C HINA B RIEFING The Practical Application of China Business In association with Transfer Pricing Associates JIANGXI SHANXI NINGXIA HUI A. R. SHAANXI JIANG- SU HENAN HUBEI SICHUAN YUNNAN HAINAN GUIZHOU HUNAN ANHUI ZHE- JIANG FUJIAN GUANGDONG GUANGXI ZHUANG A. R. QINGHAI GANSU XIN JIANG UYGHUR A. R. TIBET A.R. HEBEI INNER MONGOLIA A. R. CHONGQING SHANGHAI Hohhot Yin- chuan Taiyuan Xi'an Lanzhou Xining Urumqi Jinan Nan- jing Zhengzhou Wuhan Nanchang Fuzhou Taiwan Guangzhou Haikou HONG KONG MACAU Changsha Guiyang Chengdu Lhasa Kunming Nanning Shijiazhuang Hefei Hangzhou HEILONGJIANG Harbin JILIN LIAONING Shenyang BEIJING TIANJIN SHAN- DONG Changchun Designing and Implementing a Transfer Pricing System Identifying the Relevant Business Context Transfer Pricing Disclosures and Documentation Tax Return Disclosures Managing China Compliance Preparing Documentation Transfer Pricing Risk Management Transfer Pricing Audits and Enforcement Income Adjustments Penalties and Interest Managing an Audit Advance Pricing Arrangements Cost Sharing Agreements Thin Capitalization Transfer Pricing in China
Transcript
CHINA BRIEFINGThe Practical Application of China Business
In association with Transfer Pricing Associates
JIANGXI
SHANXI
NINGXIAHUI A. R.
SHAANXIJIANG- SUHENAN
HUBEISICHUAN
YUNNAN
HAINAN
GUIZHOUHUNAN
ANHUI
ZHE-JIANG
FUJIAN
GUANGDONGGUANGXIZHUANG A. R.
QINGHAI
GANSU
XIN JIANG UYGHUR A. R.
TIBET A.R.
HEBEI
INNER MONGOLIA A. R.
CHONGQING
SHANGHAI
Hohhot
Yin-chuan
Taiyuan
Xi'an
Lanzhou
Xining
Urumqi
Jinan
Nan-jing
Zhengzhou
Wuhan
Nanchang
Fuzhou
Taiwan
Guangzhou
Haikou
HONG KONG
MACAU
Changsha
Guiyang
Chengdu
Lhasa
Kunming
Nanning
Shijiazhuang
Hefei
Hangzhou
HEILONGJIANGHarbin
JILIN
LIAONINGShenyang
BEIJING
TIANJIN
SHAN-DONG
Changchun
Designing and Implementing a Transfer Pricing SystemIdentifying the Relevant Business ContextTransfer Pricing Disclosures and DocumentationTax Return DisclosuresManaging China CompliancePreparing DocumentationTransfer Pricing Risk ManagementTransfer Pricing Audits and EnforcementIncome AdjustmentsPenalties and InterestManaging an AuditAdvance Pricing ArrangementsCost Sharing AgreementsThin Capitalization
Transfer Pricing in China
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Published by Asia Briefing Ltd.
All rights reserved. No part of this book may be reproduced, stored in retrieval systems or transmitted in any forms or means, electronic, mechanical, photocopying or otherwise without prior written permission of the publisher. Although our editors, analysts, researchers and other contributors try to make the information as accurate as possible, we accept no responsibility for any financial loss or inconvenience sustained by anyone using this guidebook. The information contained herein, including any expression of opinion, analysis, charting or tables, and statistics has been obtained from or is based upon sources believed to be reliable but is not guaranteed as to accuracy or completeness.
Designing and Implementing a Transfer Pricing SystemIdentifying the relevant business contextDesigning and implementing a systemTransfer pricing controversy management
Transfer Pricing Disclosures and DocumentationRelated party transactionsTax return disclosuresContemporaneous transfer pricing documentationManaging China compliancePreparing documentation
Other Transfer Pricing TopicsAdvance pricing arrangementsCost sharing agreementsThin capitalization
APPENDICES .....................................................................................................67Appendix 1: Manual for Responsibility CentersAppendix 2: Related Party Transaction Disclosure Forms Appendix 3: Enterprise Function and Risk Analysis Form
CONTENTS
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Transfer pricing is a reality for any multinational company. Tax authorities need to protect their revenue base and are actively enforcing the arm’s length principle
for pricing of intra-group transactions. This means that detailed transfer pricing documentation is required and that companies need to disclose related party information on tax returns, as well as prepare themselves for possible audits.
If designed and implemented early in a business life, a transfer pricing system can complement and support an MNC’s business model and commercial objectives, as well as optimizing its global effective tax rate.
Recent developments in China, including the release of comprehensive transfer pricing regulations in early 2009, have sent a very clear signal that the mainland is no exception to this rule.
This book explores transfer pricing, providing practical guidance on what is best practice transfer pricing design, how to document your related party transactions, how to manage overall transfer pricing risk and how to defend your position in the event of scrutiny.
China’s economy and tradeChina’s phenomenal growth and increasing prominence in the world economy are well known and documented. As the largest developing country in the world, China has become an increasingly important part of the international economic community. Measured by total gross domestic product, China is likely to become the second largest economy in the world by 2010.
Foreign-invested enterprises have become the major driver behind the expansion of global trade in China. From 1990 to 1997, FIE imports constantly exceeded exports, thanks in large part to the import of capital equipment and technology. Since 1998 however, the situation has reversed and FIEs are now able to generate sufficient production, enabling China to recognize significant and growing trade surpluses. It was only in 2008 and the onset of the global economic slowdown that China's trade surplus has begun to decline as a percentage of GDP.
An Introduction to Transfer Pricing in China
CHAPTER 1
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China’s tax system
The primary tax authority in China is the State Administration of Taxation. The SAT is a ministry-level organization, which is immediately affiliated with the State Council and takes control of taxation from a strategic, regulatory and oversight perspective. Within the SAT, the International Tax Department is responsible for anti-tax evasion.
The SAT has established state tax bureaus in every province, autonomous region and special municipality. These tax bureaus are responsible for the collection and administration of taxes that generate revenue for the central government and for the collection and administration of taxes that generate revenue shared by the central and local governments. The local tax bureaus, on the other hand, are responsible for the collection and administration of taxes that generate revenue only for their respective local governments.
The SAT announced in July 2008 that it was engaging in a significant restructuring exercise. Under this restructuring, the Large Enterprise Tax Administration Department (LEAD) was formed to focus on large enterprises (a term not yet defined). The International Taxation Department will remain in charge of transfer pricing policy, bilateral advance pricing arrangement (BAPA) and mutual agreement procedures (MAP). The expectation is that this change will bring about higher levels of compliance from large taxpayers as well as establish stronger communication channels between large taxpayers and the SAT.
The number of staff focused on transfer pricing at the SAT level is very small – understood to be less than ten – and historically there have been inconsistencies in the interpretation and application of transfer pricing principles at the provincial, state and local levels. Through an extensive training process as well as the release of detailed circulars and guidance on transfer pricing, the SAT has been able to manage this resource constraint
Exports Imports1 United States Japan2 Hong Kong South Korea3 Japan Taiwan4 South Korea United States5 Germany Germany6 Netherlands Malaysia7 United Kingdom Australia8 Singapore Philippines9 Russia Thailand10 India Russia
Source: PRC General Administration of Customs
China’s major trading partners are listed in the table below.
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and ensure that transfer pricing will be more systematically and consistently enforced in the future. The SAT indicated in March 2009 their intention to develop around 500 transfer pricing specialists over the next three years.
Transfer pricing
Transfer pricing concerns the prices charged between associated enterprises established in different tax jurisdictions for their intercompany transactions.
Multinational enterprises are growing in number and complexity and are increasingly integrating their operations globally. As a result, they transfer large quantities of goods and services among operating subsidiaries in different countries as well as engage in a range of transactions relating to services, intangible property and financing activities.
The pricing system for such transfers across borders within multinationals creates considerable managerial and tax problems owing to its direct effects on the profits of both parties and the taxable revenue of all countries involved in the transactions.
The diagram below gives an overview of the types of activities and the corresponding inter-company transaction that will be caught within the definition of transfer pricing.
The arm’s length principle
The OECD Transfer Pricing Guidelines provide that the “arm’s length principle” should be used to establish the price of transactions between associated enterprises. The guidelines require a comparison between what the taxpayer has done and what an independent party would have done under the same or similar circumstances.
The arm’s length standard is applied by comparing controlled transactions with transactions between independent enterprises based on “economically relevant characteristics." Comparability is achieved if:
No differences between the controlled and uncontrolled transactions exist The differences that do exist do not materially affect the condition being examined
Supply of raw materials Purchase of finished goods Supply of right to use group IP Supply of know-how Supply of services Supply of bank and credit guarantees Supply of loan finance
Payment for raw materials Charge for sale of finished goods Payment of royalties Payment for know-how Payment of service fees Payment of guarantee fees Payment of interest
Foreign MNC
Subsidiary in China
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Reasonably accurate quantitative adjustments can be made to eliminate the effect of any differences
The arm's length principle uses the behavior of independent parties as a guide or benchmark to determine the allocation of income and expenses in dealings between related parties. In seeking price comparisons for the product flow between the two associated companies A and B, Company A may use its own sales to an unrelated company as the benchmark. If such transactions are unavailable the next best approach is to investigate sales of similar products between completely independent companies in the open market.
The increasing prominence of transfer pricing
Transfer pricing has been rising in prominence for several decades. The first interest in transfer pricing came from the United States and the desire to protect the U.S. tax base from erosion in view of the increasing presence of Japanese MNCs establishing distribution operations there. Japan soon reciprocated and Australia and other countries closely followed with transfer pricing legislation and investigation.
The issue then gained wider recognition in Europe with several countries introducing legislation and enforcement regimes. Asia, with the exception of Japan, has been a little slower to recognize transfer pricing as a significant issue, which is partly a reflection of its level of economic development and need to attract foreign investment. However, in the last five years this position has changed dramatically. Most Asian countries (including Singapore, Malaysia, Thailand, Vietnam, India and South Korea) now have transfer pricing guidelines in place and are beginning to enforce them, in some cases very actively and vigilantly.
Transfer pricing in China
A number of factors, global and China-specific, have brought the transfer pricing issue to the forefront of the SAT’s attention. These include:
The increasing globalization of the Chinese economy and increasing significance of imports and exports as a proportion of GDP
The tendency for FIEs in China to rely on intellectual property and services provided by overseas related parties
The introduction of tough transfer pricing regimes in China’s key trading partners Accession to the World Trade Organization in 2001 has resulted in a reduction in tariff rates, which creates greater revenue pressures
Tax policy changes generally, including introduction of dividend withholding tax and uniformity of the corporate tax rate to 25 percent as of January 1, 2008, increased the incentive for MNCs to use transfer pricing to influence effective tax rates
The tendency for FIEs in China to declare operating losses – over 50 percent are in
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this category; the perspective of the Chinese authorities is that a large part of these losses can be attributed to transfer pricing
The tougher economic climate that is facing China and the world will most likely put even greater emphasis on scrutiny of transfer pricing practices, as the SAT needs to compensate for generally lower tax revenue from other sources as the level of business transactions and spending declines.
Transfer pricing regulatory timeline
The following is a summary and timeline of the development and enforcement of the transfer pricing regime in China.
Transfer pricing legislation was first introduced in 1991 by the National People’s Congress under the Income Tax Law of the People's Republic of China for Enterprises with Foreign Investment and Foreign Enterprises. Under Article 13 of the law, the tax authorities had the right to make reasonable adjustments if transactions were not carried out at arm’s length and, thus, resulted in a reduction of taxable income.
On April 23, 1998, the SAT issued comprehensive transfer pricing regulations entitled “Tax Administration Rules and Procedures for Transactions between Related Parties” (SAT Circular No. 59). This circular contains 52 articles and 12 chapters which standardized transfer pricing examination and audit procedures. These regulations were reflected and amended in the “Taxation Administration Rules for Business Transactions between Associated Enterprises” (Guo Shui Fa [2004] No. 143).
On September 20, 2004, the SAT issued the "Implementation Rules for Advance Pricing Agreements for Transactions between Related Parties" (Guo Shui Fa [2004] No. 118). The implementation rules set out detailed guidelines on Advance Pricing Agreement (APA) procedures.
On February 28, 2007, the SAT issued Guo Shui Han [2007] 236 to state their position with respect to the expected profitability of the FIEs and foreign enterprises in China which undertake a sole-function of manufacturing for their overseas parent companies.
On March 16, 2007, the Enterprise Income Tax Law of the People’s Republic of China (State Council Order No. 63 of People’s Republic of China) was passed and came into effect from January 1 2008. The new EIT Law includes a range of measures designed to strengthen transfer pricing compliance and enforcement in China, as well as a range of other measures including thin capitalization, controlled foreign companies and anti-avoidance regulations. The regulations relevant to transfer pricing are contained in Chapter 6 of the legislation. This was followed by the release of the “Implementation Rules of the Enterprise Income Tax Law in People’s Republic of China,” promulgated by State Council on December 6, 2007.
On March 27, 2007, the SAT issued Guo Shui Han [2007] No. 363 stipulating specific documents and information to be submitted by enterprises and the local-level tax bureaus to the SAT during transfer pricing audits.
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On April 2, 2008, the SAT released the “Draft Administrative Regulations of Special Tax Adjustment (Trial)” to begin an extensive period of feedback and discussion on the form of the final version of the regulations.
Guo Shui Fa [2008] No. 114, issued on December 17, 2008, detailed the related party disclosure forms that will be required to be completed and submitted by all taxpayers with any related party transactions along with their 2008 tax return on or before May 31, 2009.
Finally, the SAT released the “Implementation Measures of Special Tax Adjustments (Trial Version)” (Guo Shui Fa [2009] No. 2). These transfer pricing regulations are the first comprehensive document from the SAT incorporating provisions on contemporaneous documentation requirements as well as other aspects of transfer pricing, including guidance for conducting audits and investigations, thin capitalization, controlled foreign corporations, APAs and cost sharing agreements.
The table below provides a list of each chapter of China's transfer pricing regulations and the relevant section of this book where they are discussed in further detail.
China’s transfer pricing regulations Chapter reference
1 General provisions -2 Reporting of related party transactions 33 Administration of contemporaneous documentation 34 Transfer pricing methods 25 Transfer pricing investigations and adjustments 56 Administration of advance pricing arrangements 67 Administration of cost sharing agreements 68 Administration of controlled foreign corporations -9 Administration of thin capitalization 610 Administration of General Anti-Avoidance -11 Corresponding adjustments and international consultation 512 Legal obligations 5
This guide takes a look at all aspects of transfer pricing in China. Written specifically for businesses that want to develop a transfer pricing strategy for China, it details the transfer pricing regulations of China, how to design and implement a transfer pricing system, how to collect and properly file transfer pricing documentation, and how the prepare for a transfer pricing audit by the Chinese authorities.
China Briefing’s guides are leaders in their field, providing practical and pragmatic legal and tax information to foreign investors in the PRC. They will interest all business people, lawyers, accountants and academics working in the field.
