces of onion in it! The onion represents taxation payable, and the cake mix is the sweet profits from conducting business. Which piece of cake would you most prefer to eat, the piece with less onion and the more sweet mix, of course. Taxation planning, including transfer pricing, is geared towards this.

Through formulating inter-company service and purchasing contracts, organisations are able to realise profits in low-taxation countries and shift profits around to assist in offsetting losses in others – thereby giving you more cake and less onion! Whilst transfer pricing has long been an acceptable taxation strategy in China, the current government is tightening the tax loopholes at a rapid pace and catching many companies in breach of the law at the same time.

By increasing the reporting requirements of Foreign Enterprise Income Tax Returns and conducting aggressive tax audits of foreign firms, the Chinese State Administration of Taxation (SAT) is making sure that it gets its fair share of the global taxation cake.

With the government also abolishing the dual-track corporate taxation system and phasing out preferential tax rates and tax holidays in line with WTO requirements, it may appear that China is no longer the lucrative business environment it was in the late 1990s.

On the contrary, it simply means that foreign companies must now be even more up-to-date with current laws and regulations. Similarly, firms must now, more than ever, formulate a water-tight international tax strategy and have the audit trail and documentation to justify it.

What does the tax man say?

Transfer pricing in China is governed by Article 13 of the Income Tax Law for Foreign Investment Enterprises and Foreign Enterprises and Article 24 of the Law Concerning the Administration of Tax Collection.

Since this legislation was first introduced in 1991, a time when China was attempting to lure as many Foreign Invested Enterprises (FIE) as possible into China, the regulations have been further tightened through the SAT, issuing a series of rulings (Guoshuifa).

Through these regulations, the PRC government has adopted international practices to govern transfer pricing based on comparable uncontrolled transaction principles, such as the OECD and US methodologies. Using these as guides, Chinese regulations stipulate that inter-company transactions and transactions between ‘associated entities’ should be priced using arm’s length principles.

The test of association between entities is based on control and ownership. Essentially entities are considered associated if they fall into any of the following:

Ownership:

• Not less than 25% shareholding
• A provision of loans which accounts for not less than 50% of the owner’s capital
• A provision of a guarantee on loans accounting for not less than 10% of the company’s total loans

Control:

• The legal representative or not less than half of the directors or executive management are appointed by another organisation
• The business operations are dependant on the provision of proprietary technology of another enterprise
• The purchase of raw materials or components or the sales of products are controlled by another enterprise

Once entities are regarded as being associated, the firm must classify all related inter-entity transactions and account for them according to the arm’s length transaction principle. This applies to tangible assets, intangible assets and inter-company service transactions.

According to legislation, tangible assets must be priced based on a transaction basis using one of three methods:

1. Comparable Uncontrolled Price Method (CUPM), whereby the price is determined according to comparable transactions between unrelated parties. This could be based on a market price or an internal price using the price paid or charged to independent third parties.
2. Resale Price Method, whereby gross profit margin is determined according to what is appropriate profit if it were an independent business. This is based on the functions performed, the assets used, and the risks assumed by the reseller.
3. Cost-plus Method, whereby the price is based on a markup comparable with a similar transaction with an independent seller.

However, given the difficulty in sourcing reliable public data in China, in reality, the tax authorities also consider other methods to price transactions as appropriate. These use a profit-base approach, where the price is determined based upon performance measures of a comparable company and/or industry, and include:

1. Comparable profits method, where the price is based upon profit measures taken from uncontrolled taxpayers that engage in similar business activities
2. Profit split method, where the price is based upon the allocation of group profits by relative contribution to the combined profits
3. Global Profit Allocation, where the price is based upon a formula using a yardstick to allocate the group profits. Such could be costs, turnover, capital, etc.

Intangible assets – no method is specified, but it must be based upon agreeable charges between unrelated parties.

Services – these should be charged at standard rates (i.e arm’s length) as with unrelated parties where no influence can be exerted over the price.

The idea behind the move towards using the arm’s length transaction principle is that it provides parity of tax treatment for FIEs and local enterprises. Whilst China is conforming with WTO requirements to open its market and lower barriers to entry for foreign firms, it would only appear reasonable that it also assists in providing a more level playing field for its own burgeoning domestic corporations.

The strategy

With new legislation expanding tax collection powers to a greater number of local government bodies, provincial governments offering differing preferential tax incentives and the central government announcing a crackdown on FIE’s dodging tax burdens, there has never been a more opportune time for companies to get their taxation strategy in order.

Before embarking on trying to reduce taxes in one country, move profits to another, repatriate funds etc., a company must determine what its objectives are. These must be determined globally before local objectives can be clarified.

Additionally, there are significant risks involved for companies that do not ensure methodology in their taxation and transfer pricing decisions, not just in China. One example of this risk is when a local company had been using transfer pricing to repatriate management fees for a number of years, only to be audited by authorities who decided that fees are not deductible for tax purposes. The company suddenly was faced with a massive tax bill plus interest payments and, even more importantly, penalties of up to five times the amount of under-reported taxation.

In China, the taxation authorities have a duty to audit:

1. Companies which report losses for more than two consecutive periods
2. Enterprises showing fluctuating profits
3. Enterprises showing profits lower than industry standards
4. Enterprises having transactions with affiliated companies in tax havens

Given that the holding companies of most foreign companies’ China operations come from various tax havens (e.g. B.V.I, Cayman Islands) or Hong Kong, which in itself allows tax-free status for holding entities, the tax department has a lot of audits to perform in the coming years. But, having trained more than 1000 employees for transfer pricing audits alone, they are well on their way.

With this in mind, the best way for FIEs to minimise their risk of a transfer pricing adjustment is to prepare, prepare and prepare. Taking the view that you will be audited at some stage in the future is always the safest way to play the tax game.

To be proactive, organisations should prepare an Advance Pricing Agreement (APA) stipulating their dealings with associated entities to present to the taxation authorities for sign-off. This APA can both be presented to cover future dealings as well as past transactions. It also provides organisations with the chance to plead their case if there is a legitimate reason that their transfer pricing costs differ from industry norms, thus avoiding unnecessary scrutiny at later stages.

Similarly, companies should take the opportunity to upgrade and tighten their internal controls and financial systems. Whilst incorrect transfer pricing may well be an unintentional mistake, the government will most likely take the hard-nosed approach and classify such errors as intentional misreporting.

Firms must also ensure that they record and maintain all documentation to support their transactions in case of an audit. By being able to present authorities with a clear audit trail and information (preferably in Chinese), companies may be able to avoid an otherwise arduous and unpleasant experience.

Finally, companies who operate in China, or have dealings with Chinese entities, must ensure that they fully understand the law and its implications for their organisation. Ignorance is certainly no excuse for illegal transfer pricing policies, and the SAT will certainly not be terribly understanding of companies who claim that they just did not realise.

The end game

Whether you are already in the China market or looking to enter, determine what your priorities are first and then seek professional advice to ensure that these are met within the context of the prevailing taxation rules and regulations.

Gone are the days when foreign firms could bask in tax havens and take advantage of extended tax holidays. Now, if you want to have your cake, you may have to eat some of the onion too!