Jul 2009
On 6 July 2009, China's State Administration of Taxation ("SAT") issued a notice providing further guidance on the treatment of loss making entities that are routine in nature. An unofficial translation of Guo Shui Han [2009] No. 363 ("Circular 363") is provided below along with our observations on the implications this notice creates.
Guo Shui Han [2009] No. 363 - The Notice issued by SAT to strengthen the supervision and investigation of cross-border related party transactions.
To the offices of the state tax bureaus and local tax bureaus of all provinces, autonomous regions, directly administered municipalities and municipalities separately listed on the state plan:
In order to further standardize the management of special tax adjustments and avoid overseas enterprises shifting losses to the related parties in China against the background of the financial crisis, according to the Notice issued by the SAT regarding "Implementation Measures of Special Tax Adjustments (Trial Version)" ("Guo Shui Fa [2009] No. 2"), certain issues regarding the supervision and investigation of cross-border related party transactions are clarified as follows:
- The entities that are established in China by multinational companies and have limited functions and risks such as those with sole function of production (import processing or toll processing), distribution or contract research and development etc, shall not bear market risk or risks associated with decision-making activities during the financial crisis. Accordingly, these entities shall maintain a reasonable level of profit pursuant to the transfer pricing principle of "functions and risks" commensurate with profitability.
- If the aforementioned entities with limited functions and risks incur losses, regardless of whether their related party transactions have exceeded the prescribed thresholds (under Guo Shui Fa [2009] No. 2) for contemporaneous documentation, they shall prepare and submit contemporaneous documentation and other related documents to the in-charge tax authorities for the year during which they incur losses before 20 June of the year following the loss-making year.
- The local tax authorities should strengthen supervision of cross-border related party transactions. Specifically, the tax authorities shall focus on investigating the cases where losses (including any potential losses) are shifted from overseas related parties to Chinese entities or where profits achieved by Chinese entities are shifted to tax havens, strengthen the functional analysis and comparability analysis, and select appropriate transfer pricing methods to determine the profitability of the entity under review.
PwC observations
Under Guo Shui Fa [2009] No. 2, a Chinese taxpayer is required to prepare contemporaneous transfer pricing documentation ("CTPD") if its related party transactions exceed certain prescribed thresholds unless it meets certain exemption criteria. The taxpayer needs to specify on a corporate income tax return disclosure form whether it has prepared CTPD as required, or is otherwise exempted from the CTPD requirements.
Circular 363 has expanded the compliance requirements on companies subject to the circular in two ways. First, these companies are required to prepare CTPD regardless whether their related party transactions exceed the prescribed thresholds. Second, they are required to submit the CTPD to their in-charge tax authorities by 20 June following the year their losses occur. As a result, companies subject to this circular will likely face an increased level of scrutiny on their transfer pricing and possibly face increased transfer pricing audit risk.
The current global economic downturn has put great pressure on revenue authorities, and China is no exception. Circular 363 can be regarded as one of the measures taken by the Chinese tax authorities to further strengthen its transfer pricing enforcement and protect China's tax base during the economic downturn. In a recent series of tax circulars such as Guo Shui Han [2009] No. 241 and Ji Bian Han [2009] No. 49, the large business taxation department and the Bureau of Investigation of the SAT have required selected taxpayers to perform self-assessment and report underpaid corporate income taxes, and transfer pricing is one of the main focuses.
Companies should also note that China is not alone in its efforts to protect her tax base under the current economic downturn. We have seen similar tax alerts recently released by revenue authorities in other countries in the Asia-Pacific region, including Australia and New Zealand to disallow any unreasonable losses shifted to their jurisdictions.
PwC recommendations
For multinational companies' Chinese subsidiaries with significant related party transactions, particularly those performing limited risk manufacturing, distribution and services functions for overseas related parties, robust contemporaneous documentation should be prepared. To the extent they incur losses in performing such functions, care should be taken to evaluate all facts and circumstances surrounding their related party transactions and the resulting losses, and necessary actions should be taken, as appropriate, to remedy loss situations and / or to document special factors supporting the arm's length nature of the related party transactions.
Multinational companies are also recommended to take a holistic view of their transfer pricing, both across geographic region and over time, and strive to maintain consistency and integrity of their transfer pricing policy in spite of the difficulties created by the severe economic downturn. Companies are also encouraged to consider and take advantage of alternative dispute resolution mechanisms such as the advance pricing arrangement program to proactively manage their transfer pricing, and achieve certainty on their transfer pricing.
Our China transfer pricing team will continue to closely monitor relevant developments and provide updates on a timely basis.
