Regulatory framework
China's transfer-pricing legislation was first enacted as part of the enterprise income tax system in 1991. The same transfer pricing rules have also been incorporated into the tax collection law since 1992, effectively broadening the applicable scope of transfer pricing to all taxes in China. To reinforce the regulatory framework, the State Administration of Taxation (SAT) issued specific implementing measures in 1992 and 1998, respectively. From time to time, SAT has also issued notices urging local tax authorities to strengthen transfer-pricing practice.
The following rules formulate the major transfer pricing regulations in China:
The Income Tax Law of the People's Republic of China concerning Foreign Investment Enterprises and Foreign Enterprises (effective July 1 1991) (Enterprise Income Tax Law or EIT Law), and its detailed implementing rules (effective July 1 1991) (EIT Implementing Rules);
The Law of the People's Republic of China concerning Tax Collection and Administration (amended and effective May 1 2001) (Tax Collection Law), and its detailed implementing rules (amended and effective October 15 2002) (Tax Collection Implementing Rules);
The Implementing Measures for Tax Administration of Business Transactions between Affiliated Enterprises (Guo Shui Fa [1992] No 237) (effective January 1 1993); and
The Rules for Administration of Business Transactions between Affiliated Enterprises (For Trial Implementation) (Guo Shui Fa [1998] No. 59) (effective April 23 1998) (Transfer-Pricing Rules).
Arm's-length principle
The relevant legislation adopts the internationally recognized arm's-length rule. Article 13 of the EIT Law provides that foreign-invested enterprises or foreign enterprises' establishments in China and their affiliates must conduct business transactions on the same basis as between non-affiliated enterprises. If payments or receipts are not made on an arm's-length basis, resulting in a reduction of taxable income, the tax authority is entitled to effect reasonable adjustments.
Affiliated enterprises defined
The relevant rules define "affiliated enterprise" as an enterprise having one of the following relationships with the taxpayer:
direct or indirect ownership or control in relation to capital, business operations or sale and purchase;
direct or indirect ownership or control by the same third party; or
other mutually beneficial affiliations.
The Transfer-Pricing Rules further illustrate what enterprises may be considered as affiliated enterprises:
one enterprise directly or indirectly holding 25% or more of the shares of another enterprise;
25% or more of the shares of two enterprises being directly or indirectly controlled by a third party;
loans from one enterprise to another accounting for 50% or more of the first enterprise's funds, or 10% of one enterprise's total loans being guaranteed by another enterprise;
more than half of the directors or senior management, or one managing director, of one enterprise being appointed by another enterprise;
the production and business operations of one enterprise being able to be carried out in a normal manner only with technology or similar licences from another enterprise;
the raw materials, parts, components and so on, (including their prices and transaction conditions) purchased by the enterprise for production and operation purposes are controlled or supplied by another enterprise;
the sale of the products or merchandise produced by the enterprise (including their prices and transaction conditions) is controlled by another enterprise; or
other affiliations in terms of interests that involve actual control of the production, operation or transactions of the enterprise, including relationships with family members or relatives.
Annual filing requirement
Transactions to be reported
An enterprise must report to the tax authority the following affiliated-party transactions:
the sale, use and transfer of tangible property including buildings, vehicles, machinery, tools and products;
the use and transfer of intangible property including land use rights, copyrights, trade marks, brand names, patents, franchises and designs;
provision of funds including all kinds of long term and short-term loans, guarantee, securities and all kinds of interest-bearing advances and deferred payments; and
provision of services including market survey, distribution, management, administration, technical service, maintenance, design, consultation, agency, scientific research, legal and accounting services.
Annual affiliate return
To report the above transactions, a taxpayer must file an annual return (Annual Affiliate Return) within four months of the accounting year-end (may be extended for up to 30 days upon approval) by using one of the following forms:
Type A form, applicable to enterprises with a single category of affiliated party transactions; or
Type B form, applicable to enterprises with multiple categories of affiliated party transactions.
In either case, a separate form is to be filled out in respect of each separate affiliated enterprise. Failure to file the required returns may lead to penalties of up to Rmb10,000 ($1,208).
Selection of audit targets
Within two months of receiving Annual Affiliate Returns, the local tax authority will perform assessment procedures to screen target enterprises for further investigation and audit. The Transfer-Pricing Rules have identified certain enterprises which are more likely to be selected for audit. These include enterprises suffering from losses for more than two consecutive years, enterprises with an erratic profit and loss history, enterprises doing business with affiliates in tax havens, and enterprises with profits lower than other companies within the group.
The Transfer-Pricing Rules require the tax authority to actually audit and investigate at least 30% of the key audit targets identified.
Investigation and audit procedures in general
Pursuant to the Transfer-Pricing Rules, audit procedures basically are divided primarily into two steps, a desk audit and a field audit.
Desk audit
The tax authority will issue a written notice requesting the audit target to provide certain company and financial information, including the taxpayer's approval documents, business and tax registration certificates, investment and operation contracts, articles of association, feasibility studies, annual financial statements, audit reports, account books and vouchers, commercial contracts and other relevant documents.
The tax authority will undertake a systematic analysis of the enterprise's financial information, particularly focusing on the profit or loss on sales, rates of return on investments, sales revenues, reasonableness of costs and expenses, the level of interest rates, and the reasonableness of prices for the assignment or use of tangible and intangible assets.
Field audit
If the information from a desk audit is insufficient, the tax authority may initiate a field audit at the taxpayer's premises. The tax authority will issue a notice specifying the time, place and content of the audit three to seven days in advance.
The tax authority may dispatch at least two personnel to inspect the taxpayer's accounting books, vouchers, sale and purchase contracts and other documents. They may also inspect and observe the taxpayer's administrative departments, workshops and warehouses, and interview relevant personnel.
Cooperation between tax authorities
The investigating tax authority may seek assistance of tax authorities in other localities during investigation. They may even obtain pricing information from outside China through the exchange of information with foreign tax authorities and with the assistance of PRC diplomatic offices abroad.
Burden of proof
Despite any investigation and audit effort of the tax authority, the Transfer-Pricing Rules provide that the burden of proof to establish that pricing is consistent with the arm's-length rule lies with the taxpayer being investigated.
Documentation requirement
Although relevant rules do not specifically require that taxpayers maintain contemporaneous documentations, the Transfer-Pricing Rules effectively impose a contemporaneous requirement since the taxpayers only have up to 60 days to respond to the tax authority's Notice on Provision of Specific Relevant Information concerning Business Transactions with Affiliates. Pursuant to the Transfer-Pricing Rules, the following information must be provided:
facts relating to transactions with affiliated enterprises and third parties, including sales and purchases, financing, provision of labour services, assignments of tangible and intangible assets and provision of use rights of tangible and intangible assets;
facts on elements that may contribute to the prices, such as the amount, place, form and payment method of the transaction; and
other relevant materials for determining the transactional prices or basis for charges.
Methodology
Methodology in general
The Tax Collection Implementing Rules authorize the tax authority to use the following methods to adjust the taxpayers' taxable income resulting from the non-arm's-length transactions:
Comparable uncontrolled price method. The taxable income is determined in accordance with the price in identical or similar transactions between non-affiliated entities.
Resale price method. The taxable income is determined in accordance with the reasonable re-sale profit margin to be gained from the price at which the goods are re-sold by the affiliated enterprise to independent entities.
Cost plus method. The taxable income is determined based on the mark-up achieved by a comparable seller in similar transactions with independent entities, plus reasonable costs and fees.
Other reasonable methods.
Methodologies for specific transactions
The Transfer-Pricing Rules detail appropriate pricing methods that the tax authority may use with respect to certain specific categories of transaction.
(a) Sale and purchase of tangible assets
Comparable uncontrolled price method. To ensure comparability, the Transfer-Pricing Rules require that the tax authority consider relevant factors relating to the sale and purchase, such as the method of sale, the distribution process, the product in question (brand recognition), and the social, political and economic environment.
Resale price method. This method is limited to the cases where the reseller has only undertaken simple processing or a pure purchase and re-sale, rather than any substantive value-added processing resulting in a change of shape, function, structure or trade mark.
Cost plus method. The calculation of cost must comply with the PRC tax law.
Other reasonable methods. When none of the above three methods are feasible, the tax authority may use a profit-split methodology. Upon a taxpayer's application, it is also possible to enter into an advance pricing agreement. If the taxpayer cannot provide accurate information on prices or expenses, the tax authority may use the deemed profit method. However, the tax authority is required to consider the reasonableness and applicable conditions when using alternative methods.
(b) Provision of financing
The comparable uncontrolled price method is applicable to interest charged or received from financing activities. The tax authority is required to consider comparability from relevant aspects, such as the amount of financing, currency, duration, security provided, creditworthiness, payment method, and interest calculation.
When an entity borrows funds from one source and on-lends to another, pricing adjustments may be made on the basis of a cost-plus method.
(c) Provision of labour services
The comparable uncontrolled price method is applicable to labour service fees. The tax authority is required to consider comparability from relevant aspects, such as the business nature, technical requirements, professional standards, payment conditions and costs.
(d) Rental of use rights
The comparable uncontrolled price method is applicable to use fees collected from or paid for the provision of use rights on tangible assets (such as land or buildings). Where an enterprise re-rents assets, the cost-plus method may be applicable. It is also possible to use the method of depreciation plus reasonable fees and profits.
(e) Assignment of intangible assets
The comparable uncontrolled price method is applicable to fees or charges for the assignment of intangible assets. The tax authority is required to consider comparability from relevant aspects, such as development costs, conditions of transfer, replaceability of the assets and other criteria.
Transfer-pricing adjustments
Upon a successful transfer-pricing challenge, the tax authority will require the subject taxpayer to implement appropriate pricing adjustments and pay the correct amount of tax.
Tax years subject to adjustment
Transfer-pricing adjustments normally are limited to the taxable income of the year that is subject to investigation and audit. The tax authority will effect adjustments within three years following the tax year in question. In "special" cases, adjustments may be effected within 10 years thereafter. As clarified in a 2003 SAT notice, almost any situation is considered "special" justifying adjustments for up to 10 years:
Accumulated transaction amounts with related companies reach Rmb100,000 ($12,082) or above;
The taxable income that may be increased after adjustment, based on paper audit, is Rmb500,000 or above;
Having business transactions with enterprises located in tax havens; or
Failure to disclose transactions with affiliated enterprises or filing false declarations, and failure to provide relevant pricing standards.
If the adjustments involve taxable income of prior taxable years, the Transfer-Pricing Rules also authorize retroactive adjustments up to a period of 10 prior years.
Payment of additional tax
The tax authority will issue a Notice of Adjustment of Transfer Pricing, Taxable Income and Tax Payable. The taxpayer must pay the correct amount of tax due within the prescribed period (may be extended for up to three months). Failure to pay will lead to late payment surcharges and fines.
Late payment surcharge and fine
Transfer-pricing violations also may be subject to late-payment surcharges and fines. If a taxpayer fails to pay outstanding amounts by the due date, late payment surcharges may be imposed on the unpaid amount at the daily rate of 0.05% for each day in arrears (equal to an annual rate of 18.25%). Before the amended Tax Collection Law took effect on May 1 2002, the late-payment surcharge was set at the daily rate of 0.2% (or an annual rate of 73%). The tax authority also may impose fines between one to five times of the amount of overdue taxes. Lesser fines of between Rmb2,000 ($242) to Rmb10,000 may be applicable. In serious cases of tax evasion, criminal liability may also be pursued according to law.
Deemed dividend
If an enterprise does not amend its accounting books to reflect the full amount of taxable income after transfer-pricing adjustments, the amount received by its affiliates in excess of the amount that it should have received in an arm's-length transaction will be deemed a distribution of dividends. The deemed dividend will not qualify for exemption from withholding tax, which is otherwise available to regular dividends derived from a foreign-invested enterprise. If what actually was received by the affiliated enterprise was interest or royalty, the withholding tax already paid thereon will not be adjusted.
Follow-up supervision
If a taxpayer has ever been subject to transfer-pricing adjustments, the tax authority will carry out follow-up supervision over the taxpayer in daily tax administration within three years following the taxable year in question. The supervision mainly will cover:
the taxpayer's investment, operations and any changes thereto;
changes of taxable income declared by the taxpayer;
assessment on the taxpayer's operational results via analysis of annual financial and accounting statements; and
changes of the affiliated party transactions.
Remedies
Domestic procedure
If a taxpayer is not satisfied with the transfer-pricing decision of the tax authority, the taxpayer must first pay any additional tax resulting therefrom and then file an appeal with the tax authority at the next higher level within 60 days. If the taxpayer loses the appeal, it may initiate administrative proceedings before a people's court within 15 days after the appeal decision. The taxpayer also may directly initiate court proceedings without appealing with the higher tax authority.
Competent authority procedure
The competent authority procedure offers recourse to those multinational taxpayers who believe they were unfairly treated and subject to double taxation. China has concluded more than 80 income tax treaties. Procedurally, to invoke the competent authority process, the multinational merely seeks relief from its home-country taxing authority. If accepted, and the relief requested appears justified, the competent authority of the home country and China should directly consult and negotiate a resolution. However, the process is intra-governmental and often is quite lengthy. At present, the competent authority experience with China is extremely limited. It is difficult to predict how efficient and effective the process will be.
Advance pricing agreements
To save the cost involved in a transfer-pricing audit for both taxpayers and the tax authority, the Transfer-Pricing Rules provide for the possibility of advance pricing agreements (APA) between taxpayers and the tax authority. With an APA, a taxpayer can secure an agreement in advance from relevant tax authorities on its transfer-pricing policy and the methods used for calculating prices in affiliated party transactions.
Unfortunately, although a limited number of unilateral APAs have been concluded between taxpayers and the local tax authorities (but no bilateral APA yet with a foreign tax authority), no established APA rules are available. The SAT has circulated a draft on APA rules once and the issuance of the rules has been anticipated for almost a year. According to the draft, an APA will have a term of one to three years with no retroactive effect. The standard APA procedures will consist of submission of formal application, meeting, audit and assessment, negotiation, and signing an APA.
Careful record-keeping required
Taxpayers in China are at a disadvantage in light of their burden of proof in transfer-pricing audits. Therefore, it is critical for taxpayers conducting transactions with affiliates to establish a coherent transfer-pricing policy and to maintain written records evidencing compliance with the policy. Although transfer-pricing rules, policy and enforcement in China clearly are in an evolutionary state, taxpayers should not ignore basic transfer-pricing principles that have been established globally simply because local tax officials have been accommodated and detailed information is not readily available in China under its present tax regime. When transfer-pricing audits truly accelerate, this documentation and data will be expected and needed to successfully conclude an audit. The 10-year window for transfer-pricing adjustments reinforces the need for caution and preparedness in addressing transfer pricing in China.
Biographies |
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Stephen Nelson's practice focuses on taxation of multinational companies in the People's Republic of China (PRC), as well as foreign trade with and investment in the PRC. Stephen's practice focuses on both PRC domestic taxation as well as cross-border tax planning for multinationals investing in China, including advising on PRC transfer pricing. Stephen has worked in the Hong Kong office of Baker & McKenzie for the past 18 years on various aspects of foreign investment and tax in the PRC. Stephen is co-head of Baker & McKenzie's China practice. Stephen has published numerous articles on various aspects of Chinese taxation in international tax publications, including Tax Notes International, the Asia-Pacific Tax Bulletin and Intertax. He is a frequent participant in seminars and presentations focusing on PRC tax and investment, with about 20 speaking engagements per year. Stephen is routinely named as one of the top advisers in PRC projects, tax, and foreign investment in many international publications and guides, including Chambers and Asia Law 500. Stephen received a B A from the University of Pennsylvania in 1980 and his J D from Columbia University in 1986. He was admitted to practice in California in 1986. He is a native English speaker, is fluent in Mandarin and speaks French proficiently.
Peng Tao started with the Beijing office of Baker & McKenzie in June 2000 and joined the Palo Alto office as an associate in February 2003. His practice focuses on tax, PRC-related investment, merger and acquisition, cross-border counselling, private banking and general corporate and commercial issues in China. Before joining Baker & McKenzie, Peng worked for the Bureau of the Legislative Affairs of the State Council of the PRC. Peng graduated from Peking University with an LLB in 1992 and an LLM in Administrative Law in 1997. He received an LLM from the University of Michigan in1998 and LLM in Taxation from New York University the following year. He is admitted in New York and also holds the PRC Bar qualification certificate. He speaks English and Mandarin. |
