Tax

Transfer Pricing Issues in China

2014
Author:  Jason Eberhardt

Jason Eberhardt

Senior Managing Consultant

International Tax Services

375 N. Shore Drive, Suite 501
Pittsburgh, PA 15212-5866

Pittsburgh
412.364.9395

Transfer Pricing Framework

The State Administration of Taxation (SAT) regulates transfer pricing in China, which has had transfer pricing regulations in various forms since 1991. With the introduction of Circular Guoshuifa No. 2, Implementation Measures of Special Tax Adjustments, in 2009, the SAT introduced a structured transfer pricing regime.

While China is not a member of the Organisation for Economic Co-operation and Development (OECD), its transfer pricing regulations largely follow the OECD Transfer Pricing Guidelines, and the SAT has expressed support for the OECD’s ongoing Base Erosion and Profit Shifting (BEPS) initiative.

SAT Perspectives on Transfer Pricing

The SAT presented its views on transfer pricing in Chapter 10 of the United Nations Practical Manual on Transfer Pricing for Developing Countries, “China Country Practice,” many of which are consistent with the BEPS movement. Notably, the SAT has clear views regarding the pitfalls of applying commonly used transfer pricing practices to transactions involving developing countries such as China. The SAT highlighted these areas for further consideration:

Lack of Good Comparable Companies – Often there is a shortage of good comparable companies in developing countries such as China. There are few publicly traded companies, and data on private companies can be sparse or unreliable. Accordingly, transfer pricing professionals tend to use data from comparable companies within the same geographic region, including both developed and developing country comparables. From an SAT perspective, the inclusion of developed-country comparable company data skews the results of the transfer pricing analysis because capital moves differently in developing countries than in developed countries. As such, significant comparability adjustments should be applied or an alternate transfer pricing method should be considered.

Location-Specific Advantages – Location-specific advantages (LSA) are location-specific features that enable a firm to achieve a more favorable financial outcome from the production of a product or provision of service than would be achieved if the same product or service had been produced or performed in an alternative location. LSAs frequently manifest themselves in lower costs of labor, raw materials, rent or infrastructure. From the perspective of the SAT, profits related to these LSAs should be isolated in the subject intercompany transactions and allocated to the tax jurisdiction generating the LSA benefits. Accordingly, the SAT believes a significant portion of profits generated by LSAs should remain in China.

Intangible Assets – Firms often share valuable intangible assets with their Chinese related parties when they begin operations in China. These intangibles may include marketing-based intangibles such as trade names; technology, such as patents or know-how; or various other forms of intangible assets. The SAT holds that, while the Chinese related parties often start as limited risk distributors or contract manufacturers, they commonly take on greater responsibility over time, including marketing the firm’s products in local markets and recommending process improvements to the firm’s manufacturing processes. Accordingly, the SAT believes the Chinese entity is responsible for enhancing the firm’s intangible assets—by expanding the firm’s market presence, enhancing its technology assets, etc.—and, therefore, is entitled to a reduction in its royalty rate(s) commensurate with its contributions. Essentially, China becomes the owner of the local intangibles.

Overreliance on the Transactional Net Margin Method – The SAT contends the transactional net margin method (TNMM) is overused. In particular, the SAT believes the TNMM is incorrectly applied when the preparer fails to make adjustments for geographic differences or location-specific savings.

Disclosure/Documentation Requirements

Taxpayers are required to prepare related-party transaction documentation if they meet the following criteria:

  • Related-party purchase/sale transactions of at least RMB 200 million (approximately $32.5 million)
  • Other related-party transactions (such as royalties, interest and services) of at least RMB 40 million ($6.5 million)
  • Related-party transactions not covered by advance pricing agreement
  • Foreign interest in the related-party transactions greater than 50 percent

Taxpayers meeting the above criteria must include detailed information regarding their related-party transactions, e.g., related-party identities, magnitude of purchases, sales, services, intangible assets or tangible assets, in their filed tax returns. The aforementioned criteria are relevant to the upcoming documentation deadline and should be considered when preparing local Chinese documentation.

Transfer Pricing Audits

Several characteristics render a taxpayer more likely to have its transfer pricing documentation audited, including but not limited to:

  • Failure to submit annual disclosure information or failure to maintain contemporaneous transfer pricing documentation
  • Significant intercompany transaction volumes or significant number of intercompany transactions
  • Intercompany transactions conducted with tax havens, particularly those involving royalty payments or management service fees
  • Related party exhibiting profit levels clearly outside the expected range for the functions they perform and risks assumed
  • Profit levels below industry norms
  • Long-term losses or marginal/fluctuating profits


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