Performing year-end TP adjustments in China

In the context of a challenging economic environment, pricing outcomes for intra-group related-party transactions can deviate from expected levels provided for under multinational enterprises’ transfer pricing (TP) policies. This then calls for year-end TP adjustments.

Year-end TP adjustments are typically applied to group entities performing simple functions with limited risks. These entities usually need to maintain routine profits under China’s TP guidance on the application of the arm's-length principle. That being said, not all deviations require adjustments, such as the impacts of COVID restrictions.

In this article, KPMG will discuss the key considerations, including the need to conduct comprehensive TP analysis to demonstrate the reasonableness of related-party transaction outcomes.

Enterprises operating in China and engaging in related-party transactions will, when looking to adjust upwards booked profit in China entities, typically consider:

• Adjusting related sales revenue;

• Reducing related procurement costs; or

• Creating new types of related transactions.

The following two options can be considered.

Firstly, companies should formulate suitable TP year-end adjustment targets based on their functional risks and discuss appropriate accounting treatment with auditors or professional advisers (e.g., reducing the main business costs of the adjusted entity, or increasing other business income). If there are doubts about the profit margin to be adjusted to or if the adjustment involves significant amounts, companies may consider timely communication with tax authorities.

Furthermore, the additional income generated by adjusting profits through different forms of year-end TP adjustments may sometimes generate an additional VAT burden for the company. Subject to conditions, companies may have the opportunity to seek a VAT exemption for the additional profits related to such year-end TP adjustments.

As regards the source of compensation for year-end TP adjustments, enterprises may select to have compensation provided by the actual related transaction counterparty or by the group's headquarters, or a related party holding key intangible assets.

In the process of selecting the compensation source, companies also need to consider and balance regulatory requirements in areas such as accounting, taxation, customs, and foreign exchange administration. It is crucial to pay attention to whether related compensation expenses can be tax deducted in the compensation source jurisdiction. If adjustments involve changes in the prices of traded goods, companies also need to consider the impact on customs declarations related to compensation source in terms of import/export prices.

Downward TP adjustment is aimed at bringing the company's excess profits, beyond what is compliant with the arm's-length principle, into a reasonable range.

Some companies have historically used alternative methods (such as through non-trade outbound payments) or applied for formal customs declarations (e.g., requesting customs authorities to issue a pro forma declaration to increase the price of imported goods and pay the additional duties accordingly) to achieve profit reduction and facilitate outbound remittances. However, these methods have increasingly drawn high scrutiny from tax and customs authorities, with regulatory approaches becoming more stringent in recent years.

Considering the complexities of dealing with issues in taxation, customs, and foreign exchange, many companies prefer to enhance tax certainty and effectively manage their TP outcomes by engaging in advance pricing arrangements with tax authorities. This approach allows for the proper bilateral adjustment of TP profits when necessary, facilitating corresponding foreign exchange transactions. KPMG has observed a noticeable increase in the number of companies seeking such arrangements in recent years.

For Chinese enterprises making outbound investments (Chinese ‘going out’ enterprises), the taxation and TP management in the destination of outbound investments often pose significant challenges. Overseas subsidiaries typically handle simple distribution or production functions, while strategic decisions and key intangible assets are controlled and held by the Chinese headquarters. Therefore, there may be a need for year-end TP adjustments to increase or decrease profits to align with local TP regulations.

Chinese going out enterprises need to consider the regulatory requirements in the jurisdictions of both parties involved in the year-end TP adjustments (i.e., domestic and overseas affiliated enterprises).

Factors such as the functional risk positioning of overseas subsidiaries and the nature of related-party transactions between both parties need to be comprehensively evaluated to formulate the implementation strategies for year-end TP adjustments. Simple approaches such as using debit or credit vouchers, or putting in place non-trade related-party transactions that lack substantive justifications cannot properly address year-end TP adjustments and may even expose companies to additional tax risks.

Given this, KPMG recommends that Chinese enterprises with such requirements need to plan ahead for year-end TP adjustments so as to address potential profit and loss fluctuations of overseas subsidiaries and respond to enquiries and examinations from overseas tax authorities.

Enterprises engaged in related-party transactions should proactively seek professional advice to develop comprehensive plans and implement effective year-end adjustment schemes. This approach helps to manage tax risks across accounting, taxation, customs, and foreign exchange management aspects, ensuring the desired payment arrangements are achieved.