Nov 2009
By Spencer Chong, Cecilia Lee, Charles Chan and Paul Tang, PricewaterhouseCoopers China and Hong Kong
The issuance of Guo Shui Fa [2009] number 2 titled "Implementation Measures of Special Tax Adjustments (Trial)" - commonly referred to as Circular 2 - in January 2009 marked a significant step-up in China's transfer pricing enforcement regime.
With Circular 2, China's State Administration of Taxation (SAT) aimed to combine China's previous transfer pricing regulations with their practical audit experiences over the last decade, and to introduce a number of new concepts - contemporaneous transfer pricing documentation, thin capitalisation, controlled foreign corporation, cost sharing arrangements, and general anti-tax avoidance.
The SAT is fully aware that it was very ambitious to include so many complex international concepts in Circular 2. As mentioned by one official, the intention was to "set the foundation for future developments as the new Corporate Income Tax Law will be in force in the next 10 to 15 years".
In fact, the connotation that Circular 2 is a trial (as stated in the title) provides the SAT with flexibility to issue future circulars to interpret and clarify the concepts - after they have accumulated more practical experience in the respective regimes.
There have been many transfer pricing developments in the first 200 days since the issuance of Circular 2.
Further circulars issued
In the months following the issuance of Circular 2, the SAT has issued additional tax circulars in an effort to clarify many unclear issues in Circular 2.
Guo Shui Han [2009] number 72 (dated 17 February 2009) entitled "Publication of the Implementation Requirements on 2008 Annual Reporting Forms for Related Parties Transactions' covered some interesting points:
- The SAT provided companies with detailed explanatory notes on how to complete their 2008 annual reporting forms for related party transactions to be filed with the relevant tax authorities.
In Guo Shui Han [2009] number 188 (dated 16 April 2009) called "Enhancing Follow-up Administration on Transfer Pricing Adjustments":
- The SAT imposed a five year monitoring period on transfer pricing audit cases in China with adjustments concluded after 1 January 2008.
- The deadline to submit contemporaneous documentation during the five year monitoring period is 20 June. For the 2008 year, the deadline is 31 December 2009.
- The SAT suggested that the local-level tax authorities establish and improve their transfer pricing monitoring system. In a situation where an advance pricing arrangement (APA) has been initiated by a taxpayer, the local-level tax authorities should keep up their monitoring efforts until the APA is signed and settled.
In Guo Shui Fa [2009] No. 85 (dated 29 April 2009) entitled "Strengthening Tax Collection and Administration, Preventing Tax Evasion / Avoidance and Increasing Tax Revenue": The SAT provided guidance to the local-level tax authorities on how to strengthen tax collection administration in 2009 upon tax evasion / avoidance investigation matters. This guidance consisted of:
- Strengthening the nationwide information system integration;
- Focusing and driving investigation upon the following specific industries: garments, electronics, communication equipment, computers and so on;
- Commencing general investigation efforts on the following industries: fast food, retailing, beverage manufacturing, lifts and escalators manufacturing, and automobile manufacturing industries;
- Commencing transfer pricing investigations on the following industries: financing for infrastructure, tire manufacturing, pharmaceuticals, and hotels;
- Maintaining focus on the reasonableness of intercompany royalties and service charges amongst multinational enterprises; and
- Challenging taxpayers for retaining profits in overseas tax havens to defer or avoid China tax liabilities.
Ji Bian Han [2009] number 49 dated 4 June 2009 and entitled "Launch of the Self-Assessment Exercise for the Second Batch of Large-Scale Business Groups" revealed:
- The SAT had selected the second batch of 36 large-scale business groups to carry out self-assessments from 2005 to 2007; and
- The names of the 36 large-scale business groups were stated and detailed guidance was provided as to how to carry out the self-assessments.
Guo Shui Han [2009] number 363 dated 6 July 2009 called "How to Strengthen Supervision and Investigation of Cross-Border Related Party Transactions" stated that:
- Chinese entities established by multinational enterprises that have limited functions and risks should not bear the risks associated with market policies and decision-making during the current financial crisis. Those limited function / risk entities should maintain a reasonable level of profit pursuant to the functions and risks matching principle;
- Entities that undertake limited functions but incur losses should prepare contemporaneous documentation and other related documentation for the year in which the losses occurred and submit that documentation to the in-charge local tax authorities before 20 June in the following year; and
- The local tax authorities are urged to investigate the cases where the losses are shifted to China or the profits are shifted to tax havens.
The issuance of the various tax circulars listed above indicates that in 2009 the Chinese tax authorities are focusing their transfer pricing administration on the protection of China's tax base during the economic downturn.
The SAT requires the tax authorities to strengthen transfer pricing investigations on the industries that are less influenced by the financial crisis, such as garment and footwear manufacturing, fast food, automobile, tire manufacturing, and pharmaceutical industries.
Accordingly, the SAT further asks multinational enterprises not to allocate losses to their Chinese subsidiaries with limited functions and risks. The SAT also believes that foreign-owned Chinese subsidiaries with limited functions and risks should be protected from any economic volatility due to their functional and risk profile.
All stakeholders are busy
The SAT has been very active in recent months to ensure that all stakeholders understand the content of Circular 2 and the rationale behind it. The SAT has been providing training to local tax officials, stepping up enforcement, and collecting feedback.
In March 2009 the SAT held a full-day seminar in Beijing to provide an open dialogue with taxpayers to explain key points of Circular 2 and to listen to their feedback. The opening speech was delivered by Wang Xiao Ping, director of the International Taxation Department. Some of the key messages he had were:
- The SAT will have bilateral APA negotiations with the competent authorities of Japan, Korea, Singapore, US, and Denmark in 2009;
- The SAT would increase information collection via internal and external databases and by exchanging information with treaty partners;
- The SAT would beef up national and regional joint transfer pricing audit enforcement in future years and expand its specialised investigation team to 500 officials nationwide over the next three years; and
- After the taxpayers' presentation and Q&A sessions, the SAT acknowledged that Circular 2 does not answer all questions and that they would set up additional channels or issue further circulars to clarify their positions.
In June 2009 the SAT conducted an online Q&A session and shared the following:
- There are no safe harbour rules for related-party transactions - each would be assessed on a case by case basis.
- Taxpayers' reimbursement items should be regarded as one of the related-party transactions in completing their related-party transaction disclosure forms and included in the calculation of the RMB40 million ($5.8 million) contemporaneous documentation exemption threshold for related-party transactions that are not purchases / sales of tangible goods (for example royalties, services and interest).
- Transfer pricing principles / adjustments could affect the amount of Chinese business tax incurred by an entity.
- The SAT also reinforced that no transfer pricing investigation or adjustment would be made with respect to intra-China domestic related-party transactions if the effective corporate income tax rates of related parties are the same. The effective corporate income tax rate should be calculated as:
Actual corporate income tax paid (by taking into consideration any preferential tax treatment, accumulated losses and government subsidiaries) divided by taxable income.
In July 2009 the SAT visited various regional tax authorities and asked them to increase the number of officials handling the increasing workload on transfer pricing audits and documentation review. The SAT also issued questionnaires to large enterprises to collect information relating to their transfer pricing compliance.
In August 2009 the SAT conducted training at their Taxation Training Centre located in Yangzhou for national tax officials who have been identified to specialise on transfer pricing audit cases.
In September 2009 the SAT led a pharmaceutical industry-focused national transfer pricing training in Xi'an. Practitioners from the big four accounting firms and representatives from some companies in the industry were invited to share their experiences and views.
Local tax authorities' busy too
The local-level tax authorities are learning the new concepts and have started national audits on specific industries and have begun asking for transfer pricing documentation.
In August 2009 some local tax authorities requested 2008 transfer pricing documentation from taxpayers even before the official special deadline of 31 December 2009.
Between June and September 2009 some local tax authorities issued initial documentation requests to companies in specific industries (as mentioned above) to collect related-party transaction reporting information. Some started to ask for valuation reports of the company and are trying to evaluate the transfer pricing impact of restructurings.
From the taxpayers' perspective
Taxpayers are busy preparing documentation and evaluating their transfer pricing position and strategies.
Up till 31 May 2009 taxpayers in China were very busy with filling in and compiling the related-party transaction disclosure forms. There are many uncertain areas relating to the forms. The SAT has collected feedback from taxpayers and is expected to revise of the forms for 2009. In addition, the administration is likely to intensify the updating and maintenance of its national electronic database, which will facilitate future exchanges of information among different tax authorities throughout China.
Companies that are subject to the contemporaneous documentation compliance requirements for 2008 must complete the documentation by 31 December 2009. Companies reporting losses in 2008 should take extra care in explaining their loss positions given the requirements of Circular 363.
Many companies are also revisiting their FY2009 transfer pricing policies as year-end approaches. In particular companies should consider how these reconcile with their existing structure and their 2008 transfer pricing position. Companies should also see this as an opportunity to revisit the tax efficiency of their structures and make any necessary changes before the books are closed at year end.
Bilateral dispute resolution
More companies are contemplating applying for an APA to manage their transfer pricing risks in China. There are about 40 bilateral APA cases under discussion. There have been 12 bilateral APAs concluded between China and other countries. The countries involved have been Japan, the US, Korea, and Denmark. In the last 200 days, the SAT has met with the competent authorities of Japan, Korea, Singapore and Denmark to discuss bilateral APA cases and other matters relating to cross-border dispute resolution.
There will be trouble in reconciling the different interests of the tax and customs authorities. Multinational enterprises doing business in China may find that income tax and customs authorities have different rules for testing arm's-length prices. Therefore, it will be difficult for taxpayers to balance the implications of transfer pricing and customs duties in cases of customs valuation audits, transfer pricing investigations, and transfer pricing self-adjustment.
The development and release of the contemporaneous documentation requirements have been monitored by the customs authorities. Furthermore, the annual related-party transaction reporting forms prepared and submitted by taxpayers may also contain some information that is useful to the customs authorities. (For instance, the transfer pricing methods and the status of intangibles disclosed in Form 3 and Form 5 could be used by the customs authorities for customs valuation purposes.) There have been cases where the customs authorities require the enterprises to provide transfer pricing documents when conducting customs valuation audits.
According to a recent interview with an SAT official, the Chinese tax authorities have been aware of the customs issues related to transfer pricing arrangements, and they have been trying to coordinate with the customs authorities about adjustments. However, it is also acknowledged that there is no protocol or effective mechanism agreed upon and set up with all authorities involved to deal with the issue.
What to expect in the next 200 days
The SAT has been very determined in stepping up its transfer pricing enforcement. The tax authorities will likely ask for the submission of transfer pricing documentation in particular from companies in the targeted industries (such as the pharmaceutical industry).
In response to the recent economic downturn, the SAT has issued various circulars to stress the need to protect China's tax base and ask companies not to shift losses to China. It is expected that there will be more challenges from tax authorities on loss making companies in 2010.
The SAT has started their learning curve on various international tax concepts as introduced in Circular 2 (such as controlled foreign corporations, thin capitalisation, and general anti-avoidance). Over the last few months we have seen some authorities starting to look into these issues, including anti-tax avoidance enquiries about group restructuring. These activities indicate that the SAT is keen to put these concepts into practice.
This article is reproduced from its original publication entitled "China's new transfer pricing rules: the first 200 days" in the November 2009 issue of Transfer Pricing Week (TP Week). Copyright 2009 by Transfer Pricing Week. Reprinted with permission.
