How
Transfer Pricing can be the icing on your cake!
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 loop-holes at a rapid pace, and catching many companies
in breach of the law at the same time.
Through
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 1990's.
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 taxation strategy and have the audit
trail and documentation to justify it.
Transfer
pricing in China is governed by Article 13
of 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 as 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 organization.
·
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 upon market price or an
internal price using the price paid or charge 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 upon the functions performed,
the assets used and the risks assumed by the reseller.
3) Cost-plus Method, whereby the price is based upon a
mark-up comparable with a similar transaction with an independent
seller.
However,
given the difficulty in sourcing realiable 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 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 tax payers 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 FIE's
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 there taxation strategy in order.
Before
embarking on trying to reduce taxes in one country, move profits to
another, repatriating 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 where 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 purpose. 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:
a)
companies who report losses for more than two consecutive periods;
b)
enterprises showing fluctuating profits;
c)
enterprises showing profits lower than industry standards; and,
d)
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 FIE's to minimize 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 pro-active, organisations should prepare an "Advance
Pricing Agreement" (APA), stipulating its 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 the China, or have dealings with Chinese
entities, must ensure that they fully understand the law and 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 advise
in ensuring 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!
Cameron
Hume , LehmanBrown - Beijing.
