China's taxation environment has changed dramatically in the past 18 months, with rates being standardised across the country, incentive schemes being discontinued, targeted customs investigations and multiple changes in indirect tax rules. However, the greatest effects may come from the institution of a new and relatively advanced transfer pricing regime.

China's interest in transfer pricing, which affects how profits (and therefore tax revenue) are allocated between jurisdictions, has been mirrored by similar interest in the US and Europe, as well as Japan and China's other key trading partners, leading to a situation where multinationals can be challenged on both sides of any international transfer of property or services, as well as cross-border financing arrangements within the group.

The challenges come from several fronts: new documentation and reporting requirements, the creation of the Large Enterprise Administration Department (LEAD) and new risk management requirements for large enterprises, and the use of software (CTAIS) to build searchable databases of taxpayer information.

Meanwhile, the increasing size of China's transfer pricing adjustments, the growing technical sophistication of its staff, and increasing focus on and guidance for transfer pricing audit cases makes the situation even more challenging.

Into force

The key aspects of China's new corporate income tax system are effective from January 1 2008, although they were released at different times: the corporate income tax law (CIT law) was released in March 2007, the CIT Law Implementation Rules were released in December 2007 and the Implementation Measures of Special Taxation Adjustments (which primarily deals with transfer pricing) were released on January 8 2009 through Circular 2 and made effective for the 2008 calendar year.

The finalisation of the implementation measures (which were previously released in draft form) has been accompanied by a flurry of other circulars regarding transfer pricing rules, as shown in Table 1.

Table 1 shows three areas receiving particular coverage from circulars:

• reporting and documentation requirements (Circulars 86, 121, 114, 72 and 134);

• audit and investigation (Circulars 188, 85 and 85); and

• the handling of large enterprises (Circulars 1064 and 90).

In addition, Circular 2 contains a significant amount of material on advance pricing arrangements (APAs), which allow taxpayers and tax authorities to negotiate on transfer pricing calculations and gives details on the contemporaneous documentation and other requirements.

Large enterprise tax risk management: Circular 1064 and Circular 90

For large enterprises, the developments surrounding the creation of the LEAD may be the most significant. News of the LEAD's creation began to spread in August, however, not until the release of Circular 1064 in December was there any official information. Circular 1064 lists 45 companies that are to liaise with the State Administration of Taxation (SAT) which houses the LEAD. This list consisted mainly of large, complex groups from a range of industries, including the China operations of 10 multinational companies.

Circular 90, the second circular to deal with large enterprises, provides detailed guidelines on tax risk management. As with the new transfer pricing guidelines, they bring China level with, or beyond, the requirements in many developed countries and can be seen as a non-binding equivalent of recent legislation such as Schedule 46 in Finance Bill 2009 in the UK, which requires chief accounting officers to sign off on companies' tax compliance. The key message conveyed by this circular is that taxpayers are advised to assess their tax risk and risk control systems and submit risk assessment reports to the tax authorities. It should be noted that these however are not mandatory compliance requirements.

In the case of Circular 90, an article released simultaneously on the SAT website quoted officials from the LEAD as stating that while implementation of these suggestions for managing tax risk were "not mandatory," not following the guidelines would "probably" attract the attention of the tax authorities, which could in turn increase an enterprise's tax audit risk and tax compliance costs.

The article also stated that since all types of enterprises typically encounter these issues, therefore, the guidelines contained in Circular 90 were applicable not only for the selected 45 large enterprises (that is, the enterprises listed in Guoshuihan [2008] No 1064) but also for other large enterprises that might need internal tax risk control systems. Since the law does not limit the type of enterprises that may be subject to these de facto compliance rules, it is possible that the rules could eventually be applied to all companies, regardless of characteristics such as size, legal structure or industry.

Reporting: Circulars 86, 121, 114, 2, 72 and 134

The new reporting requirements, of which every large multinational doing business in China is surely aware, are the linchpin which holds together the new transfer pricing regime. They are both necessary and sufficient: without them, there would be no way to enforce the new rules across such a large country, with them, combined with the database software the tax authorities have developed (which is described in Circular 72), the Chinese government will be able to quickly create a strong transfer pricing administration. In addition, the act of filling in the forms and documentation itself will create a self-policing mechanism among taxpayers, thus doing the SAT's work for them.

To provide a summary of the new requirements, there are now two types of transfer pricing reporting in China: annual filing, which refers to the annual reporting forms and contemporaneous documentation, which has more detailed content requirements than the annual filing. All companies must submit annual filings, while only certain companies must prepare contemporaneous documentation.

The contemporaneous documentation needs to be maintained by the taxpayer for 10 years but only needs to be submitted when requested by the tax authorities. However, the law allows authorities to request documentation not only from audited enterprises but also companies who are not being audited but who have similar operations to the audited company.

There are some other additional but more specific reporting requirements. First, if related-party debt levels exceed a certain safe harbour level, so-called thin-capitalisation documentation will need to be provided to support the arm's-length nature of the financing arrangement. Otherwise, the interest expense of the debt that is considered as excessive will be deemed as non-deductible for corporate income tax purposes.

This is detailed in circulars 121 and 2. Secondly, Circular 86, which was passed in August 2008, stipulates that besides being at arm's length, service charges must also be supported by relevant documentation including separate signed contracts for each legal entity, which must be provided to the tax authorities. Lastly, companies with a cost sharing arrangement should also prepare relevant documentation and submit to the tax authorities by June 20 each year.

Audit: Circulars 106, 188, 85 and 85

The tax authorities have released several audit-related circulars in quick succession over the past few months. Firstly, Circular 188, covering the post-audit follow-up period: during this phase, which lasts for five years from the year after the most recent year for which taxable income was adjusted, taxpayers are required to submit follow-up documentation each year. The circular reminds local tax authorities to "strictly follow" these practices, and clarifies that the requirements found in the new regulations apply to all adjustment cases concluded after January 1 2008, although with a grace period for 2008 financial year related adjustments. In addition, for APAs, before the official signing, tax authorities should adhere strictly to the adjustment plan to prevent decreases in profits and ensure tax payment.

Released the same month, Circular Guoshuifa 85 listed new rules strengthening the collection of the main four types of Chinese taxes: international taxes (which includes transfer pricing), turnover taxes, income taxes and property taxes. At same time, it was reported that China's first-quarter tax revenues had fallen more than 10% since the previous year. The circular provided specific directions for future investigations to take: for transfer pricing, a list of industries or groups to be investigated was provided. These areas included large retailers, fast food and hotel chains, and manufacturers of beverages, pharmaceuticals, clothing, elevators, automobiles, computers and information technology systems. Also included on the list were outbound investment, overseas subsidiaries and the "financing of the construction of infrastructure" and, specifically, highways.

Most recently, Circular Jibianhan 85 launched the investigations mentioned in Circular Guoshuifa 85 (the two circulars are referred to by their Chinese names to avoid confusion), starting with operators of highways. The local and provincial tax authorities were given a relatively short period of time (until mid-July) to submit formal, written reports, providing room for investigations into the other industries as well. At the rate of six weeks per industry, it would take between a year and a year in a half to cover all of the industries mentioned in Circular Guoshuifa 85.

Meanwhile, several aspects of the law make such investigations and audits even more risky for the taxpayer. Tax authorities can use non-public information and materials when analysing and evaluating related-party transactions, and transfer prices or profit margins below the median level of the inter-quartile range of comparable transactions will be subject to a tax adjustment up to the median level or above.

Some statistics about the increasing levels of tax adjustments and recovered taxes in transfer pricing, as provided by Circular 106, are provided in Table 2.

Implications and suggestions

With the tax authorities under increasing pressure to generate revenues, many taxpayers will be justifiably concerned. However, while the tax authorities may have a good number of fancy tools at their disposal, such as their CTAIS software, the taxpayer is not entirely defenceless. There is still some time before the rest of the storm hits, and key is to get prepared now, build up a credible story, and make sure you have your supporting evidence in order.

Where feasible and appropriate, taxpayers can also take advantage of the SAT's growing APA programme to lock in a deal with the authorities for many years down the road. In all of these endeavours, independent specialists can help you to prepare your case, and provide a third-party perspective on whether your company is prepared for the worst or not doing enough to be ready.

Biographies
		Steven Tseng KPMG in China Tel: +86 21 6288 2338 Email: steven.tseng@kpmg.com.cn Steven Tseng is the partner in charge of global transfer pricing services (GTPS) for KPMG in China and Hong Kong. As of October 2007, Tseng assumed the leadership of the Asia Pacific region of global transfer pricing services for KPMG's network of firms. The region comprises key jurisdictions such as Australia, China, India, Indonesia, Japan, Korea, Malaysia, New Zealand, the Philippines, Singapore, Taiwan, Thailand, and Vietnam. Tseng is a member of the GTPS global steering group, and the global consumer markets industry lead for GTPS. He leads more than 200 full-time transfer pricing specialists in Greater China and 450 in the Asia Pacific region. He has been active in advising multinational companies on transfer pricing issues since 1994. Tseng's transfer pricing career included experience in the US, Japan, Nordic region and he has been working on transfer pricing in China from 2005. Before KPMG's network of firms, he worked for the Federal Reserve Board (DC), PricewaterhouseCoopers (DC, Tokyo, Boston), and Goldman Sachs (New York). Tseng's clients cover almost all industries including energy, financial services, telecommunications, chemicals, electronics, machinery, consumer goods and non-profitable associations.
		Cheng Chi KPMG in China Tel: +86 (21) 2212 3433 Email: cheng.chi@kpmg.com.cn Cheng Chi is a partner in KPMG's global transfer pricing services group responsible for the Central China region. Before joining KPMG in China, Chi led the transfer pricing and tax effective supply chain practice in the Central China region for another big-four accounting organisation. He started his transfer pricing career in Europe covering many of its major jurisdictions while based in Amsterdam; Chi returned to China to practice in 2004. Chi was a logistics and supply chain specialist, having worked for TNT and Singapore Airlines before entering professional services. A frequent speaker at both internal and external events, Chi has also published on transfer pricing in leading journals such as International Tax Review. Chi provided consultation to the Chinese tax authorities in a number of key anti-avoidance legislative initiatives. Chi holds a master's degree in international business studies from the Universiteit Maastricht. Moreover, he is a Chartered Controller (Belgium).