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Introduction to transfer pricing in China
Transfer pricing rules
- China’s transfer pricing (TP) legislation includes the Corporate Income Tax Act (2007) Part 6 and a litany of law-equivalent tax bulletins and announcements from 2017 and onward. The legislation is based on the arm’s length principle throughout, the description of which is highly similar to the OECD Guidelines’; yet OECD is not mentioned in the China legislation. The rules are not heavily formulaic but instead are principles-based.
- The TP rules apply to China resident taxpayers as well as non-residents having China-sourced incomes. China tax authorities use a 'risk-centric' approach to govern the TP practices of taxpayers. When perceiving such risk, they may notify the taxpayer to perform a self-assessment or directly flag it for a formal TP audit procedure. Taxpayers can also activate the self-assessment protocol and adjust the income tax return, voluntarily.
- The regime is a 'one-way street', ie upwards-only adjustments are permitted. This, however, is not to be confused with the adjustments under MAP or APA, where downward ones are possible.
- The filing of intercompany transaction tables constitutes part of the compulsory filing of annual income tax returns, even for taxpayers with nil intercompany dealings. Country by Country Reporting (CbCR) is also in the income tax annual filing package, but is only applicable to larger Chinese multinational groups (over RMB5.5b).
- Under a separate scheme, transfer pricing documentation (TPD) is mandatory with different di minimis, and deadlines for preparation are provided in the rules. The scheme has three tiers -- Local File, Master File and Special Purpose File (for matters such as thin capitalization and cost sharing arrangement). Failure to fulfill the TPD obligation can result in an escalating levels of penalties, from cash penalty all the way to formal TP audit. By contrast, having a decent TPD will shield a taxpayer from penalties during a TP dispute with the authorities.
- China’s TP rules are noticeably similar to the OECD Guidelines in all the fundamental aspects, although OECD or OECD Guidelines are not mentioned in the China rules. Therefore, the quoting of OECD provisions by taxpayers for their own defense can be dismissed in a real-world TP dispute.
- Some key developments of the OECD legislations, and most notably the BEPS, are also reflected in the more recent updates of China’s TP legislations.
Transfer pricing methods
- The most appropriate pricing method should be selected to provide the most reliable measure of an arm’s length result in each case. The comparable uncontrolled price, resale price, cost plus, transactional net margin, and profit split methods are all accepted but the method used must be in line with the functional and risk profile of the tested entity or the tested transaction. Other methods can also be used if justifiable and appropriate.
- There is no set hierarchy for the selection of methods.
- China has a self-assessment regime which can be activated by taxpayers either voluntarily or under non-binding notification of tax authorities. Taxpayers shall compute the (upward) tax adjustment amount based on the arm’s length principle and lodge a specific table.
- Completing a self-assessment and voluntarily paying up the tax does not offer taxpayers immunity from a future formal TP audit, although such chances are in reality very low.
Transfer pricing documentation
Preparation of transfer pricing documentation
- Local File becomes mandatory for a Chinese entity, if its annual amount of intercompany transactions exceeds any of the following thresholds/di minimis:
- RMB 200 million for normal buy-sell
- RMB 100 million for buy-sell of financial assets
- RMB 100 million for buy-sell of intangible properties
- RMB 40 million for non-buy-sell dealings (service fee, royalty, interest and etc.).
- Regardless of the above thresholds, a single-functioned Chinese contract manufacturer, distributor or contract R&D/engineering service provider is obliged to prepare a Local File, if in loss position.
- Master File is mandatory for a Chinese entity, if its annual amount of intercompany dealings is over RMB 1 billion under aggregated basis, or if its overseas ultimate parent company has prepared one as so requested by its own country ruling.
- The due date of preparing a Local File is 30 June the following year, or of a Master File within 12 months of the ultimate parent company’s fiscal year-end. Submission of the files is not mandatory unless so requested by the in-charge tax authority, in which case the Chinese entity has 30 days to oblige.
- All the files need to be in Chinese.
Master and local file
- China TP rules provide specifically the content layouts for both Master File and (China) Local File. They are similar in terms of concepts and styles to OECD’s Master File and Local File, yet local deviations do exist. The China ruling has a stronger emphasis on 'China value' by means of location saving, market premium, local intangibles and etc.
- TP documentation must be kept for no less than ten years.
Some risk factors for challenge
- High volume intercompany transactions or multiple types of intercompany transactions.
- Consecutive loss, low margins or fluctuating profit patterns.
- Significantly lower margin than the industry/market norm.
- Profits not commensurate with the function and risk profile.
- Intercompany dealings with affiliates in tax havens or low tax jurisdictions.
- Failure in fulfilling in TP filing or TPD obligations.
- Thin capitalization.
- Deferral of dividend repatriation by a Controlled Foreign Corporation (CFC).
- Penalties in relation to failures in fulfilling TP filing and/or TPD obligations:
- Cash penalty of RMB 2,000 to 10,000 for the failure of filing TP forms, or for the failure of producing/keeping TPD
- Cash penalty of RMB 10,000 to 50,000 for the failure of submitting TPD to tax authorities (if so requested) or for submitting false or incomplete information
- For the preceding offense, tax assessment (by way of deemed profit rate) can also apply.
- For a formal TP audit procedure, interest (at the basic lending rate of China central bank), as well as a 5% penalty, will be calculated on top of the assessed back tax. The penalty, however, is waived provided the taxpayer has duly prepared TP documentations.
Economic analysis and how to demonstrate an arm’s length result
- One of the China rulings lists BvD as the preferred database for comparable searches. Nevertheless, the diversification of databases is the trend in reality.
- Local comparable companies are preferred, whilst APAC (regional) comparable companies are commoner and generally accepted.
- Using interquartile range is the norm in China, in a stricter term – if the PLI of the tested party falls in the range and is lower than the median, tax authority is legally empowered to adjust the tested party’s margin to a level no lower than the median.
- Performing capital intensity adjustment on comparable analysis is legally disallowed, save for toll manufacturing business and subject to a cap of 10% (for the difference between before and after adjustment PLIs).
Advance Pricing Agreements (APAs), dispute avoidance and resolution
- China allows unilateral, bi-lateral and multi-lateral APAs. Application will be considered only if the Chinese entity’s annual amount of intercompany transactions has exceeded RMB 40 million in the three preceding years.
- The state level authority (State Administration of Taxation, or SAT) administrates bi-lateral and multi-lateral APA applications, and delegates unilateral ones to the authorities of provincial level.
- The official targets of timeline are 24 months to complete a bi-lateral APA and 12 months a unilateral APA. In reality, the timelines could be prolonged.
- An APA in China normally covers a forward-looking period of 3 to 5 years, and provides the applicant an option of back-logging a maximum of 10 years for an ongoing TP assessment.
- China has a fairly extensive treaty network, and the Mutual Agreement Procedure (MAP) will often be available when double tax occurs.
- There is no charge for APA or MAP, but the SAT may refuse to accept a case.
- Domestic intercompany transactions are exempted from TP assessment, if the effective tax rates of the transaction parties equal.
- Notwithstanding the di minimis of TP documentation, a Chinese resident company with lower than 51% foreign ownership is exempted from preparing any documentation, if its intercompany transactions are purely domestic.
SAT and taxpayer behaviour
- China SAT used to be one of the strictest regimes of APAC for TP audit and assessment. The back tax assessed can easily cross the level of RMB 20 million for a single case.
- This trend has abated in recent years, when the SAT has been lodging less formal audit cases and encouraging self-assessment procedures instead.
- The economic fallout of COVID-19 is likely to have widespread impact and an increase in TP and general anti-avoidance enquiries globally is expected. All MNCs should be reviewing their potential exposure to transfer pricing enquiries and updating documentation accordingly.
- It is also likely that SAT will not exempt Chinese contract manufacturers or 'cost plus' service entities from challenges, if they are claiming losses because of the pandemic.
- Where supply chains have been disrupted or work brought to a halt due to lockdown measures, expected profits may not eventuate. Comparable companies will often have been affected in the exact same way as multinational groups, but evidence must be gathered and documented contemporaneously.