China pioneers a coordinated management approach to TP
Xiaolin Guo of the Shenzhen Tax Service, State Taxation Administration of China, reports that an innovative transfer pricing model that brings together Shenzhen’s tax and customs authorities has swiftly proved successful.
Tax and customs authorities supervise cross-border trade in goods between related enterprises. However, different legal bases and the focus of their respective supervision could lead to separate assessment outcomes from the same transaction.
This could lead to unreasonable tax results and an increased compliance burden for taxpayers, which has long pained many multinational enterprise (MNE) groups across the world.
Aimed at optimising the business environment for taxpayers, an exploratory effort was made in China to conduct coordinated management of transfer pricing (TP). The first case has been successfully concluded, which was led by the State Taxation Administration (STA) of China and the General Administration of Customs (GAC) of China and was implemented by the Shenzhen Tax Service, STA and Shenzhen Customs.
Subsequently, under the guidance of the STA and the GAC, the Notice on Related Issues Concerning Coordinated Management of Transfer Pricing of Goods Imported from Related Parties and its associated documentation were jointly issued by the Shenzhen Tax Service, STA and Shenzhen Customs. This article describes the innovative model of coordinated management.
2. International reference points
The World Customs Organization (WCO), the Organisation for Economic Co-operation and Development (OECD) and the United Nations (UN) consistently advocate closer cooperation between tax and customs authorities to meet the challenges brought by economic globalisation and digitalisation for cross-border trade tax-related administration.
(1）UN and OECD guidelines
The United Nations Practical Manual on Transfer Pricing for Developing Countries (2021) (Section 3.6.6) points out that the price paid or payable for imported goods and services under certain circumstances is the starting point for determination of the assessment of customs duties. A higher import price reduces the profit and thus the direct tax, such as corporate income tax, that could be collected, while a lower import price reduces customs duties.
There is an inherent conflict between the tax and customs authorities in terms of revenue collection and motivation. It is therefore necessary for tax and customs authorities to achieve convergence between TP methods and customs valuation through better communication and mutual coordination, which would help to reduce the taxpayers’ compliance burden. They could make use of TP data and cross-departmental information, as appropriate, to determine whether the price of a controlled transaction is fair.
The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2022) also points out that enhanced cooperation between tax and customs authorities in the area of information exchange would be particularly useful. Countries that have separate customs and tax administrations may consider improving the information exchange mechanism so that the information can be communicated more easily between these administrations (paragraph 1.158).
(2）The WCO Guide
The WCO and the OECD held joint meetings in 2006 and 2007 respectively to exchange views on the concerns regarding the polar positions taken by tax and customs authorities.
The WCO Guide to Customs Valuation and Transfer Pricing, published by the WCO in 2015 and revised in 2018, presented research on the relationship between customs valuation and TP.
The Technical Committee on Customs Valuation (TCCV) of the WCO approved and adopted Commentary 23.1. It acknowledges that documentation prepared for TP purposes can be used as one of the information sources for customs reference and as a possible basis for examining the circumstances of a sale.
However, the use of the TP study should be considered on a case-by-case basis. The TCCV subsequently issued two case studies to illustrate scenarios where customs took into account TP information in verifying the customs value.
The WCO also issued the Guidelines for Strengthening Cooperation and the Information Exchange between Customs and Tax Authorities at the National Level in October 2016, which proposes to develop memoranda of understanding/agreement (MOU/MOA) for smoother and closer cooperation between customs and tax authorities.
Many other countries have begun to explore and establish effective liaison and dispute resolution mechanisms between tax and customs authorities.
The National Tax Service (NTS) and the Customs Service of the Republic of Korea (ROC) entered into an MOU calling for the coordination of TP and customs audits for Korean taxpayers importing goods from related parties.
In the United States, there have also been coordinated efforts to enhance cooperation between the Internal Revenue Service (IRS) and the United States Customs and Border Protection (CBP).
The Canada Revenue Agency (CRA) and the Canada Border Services Agency (CBSA) reviewed TP methods and customs valuation methods, and provided guidance regarding the possible ways to achieve consistent results.
3. Success of China’s first case
Under the guidance of the STA and the GAC, after receiving an enterprise’s application, the Shenzhen Tax Service and Shenzhen Customs jointly conducted coordinated management of the transaction valuation of goods imported from related parties according to the arm’s-length principle. That was based on the provisions regarding TP and advance pricing arrangements in domestic tax laws, and regarding advance ruling and customs valuation in domestic customs laws.
The enterprise’s trust in the Shenzhen Tax Service and Shenzhen Customs and its cooperation – together with professional support from the third-party advisor, KPMG China – contributed greatly to the success in reaching a consensus on the case.
There were multiple practical challenges in concluding the case due to different laws and divergent analyses that tax and customs authorities focus on.
Nevertheless, the Shenzhen Tax Service’s and Shenzhen Customs’ overriding objective of reducing the compliance burden for enterprises enabled both parties to overcome restrictions within their own expertise, learn from each other, and reach a consensus on technical difficulties. This has satisfied the management requirements of both authorities, while minimising the taxpayer’s compliance cost.
(1) The object of evaluation
Customs and tax authorities evaluate the price of imported goods in related-party transactions based on the arm’s-length principle. However, customs administrations usually evaluate the prices of individual commodities in customs declarations rather than evaluating different items together, while TP analysis for tax purposes is generally aimed at evaluating the rationality of the profit level of a transaction.
Due to the lack of a ‘price of similar goods’ (comparable uncontrolled price, for tax purposes) in practice and the wide variety of goods imported, it is not feasible to review and adjust the prices of goods on an item-by-item basis. Therefore, it was ultimately agreed that in this case the overall transaction, rather than each commodity, should be assessed, so as to make the valuation result reasonable and easy to comply with.
(2) TP method selection
There is a strict order in the application of customs valuation methods, and the pricing method valuing the same or similar products is preferred.
However, the selection of a TP method for tax purposes does not follow such strict order. Therefore, tax and customs authorities would have to discuss the rationality of the method to be selected.
In terms of selecting comparable companies, customs valuation focuses strictly on the comparability of products and the geographical locations of the comparable companies. However, in TP, in addition to product comparability, functions and risks undertaken by the comparables are also important considerations.
These differences make it more difficult to select comparable companies that are acceptable to both authorities.
In this case, the comparability of products and the comparability of functions and risks were taken into account, and both authorities gave consideration to the respective proportion of wholesale and retail business and their contribution to corporate profits.
Eventually, two sets of comparable companies reflecting wholesale function and retail function respectively were selected and the gross profits of these comparable companies were calculated to arrive at a benchmarked range of overall gross profit level.
(3) The applicable period
Given that the coordinated approach is still in the exploration stage and retroactive adjustment is difficult to implement, the two authorities eventually concluded the case through advance pricing for tax purposes and customs ‘advance ruling+’ under the current legal framework, which provides tax certainty for the enterprise’s transactions of goods imported from related parties in the next few years.
4. The regulatory mechanism
Based upon the experience of the above case, the STA and the GAC agree that coordinated management is feasible from a regulatory and practical perspective, and the feedback from the enterprise was also very positive.
In order to enrich practices, the STA and the GAC supported the Shenzhen Tax Service and Shenzhen Customs in jointly drafting the Notice on Related Issues Concerning Coordinated Management of Transfer Pricing of Goods Imported from Related Parties and associated documentation. The Notice was officially released on May 18 2022.
The Notice has six main articles that set out the contents and criteria for the application of coordinated management, its procedures, nullification and renewal, and other related matters.
(1）Contents and application criteria
The Notice specifies that “coordinated management of TP of goods imported from related parties” refers to:
The joint evaluation of the price of goods imported from related parties by Shenzhen Customs and the Shenzhen Tax Service; and
The joint signing of a memorandum of coordinated management in the TP of goods imported from related parties with enterprises after reaching a consensus among the parties.
Enterprises in Shenzhen that meet the requirements of Article 4 of the Decree of the General Administration of Customs No. 236 and Article 4 of the Public Announcement of the State Taxation Administration No. 64 are eligible to apply for coordinated management of TP.
(2）Coordinated management procedures
The Notice specifies that coordinated management includes four procedures:
Application and acceptance;
Evaluation and negotiation;
Memorandum signing; and
(a) Application and acceptance
The enterprise will submit a written application to Shenzhen Customs or the Shenzhen Tax Service, together with the Application Form for Customs Advance Ruling (Price) and the Application Form for Pre-filing Meeting of an Advance Pricing Arrangement and other relevant documentation.
Shenzhen Customs and the Shenzhen Tax Service will provide a reply within 10 days as to whether the application is accepted.
(b) Evaluation and negotiation
After accepting the application, Shenzhen Customs and the Shenzhen Tax Service will start the joint evaluation within 15 days, and conduct interviews and on-site assessment where appropriate.
(c) Signing of the memorandum
If Shenzhen Customs and the Shenzhen Tax Service reach an agreement through consultation, the authorities will sign a memorandum of coordinated management with the enterprise. At the same time, Shenzhen Customs will make an advance ruling on import price, and the Shenzhen Tax Service will reach an advance pricing agreement with the enterprise.
If Shenzhen Customs and the Shenzhen Tax Service are unable to reach an agreement through consultation, the coordinated management procedure will be terminated and the authority that accepted the application will inform the enterprise of the decision.
(d) Implementation of the memorandum
During the covered period of coordinated management, the enterprise will submit an annual report on the implementation of the memorandum to Shenzhen Customs and the Shenzhen Tax Service within six months after the end of each year. Shenzhen Customs and the Shenzhen Tax Service will conduct follow-up supervision respectively.
(3）Nullification and renewal
The memorandum of coordinated management will automatically be null and void when it expires. Enterprises may apply for renewal 90 days before the expiry date.
5. Key breakthrough
The Notice marks the first regulatory mechanism that local tax and customs authorities have built in China for coordinated management in the TP of goods imported from related parties. It is expected to reduce tax-related costs associated with cross-border trade and improve tax certainty.
Joint governance and coordinated law enforcement of TP and customs valuation will also improve the supervision efficiency of both authorities. The STA will increase collaboration with the GAC and extend relevant practices to more regions in China based on other successful experiences.