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China's rapid development as a global commercial centre had started to outpace some of its corporate tax rules. In order to place economic development in parity with its corporate tax system, China recently passed the Corporate Income Tax (CIT) Law, which will become effective from 1 January 2008. The Legislation contains a chapter entitled 'Special Tax Adjustments' that in part deals with the special issues related to transfer pricing. Some of these provisions will have significant impact on foreign investors doing business in China.
Cost contribution arrangements
The Legislation includes a provision codifying tax deductibility of cost contribution arrangements (CCA) payments. This is welcoming news for taxpayers, as a Chinese taxpayer under the current regime must apply for and obtain special approvals to use the CCA and to claim tax deduction of CCA payments, but few taxpayers have succeeded in obtaining such approvals. The new provision provides for tax deductibility of CCA payments although a CCA may still need to satisfy certain yet to be specified conditions in order to be recognised. We anticipate further guidance on these specifics to be forthcoming, but until then taxpayers should follow OECD principles regarding CCAs.
Transfer pricing documentation
The Legislation provides that taxpayer must prepare and maintain transfer pricing documentation, some portions of which must be contemporaneous with the annual tax filing. It also authorises the tax authority to 'deem' a taxpayer's taxable income if the taxpayer fails to provide required documentation or provide false or incomplete documentation. This provides further legal basis for China's contemporaneous documentation rules, which are expected to be issued shortly by the State Administration of Taxation (SAT). Again, until specific documentation requirements are released, it is recommended that taxpayers prepare documentation for China either in accordance with your home country requirements or follow OECD guidelines.
Special interest levy
Perhaps one of the most significant impacts of the Legislation on transfer pricing is the imposition of a special interest levy on transfer pricing adjustments. This is a significant change from the current practice where there is no interest or penalty for any transfer pricing adjustments, except for the normal tax associated with the adjustment.
The Legislation leaves the interest levy detail to the implementation rules, which will be issued later this year. It is not yet clear how the special interest levy would be calculated and whether it will be applied retrospectively. While it is possible that the interest levy may include both an interest and a penalty component, it is not clear whether a taxpayer can avoid a penalty, if any, if it makes a good faith effort by preparing contemporaneous transfer pricing documentation, for example. Possibly a penalty interest 'surcharge' in addition to the time value of money interest rate would be applied only to undocumented positions.
The SAT can make adjustments back as far as 10 years, therefore, the cost to taxpayers will increase substantially with the interest levy on transfer pricing adjustments. The Legislation provides significant added incentive for taxpayers to institute good transfer pricing policy and properly document it, to mitigate any associated adjustments and interest/penalty risks.
Commercial substance needs
The legislation introduces a general anti-avoidance rule which authorises the SAT to make adjustments where the taxpayer enters into an arrangement 'without reasonable commercial purpose'. China in the past has put much emphasis on the form of activities; now substance needs to be equally considered by taxpayers for their commercial and intercompany arrangements. It would be advised that taxpayers review the substance of their current and future commercial arrangements in China.
The impact
The new CIT law has clearly signalled that China will increase scrutiny of intercompany transactions. While the new Legislation sets a solid framework for changes to China's anti-avoidance legislation, the degree of its impact on transfer pricing will be made clearer with the issuance of the specific implementation rules.
Taking into account the provisions of the CIT, combined with the opportunity to utilise transfer pricing arrangements such as advance pricing arrangements and CCAs, we recommend that multi-nationals with operations in China act immediately to carefully evaluate their transfer pricing to ensure compliance with the arm's length principle, substance requirements, reasonable documentation and consider appropriate planning strategies.
This article is reproduced from its original publication entitled "Essential elements" June-July 2007 issue of World Finance. Copyright 2007 by World Finance. Reprinted with permission. |
