With China now a full member of the World Trade Organisation (WTO), foreign investors will undoubtedly play a more active role in the Chinese market. As a consequence, crossborder inter-company transactions between foreign investors and their Chinese subsidiaries will become more common, and at the same time more complex. This trend, and the increasing aggression of the Chinese tax authorities on transfer pricing enforcement, means that it is an issue that foreign investors cannot afford to neglect.
In May 1998, the State Administration of Taxation (SAT) issued a tax circular (number 59) regarding the regulation of the taxation of transactions between associated enterprises. It is a very comprehensive ruling that marks a milestone in the history of China's transfer pricing regime.
A clear message to taxpayers
The issuance of Circular 59 has sent a loud and clear message to taxpayers: China is getting serious in its transfer pricing enforcement. Since then, the Chinese tax authorities have acted to reinforce this message. Measures include: a sharp rise in the number of transfer pricing investigation cases, with a corresponding increase in the amount of adjustments on taxable income, resulting in additional income tax payable; the setting up of specialist transfer pricing teams in tax bureaux; the training of specialist tax officials in transfer pricing tax investigation; and conducting joint investigations with the SAT on Chinese subsidiaries of multinational corporations.
Companies with certain characteristics are most likely to be selected for transfer pricing investigation, including those:
-whose management and decision-making are controlled by an associated company;
-that conduct a significant amount of transactions with associated companies;
-that make losses for more than two consecutive years;
-with losses or minimal profits for an extended period of time, but continue to expand their scale of operations;
-with a fluctuating profit pattern;
-that conduct transactions with associated companies located in tax havens, including Hong Kong;
-whose profit level is lower than those of other companies in the same industry or lower than other members of the associated group;
-that have rendered various 'unreasonable' payments to associated companies; and
-that experience a sharp decrease in profits after a tax holiday expires or that conduct suspicious activities to avoid taxes in China.
For a manufacturing foreign-investment enterprise, which is the most common case in China, the following transactions are the typical hot spots that the Chinese tax authorities will look into in the event of transfer pricing investigations:
-importing raw materials from overseas affiliates;
-exporting finished goods to overseas affiliates;
-licensing trade marks/technology from overseas affiliates and paying royalties; and
-paying service fees for service provided by overseas affiliates.
Taxpayers should note that intra-China related party transactions will also be scrutinised by the Chinese tax authorities.
The investigation procedure
The investigation process is much the same in all cities, although there may be slight differences in local practice. It usually involves five steps:
1.) Selection of investigation targets
Based on the information disclosed in a company's annual corporate income tax return, such as the amount and types of related party transactions conducted by the company during the year and the profit levels of the company in previous years, the tax bureau would select the target companies that are to be investigated and prepare for an on-site investigation. Usually, at least two officers would be assigned to each case.
2.) Site visits
The tax officers in charge of the investigation would then conduct on-site visits to the company. During the on-site investigation, they would question the entity's management and other personnel whom the tax officers regard as relevant to the company's related party transactions and pricing policies. The officials would also ask for voluminous documents such as the company's pricing policy, costing information, accounting records, contracts and invoices that they consider necessary to conduct and facilitate the investigation. In addition to the information/documents requested on the spot, a notice would also be issued by the tax bureau requesting further information/documents, including information on overseas-related companies. This often poses a problem to the taxpayer as the requested information/documents may be difficult to access or located with an overseas- related company. In some cases, the information may not exist at all.
3.) Internal analysis
The tax bureau would then analyse the information provided using various tools. The authorities may use internal comparable data to consider whether the investigated company has manipulated its transfer price for the purpose of shifting its profit out of China.
4.) Negotiation with the taxpayer
Should the tax bureau believe that the company's related party transactions were not conducted in accordance with the arm'slength principle, the tax authority would propose an adjustment. The taxpayer therefore must maintain regular contact and discussions with the tax officers throughout the investigation process so as to avoid a premature conclusion of transfer pricing adjustments. Once a formal Investigation Determination Notice is issued by the tax bureau, it would be difficult in practice to appeal the adjustment.
5.) Conclusion of the investigation
When the company receives the Investigation Determination Notice, even if it does not agree with the adjustment, it has to pay the tax within a prescribed period of time before it can initiate the appeal process. Moreover, according to Circular 59, the tax bureau would conduct a follow-up review on the investigated entity for at least three years.
Several transfer pricing adjustment methods have been stipulated in Circular 59, but they all confer negative consequences to the taxpayer. The most obvious is the additional taxes being payable on the adjusted income where the income might already be subject to tax in another jurisdiction. This is commonly known as double taxation. Value-added tax, business tax and consumption tax may also be imposed, depending on the type of transactions subject to adjustments. The adjustments may also accelerate the start of the taxpayer's tax holiday, resulting in income tax payable earlier than would otherwise be the case. In addition, the company would also be subject to a follow-up review, which means it would have to face the hassle of future tax audits.
In the past, many taxpayers have paid insufficient attention to the issue of transfer pricing in China, as well as the measures that they should have taken to substantiate their transfer pricing policy and mitigate their exposures and adjustment risks. Despite its late start, China is fast becoming more sophisticated on its transfer pricing enforcement. Therefore given the aggressive attitude of the Chinese tax authorities, the adverse consequences of a transfer pricing adjustment coupled with the fact that there are limited practical appeal channels in China, multinational corporations should add China to their list of countries that require careful monitoring in relation to the issue of transfer pricing.
This article was written by Spencer Chong, tax partner, and Rhett Liu, tax manager in the China Transfer Pricing division of PricewaterhouseCoopers in Hong Kong.