China's tax system has experienced great changes in 1994, with rapid economic development creating a necessity for the tax system to grow and adapt, and new laws are continually being implemented to replace outdated laws. According to Commissioner of the State Administration of Taxation, one of the main tasks for the 10th five-year plan (2001-2005) is to carry out further reform on the current tax system. It is expected that the 11 th five-year plan will continue along the same lines. Additionally, China's accession to WTO required changes in areas such as import duties and its changes such as these, which are in turn driving other changes in order to maintain revenue balance. With these China has been improving its collection and management systems and regulations in relation to these.
China is currently not a member of the Organization for Economic Co-Operation and Development, otherwise known as OECD, though it does have observer status. Chinese regulations in relation to cross border business have largely been formulated on the recommendations set out by the OECD and incorporate ¡§arm's length principle¡¨. These regulations specify that should an enterprise fail to conduct business with its related parties at arm's length, and that business results in profit shifting out of China, China may adjust the pricing and tax the deemed income accordingly. Up until recently China was quite lose on its interpretations of what constituted arms length and pricing, however with its ever-increasing need for tax revenues it is becoming more sophisticated. Consequently, companies need to ensure that they can justify their practices, prepare adequate documentation to support these and be in a position to defend these should they be investigated.
Criteria for being investigated
China's regulations provide that transfer-pricing reviews can be conducted on target companies, target companies being those that meet the following criteria's:
• Continuing losses (greater than 2 years).
• Marginal profits or losses with expanded operations.
• Erratic Profits.
• Lower than average profit margins for the industry the company operates in.
• Payment of unreasonable fees to overseas related party companies.
• Sudden drop in profits after tax holiday
Recent regulations have enhanced the scope of possible investigation targets. Under previous transfer pricing circulars, the normal period of investigated was three years, however in
April 2004 the SAT extended the transfer pricing adjustment period up to ten years under special circumstances. Guoshuifa (2003) No. 47 provided that it was possible for the SAT to request details of all inter-company transactions of FIEs whereby special circumstances were deemed as:
• Cumulative inter-company transactions > US$12,000.
• Inter-company transactions with companies incorporated in tax havens.
• Company has not provided sufficient documentation (on pricing for example).
• SAT is expected to adjust income from inter-company transactions > US$60,000
Given that most foreign companies have transactions that fall within the confines of special circumstances, it provided the SAT opportunities for much greater investigation.
Circular 70 was issued on June 9, 2004 aimed at strengthening transfer pricing enforcement efforts on a nationwide basis. The circulars provide clear evidence and measures that the SAT has become increasingly sophisticated in the transfer pricing area since Circular [1998] 59 and Circular [2003] 47. SAT also recently issued Circular 370 to all the subordinate tax bureaus on the various aspects of anti-avoidance/transfer pricing audit to be undertaken in 2004. The key components where:
1) Information Sharing and Use
There would be greater co-operation amongst tax officials. For example, tax officials in different locations are now required to share information on high-risk taxpayers and provide to the SAT suggested targets for national joint transfer pricing audits.
The anti-avoidance tax officials are also required to share information with tax officials in-charge of other taxation such as income tax, turnover tax and customs, and other regulatory bodies, e.g. Ministry of Commerce, Administration of Industry and Commerce, etc.
2) Adjustments
After a transfer pricing investigation has been completed, the tax authorities may adjust the relevant taxable amount if it is deemed that the RPT does not abide by the "arm's length" principles.
The adjustments may be based on the following four principles including:
• the pricing of the same or similar business transactions between unaffiliated enterprises (uncontrolled transactions method),
• the profit margin obtainable if the goods were resold to a non-affiliated party (resale price method),
• the cost plus a mark-up% (cost-plus method) and
• other reasonable methods (non-specified methods).
3) Tailor-Made Software
A new internal tailor-made software is being used by the tax authorities in some provinces for the detection of prospective transfer pricing irregularities. The software reviews a companies financial information and statistics in relation to industry norms and where there are variances in key performance indicators its provides details of possible adjustments between it and the industry statistics. The issue with this for companies is that no one company is ever the same, products can very tremendously and some of the Chinese industry catelog categories are quite wide in their scope. Consequently, companies which are being good corporate citizens but just happen to work on lower margins than other competitors in order to win business and survive might be reviewed for investigation, therefore required to justify its practices. This can be both time consuming and troubling, especially to smaller organizations.
4) Filing Requirements
When related parties transactions (RPT) occur, the taxpayer now has an obligation to submit a declaration form. If there is only one category of transaction with the related party, declaration form A should be submitted, which needs to be completed on an annual basis and returned to the tax authorities within four months of the end of the tax year. Where there is greater than one category of RPT conducted, a type B form need to be submitted.
5) Consequences and Penalties
There are no specific penalties detailed in the transfer pricing taxation laws or regulations.
However, if the taxpayer had any tax payable resulting from a transfer pricing investigation, the taxpayer would need to settle the payment within the time limit prescribed by the authorities. If the taxpayer failed to do so within the time limit, a surcharge of 0.05% per day would be imposed. For serious violations, the taxpayer may face tax penalties of up to five times the amount of understated taxation.
The key question on penalties on transfer pricing, is there a difference of opinion or is there deliberate tax evasion, which may give rise to penalties ranging from 0.5 to 5 times of the tax underpaid and interest thereon at 18.25% per annum.
Another worrying question is where the Customs Bureau fit within these rules. For instance, a company importing raw materials at a lower price in order to make profits in China, therefore best utilizing its tax concessions, could be argued by the Customs Bureau for having too low a price and therefore reducing import VAT and import duty payable. Transfer pricing issues are not usually criminal offences, customs duty though can be seen as criminal.
It should also be remembered that in China, the taxpayer bears the burden of proof during transfer pricing disputes, it is therefore vital that proper documentation and support for your transfer pricing polices be carried out.
Why prepare documentation
Many companies attitude towards related party transaction is that if questioned they will pull something together.
However, if SAT requested information, companies need to provide detailed supporting documentation and information within 60 days. Given that under Circular 47 the tax man can venture back ten years, and given that most larger corporations would have had staff turnover or have been reorganization during this time, 60 days is not very long. It also should be remembered that China has no obligation to follow OECD mutual agreement procedures on adjustments, meaning that if there is any adjustment in China a company might not be able to obtain a corresponding adjustment in it home jurisdiction, therefore it being effectively to double taxed.
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Documents requirements
Companies preparing documentation to support their related party transactions should look to prepare the following principal documentation, plus of course anything addition requested by the tax man.
• A description of the taxpayer's organizational structure,
• An overview of the taxpayer's business,
• A description of the method selected and an explanation of why that method was selected,
• A description of the alternative methods that were considered,
• A description of the controlled transactions (including the terms of sale),
• A description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made,
• An explanation of the economic analysis and projections relied upon in developing the method
It must be remembered that the tax man does not necessarily know a companies business or understand it, and therefore by providing some basic information on structure, what the business does, how this compares with competitors etc., the company can firstly make the tax mans life easier, secondly, it can bring individual identity to the company versus the tax mans industry statistics.
The documentation process
1) Gathering of background information.
2) Review of risks to company
3) Review of benchmarks and industry norms, China and internationally.
4) Collection of supporting documentation, spreadsheets, financials etc.
1) Background information:
Background information should include a) Qualitative information, such as Corporate background, inter-company transactions and related party transactions, industry and market overview, China and internationally, highlighting trends, norms etc. relating to common business practice, and b) Quantitative information, such as copies of audited financial accounts and taxation filing forms, financials by product, type of product etc.. This later item depends on the company, how best to categorize / segment.
2) Review of benchmarks and industry norms, both Chinese and International
The purposes of risk assessment are to review what the company does, risks undertaken, assets employed and importance to each business unit, segment or product category. This includes manufacturing, research and development, procurement, sales and distribution, marketing, finance and administration, etc. It could also include a review of internal costing systems and allocation basis. It might take into account business risks which can include market risk, inventory risk, credit risk, foreign exchange risk etc., as well as intangible risks can include patents, technical know-how, trademarks, trade names, brand names, etc. Key behind this is to determine the individuality of the company versus the industry. No company is ever alike in terms of its current stage of development and the risks it is taking in doing business.
3) Pricing method selection
A review of benchmarks and industry norms is required, which would include a selection of comparables, internal and external information relative to the different transfer pricing methods the company wished to use. Comparable Uncontrolled Price (¡§CUP¡¨) would use straight price comparisons, a selection of an internal transaction basis for Resale Price Method (¡§RPM¡¨) or Cost Plus Method (¡§CPM¡¨). Also for consideration are other methods, such as Profit Allocation Method etc., and the comparable information required to justify this as a reasonable method of choice. It must be remembered that the selection of method should be based upon economic substance. At least three methods must be chosen for testing of pricing of which two must support current pricing methods. Testing requires allocation of the business to segments, categories, and selection of products which best represent these, an analysis of pricing of products relative to chosen methods, identification of comparables, benchmark analysis and review of differences relative to business and its risk assessment.
External comparables might not be easily to locate, especially in China, plus the competition are not likely to part with such information readily. Also, the level of comparability is sometimes questionable, since companies can be in different stages of development, different operational structures, top of market, bottom of market, sub/niche markets etc.
Meanwhile internal comparables can be limited for SME's and for larger companies there might not be consistency across the group. Examples of documentation for external comparables and information on market and industry, would be internet downloads of third party comparables, press cuttings, industry background, prices lists, corporate structure, advanced pricing agreements, brochures and catalogs, Price lists (can use dummy company or advisors to request pricing from competitors), marketing materials, management accounts and reports, internal presentations and business plans, Government statistics on products, industry etc.
What constitutes quality documentation ?
Poor Quality Documentation
• No Analysis of functions, risks, assets, market conditions & business strategies.
• No taxpayer documentation or process to enable a check on selection of methodologies.
• No comparables review.
• Poor application of documentation to methodology and comparables.
• No review or demonstration of implementing arms length principles.
High Quality Documentation
• Sound analysis of functions, risks, assets, market conditions & business strategies.
• Selection of method fully supported with documentation.
• Comparables, internal and external.
• Application of documentation with clear direction and easy to follow.
Clearly shown effort to support methodology and application or arms length principles.
Preparing necessary documentation
All information presented to the tax authorities, including government and corporate documents and explanations on pricing, should be translated into Chinese.
For the provision of labor services taxpayers should present materials showing whether the enterprise accepting the services of an associated enterprise obtains actual benefits and services fees paid or charged are reasonable, plus copies of services agreements covering these. For financing transactions taxpayers should present materials showing the normal interest rates of the concerned transactions and justification for the various fees and expenses.
Summary
Transfer-pricing planning is a dynamic process, which requires constant review and fine-tuning, it is not a science, in other words there are no black and white answers, everything is open to determination through proper supporting evidence of practices and methodologies. Taking into a larger context, this can refer to any related party transaction over the past ten years.
The real challenge in China is to balance conflicting demands of local and international pricing rules in order to avoid double taxation, as well as the different interpretation of the rule and requirements by the different tax bureaus within China.
The approach of the Chinese authorities is tough and practical, but as long as companies put all the necessary procedures in place and complete all the necessary documentation then companies can avoid any penalties and possible double taxation, not to mention the headaches of investigation and audit.
Russell
Brown, Managing Partner, LehmanBrown International Accountants
beijing@lehmanbrown.com
Telephone: +86 10 85321720
This article was published in the November 2004 edition of Eurobiz magazine.
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