FAQs – China Transfer Pricing

Transfer pricing laws and regulations

What are the laws and regulations on transfer pricing in China?

The laws and regulations on transfer pricing in China are as follows:

1. “The Corporate Income Tax Law of the People’s Republic of China” issued on 16 March 2007 and effective from 1 January 2008;
2. “The Implementation Regulations of the Corporate Income Tax Law of the People's Republic of China”  published on 11 December 2007;
3. “The State Administration of Taxation on Matters Relating to Improved Administration of Related Party Declarations and Contemporaneous Documentation” released in Announcement [2016] No. 42on 13 July 2016;
4. “Special Tax Investigations, Adjustments and Mutual Agreement Procedures” released in Announcement [2017] No. 6 on 28 March 2017;
5. “The Enhancement of the Administration of Advance Pricing Agreements” released in Announcement [2016] No. 64 on 18 October 2016;
6. “The Notice of Anti-Avoidance Examination on Significant Outbound Payments” released in Circular [2014] No. 146 on 29 July 2014.
   The statute of limitations for transfer pricing adjustments is 10 years.

The arm’s length principle

What is the arm’s length principle?

The arm’s length principle refers to the principle under which all the non-related transaction parties conduct their business based on fair transaction value and conventional operation. That is, the principle whereby totally independent, non-associated enterprises or individuals set prices based on open market conditions to handle the distribution of income or costs between them.

The arm’s length principle is already accepted and adopted by the majority of the countries worldwide, and has become the guiding principle of the tax authorities of the various countries when handling transfer pricing between associated enterprises. Whether or not the pricing of the internal business transactions of the associated enterprises of the MNEs is accepted or not by the taxation authorities basically depends on whether the associated enterprises conduct their transactions, according to the arm’s length principle and price them as if they are between non-associated enterprises.

The Chinese tax laws clearly stipulate that the collection and payment of consideration or fees of business dealings between associated enterprises must comply with the arm’s length principle. If the collection and payment of the consideration or fees are not in compliance with the arm’s length principle, thereby enabling the reduction of taxable income or income tax, the tax authorities will have the right to intervene to make reasonable adjustments.

What are the issues in the actual application of the arm’s length principle?

In order to apply the arm’s length principle to transactions between associated enterprises, it is necessary to identify a similar transaction between independent enterprises under comparable conditions. However, in many cases, it is hard to find similar transactions that happen between the independent enterprises.

It is important to acknowledge that associated enterprises may engage in transactions that independent enterprises would not be willing to engage in, because they may face certain commercial situations that are different from those faced by independent enterprises.

Identification of related party and the types of related party transactions

What is the definition of a related party?

The concept of “related party” refers to an enterprise that is directly or indirectly controlled, or being substantially influenced by another enterprise.

Article 2 of Announcement 42 defines a "related party relationship" as any of the following relationships which the enterprise has with another enterprise, an organization or an individual:

What are the common types of related party transactions?

Related party transactions mainly include:

• Transfer of the right to use or ownership of tangible assets. Tangible assets include merchandise, products, buildings, transportation vehicles, machinery and equipment, tools, apparatus, etc.

• Transfer of financial assets. Financial assets include accounts receivables, notes receivables, other receivables, equity investments, debt investments, derivative financial instruments, etc.

• Transfer of the right to use or ownership of intangibles. Intangibles include patents, non-patented technological know-how, trade secrets, trademarks, brand names, customer lists, sales channels, franchise rights, government licenses, copy-rights, etc.

• Financing. Financing includes all types of long-term and short-term loans (including group’s cash pool), guarantees, all types of interest-bearing advance payments and deferred receivables or payables, etc.

• Services. Services include market survey, marketing planning, agency, design, consulting, administrative services, technical services, contract R&D, maintenance services, legal services, financial services, audit, recruitment, training, centralized procurement, etc. 

Transfer pricing methods

What are the applicable transfer pricing methods?

The comparable uncontrolled price method (CUP), resale price method, cost plus method, the transactional net margin method (TNMM), and the profit split should be used.

The other methods in compliance with the arm’s length principle may be acceptable

What is the comparable uncontrolled price method (CUP) and its application conditions?

The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. The CUP is applicable to all types of related party transactions.

In the application of the CUP, comparability analysis should particularly investigate the differences between related party transactions and third party transactions in respect of assets transacted, services provided, contract terms, the economic environment and business strategies.

What is the resale price method and its application conditions?

Under the resale price method, the arm’s length price for goods purchased from a related party is determined by deducting the gross profit of a comparable unrelated party transaction from the resale price to unrelated parties for goods purchased. The resale price method shall apply where the resellers engaged in simple processing or buy-sell activities that do not involve substantial value-added processing such as alteration of appearance, functionality, structure or a change of the trademark.

The comparable analysis shall focus on the differences in functions, risks, and contractual terms between the related party transactions and the unrelated party transactions, as well as other factors influencing the gross profit.

What is the cost plus method and its application conditions?

The cost plus method determines the arm’s length price of related party transactions by adding a gross margin derived from the comparable unrelated party transactions to a reasonable cost base of the related party transaction. The cost plus method shall apply to related party transactions involving purchases and sales, transfer and use of tangible assets, provision of services, and financing.

The comparable analysis shall focus on the differences in functions, risks, and contractual terms between the related party transactions and the unrelated party transactions, as well as other factors influencing the cost mark-up rate.

What is the Transactional Net Margin Method (TNMM) and its application conditions?

The profit split method determines the profit to be allocated to each party in the related party transaction based on their contribution to the consolidated profits derived from the related party transaction. The profit split method can be categorised into the general profit split method and the residual profit split method. The profit split method shall apply to situations where related party transactions are highly integrated and where it is difficult to separately assess the transaction result of each participant.

The comparability analysis shall focus on the functions performed, risk borne and assets employed by each participant; the allocation of costs, expenses, income, and assets to each participant; the location special factors such as cost savings, market premium etc ; other contribution factors; and the reliability of the information and assumptions used to determine the contribution of each participant to the residual profit. 

What is the profit split and its application conditions?

The profit split method determines the profit to be allocated to each party in the related party transaction based on their contribution to the consolidated profits derived from the related party transaction. The profit split method can be categorised into the general profit split method and the residual profit split method. The profit split method shall apply to situation where related party transactions are highly integrated and where it is difficult to separately assess the transaction result of each participant.

The comparability analysis shall focus on the functions performed, risk borne and assets employed by each participant; the allocation of costs, expenses, income, and assets to each participant; the location special factors such as cost savings, market premium etc; other contribution factors; and the reliability of the information and assumptions used to determine the contribution of each participant to the residual profit.

Comparability Analysis

What are the steps for a comparability analysis?

Searching information on comparable transactions contains nine steps as follows:

• Determination of years to be covered.

• Broad-based analysis of the taxpayer’s circumstances.

• Understanding the controlled transaction (s) under examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account.

• Review of existing internal comparables, if any.

• Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability.

• Selection of the most appropriate transfer pricing method and depending on the method, determination of the relevant financial indicator.

• Identification of potential comparables; determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors.

• Determination of and making comparability adjustments where appropriate.

• Interpretation and use of data collected, determination of the arm’s length remuneration.  

What is product comparable?

A product comparable is one that concerns a price for a product in a specific transaction, or in other words a CUP.

What is functional comparable?

A functional comparable concerns information on either the gross margin or the operating margin (or gross or net profit mark-up rates on costs) of a company with functionality similar to that of the tested party. Functional comparables are normally identified by performing comparables searches in commercial databases, but can also be identified through searching the Internet.

What are internal comparables?

Internal comparables are similar transactions between the tested party and unrelated companies that are comparable to the controlled transactions being studied. Internal comparables normally have high degrees of comparability because the functionality differences are limited, and few or no adjustments are required.

What are external comparables?

External comparables are transactions between unrelated companies, one of which is comparable to the tested party. External comparables are normally very difficult to find in practice and often there are comparability issues because of differences in functionality or lack of information to assess comparability

Which comparability factors should be applied to determine comparability? 

These comparability factors are:

• Characteristics of the property or services transferred
• Functions performed by the parties involved
• Contractual terms
• Economic circumstances
• Business strategy

Which information is required for a value chain analysis?

A value chain analysis contains the following:

• Flows of business, goods and materials, and capitals within the group;
• Annual financial statements of each of the aforementioned parties for the immediately preceding fiscal year;
• Measurement and attribution of value creation contributed by local specific factors;
• Allocation policies and actual allocation results of the group’s profiles in the global value chain.

Transfer pricing documentation

Which companies should prepare local file?

Companies whose amount of yearly related party transactions satisfy any one of thefollowing criteria shall prepare Local File:

• The amount of transfer of ownership of tangible assets exceeds RMB200 million.
• The amount of transfer of financial assets exceeds RMB100 million.
• The amount of transfer of ownership of intangible assets exceeds RMB100 million.
• The total amount of other related party transactions exceeds RMB40 million.
• Enterprises engaging in tolling or contract manufacturing for overseas related parties or engaging in simple distribution or contract R&D in a LOSS situation.

Which companies should prepare master file?

Companies meeting either of the following criteria shall prepare the Master File:

• Have cross-border related party transactions and the ultimate holding enterprise has already prepared the Master File, or
• The total amount of related party transactions exceeds RMB 1 billion.

Which companies should prepare special issue file?

There is no specific threshold criterion for the Special Issue File. Companies meeting either of the following criteria shall prepare the Special Issue File:

• An enterprise which has entered into or executed a cost-sharing agreement; or
• Where the related party debt equity ratio of the enterprise exceeds the standard ratio and it is required to state whether the independent transaction principle is complied with.

When the transfer pricing documentation should be prepared?

The Master File should be completed within 12 months after the fiscal year end of the group’s ultimate holding company, while the Local File and Special Issue File should be completed by 30 June of the year following the year in which the related party transactions occur.

What information is required for local file?

The information required for the Local File includes:

Overview of local enterprise

• Organisation structure
• Management structure
• Business description
• Business strategies
• Financial data for each business
• Information on restructuring or transfer of intangibles

Related party relationships

• Information on related parties involved
• Information on the income taxes of each related party
• Changes in the enterprise's related party relationships

Related party transactions

• Overview of related party transactions
• Value chain analysis
• Outbound investments
• Related party equity transfer
• Related party services
• APAs and tax rulings related to related party transactions

Comparability analysis

• Factors taken into consideration in comparability analysis
• Information on functions performed, risks borne and assets used by comparable companies
• Selection criteria and rationale for accepted comparable information
• Information on internal or external comparable uncontrolled transactions and financial information of comparables
• Comparable adjustments and the underlying reason

Selection and application of transfer pricing method

• Selection of tested party and the underlying reason
• Selection of transfer pricing method and the underlying reason, the enterprise’s contribution to the group's overall profit or residual profit
• Assumptions and judgment made in establishing arm’s length prices or profit
• Application of transfer pricing method and comparability analysis results
• Any other materials supporting the selected transfer pricing method
• Analysis and conclusion of whether the transfer pricing policy is of arm’s length nature

What information is required for master file?

The information required for the Master File includes:

• Organisation structure

An organizational chart for the company to illustrate the global organisation structure and equity structure of the enterprise group and geographical distribution of all the member entities.

• Business of an enterprise group

A description of the global group’s business, including profit divers, supply chain and geographical markets of the top five products or services, important services rendered by related parties, a brief functional and risks analysis for group entities as well as recent business restructurings.

• Intangible assets

A description of the global group’s intangibles such as overall strategies for development and application of intangibles and determination of ownership of intangibles, important agreements on intangibles, the group’s transfer pricing policies for R&D and intangibles.

• Financing activities

Information on the global group’s financing arrangements with both related and unrelated parties, member entities performing centralised financingfunction, overall transfer pricing policy for financing arrangements.

• Financial and tax situation

Information on the global group’s financial and tax position, containing consolidated financial statements, APAs, other tax rulings on income allocation as well as the entity filling the CBC report.

What information is required for the special issue file for a cost-sharing agreement?

What information is required for the special issue file for thin capitalisation?

Annual disclosure forms (including CbC template)

Which companies should file annual disclose forms?

A tax resident enterprise that pays Enterprise Income Tax according to its financial records and a non-tax resident enterprise that has an establishment or a place of business in China and settles Corporate Income Tax based on its actual accounts shall, at the time of submitting its annual Enterprise Income Tax return, report related party transactions based on its dealings with related parties, and file the “People’s Republic of Chinese Enterprise Annual Reporting Forms for Related Party Transactions (2016 version). 

Which companies should file Country-by-Country (CbC) Report?

The residual enterprise is the ultimate holding company of a multinational enterprise’s group having total consolidated group revenue of more than 5.5 billion RMB during the fiscal year immediately preceding the reporting fiscal year as reflected in its consolidated financial statements for such preceding fiscal year.

For an enterprise that is not required to file the CbC report under the aforementioned provisions, the tax administrations can require the taxpayer to provide the CbC report during a special tax investigation if the MNE to which the enterprise belongs is required to prepare the CbC report in accordance with the relevant regulations of another country and one of the following conditions is met:

• The MNE has not filed the CbC report to any other countries;
• Although the MNE has filed the CbC report to another country, there is no mechanism in place to exchange CbC report between China and that country;
• Although the MNE has filed the CbC report to another country, and there is a mechanism in place to exchange the CbC report between China and that country, the CbC report has not been successfully exchanged to China.

What information is required for the CbC report?

The CbC report shall mainly disclose information relating to the global income, taxes and business activities of all constituent entities of the MNE group to which the ultimate holding company belongs on a country-by-country basis. 

Penalties

What are the penalties for not fulfilling the reporting requirements for annual disclosure forms?

• Penalty amount up to RMB 50,000;

• Risk of being transfer pricing audited.

What are the penalties for not fulfilling the reporting requirements for transfer pricing documentation?

Transfer pricing investigations and adjustments

Which types of enterprises tax authorities shall focus on in particular when conducting transfer pricing investigations?

Tax authorities shall focus in particular on enterprises with the following characteristics when conducting transfer pricing investigations:

• Enterprises with significant amount of related party transactions or relatively more types of related party transactions;

• Enterprises with continuous losses, low profitability or fluctuating profitability;

• Enterprises with profit level lower than those of other enterprises in the same industry;

• Enterprises whose profit levels do not match their functional and risk profiles or whose shared benefits do not match their allocated costs;

• Enterprises that engage in transactions with related parties in low tax countries (jurisdictions);

• Enterprises that fail to file their related party transactions reporting form or to prepare contemporaneous documentation;

• Enterprises whose related party debt-to-equity ratio exceeds the standard ratio;

• Enterprises controlled by Chinese tax resident companies, or by Chinese tax resident companies together with Chinese nationals, which are established in a country (jurisdiction) where the effective tax rate is lower than 12.5% and failed to distribute profits or reduced distribution profits other than for reasonable operating needs;

• Enterprises who engage in tax planning schemes or tax arrangements that lack reasonable business purposes.

The SAT has used the above list of targets to assist in devoting its resources to higher risk cases, thereby maximizing the effectiveness of its audits.

The issue of royalty and service fee remittances remain focus areas which are likely to give rise to transfer pricing scrutiny and are the key feature of audits. In addition, the SAT has intensified industry-focused or group enterprise-oriented national joint investigations, targeting industries including pharmaceutical, automotive, although by no means have limited to these industries.

The major transfer pricing issues within these industries include outbound royalty payments, local marketing intangibles and location specific advantages. It is also worth noting that the SAT has been continuing to strengthen its focus on nationwide and industry-wide transfer pricing audits, In a nationwide audit, companies within a multinational group are simultaneously audited, whereas industry-wide audits focus on companies in specific industries.

Intra-group services

Which types of services provided by related parties shall not be considered beneficial services?

• A service activity that has already been procured or carried out by the enterprise itself.

• A service activity that is carried out to exercise control, management and supervision of enterprise with a view to protecting the investment interests of a direct or indirect investor.

• A service activity that is not specially carried out for enterprise although the enterprise has obtained an incidental benefit by belonging to a particular group.

• A service activity that has already been paid for in another related party transaction.

• A service activity that is not relevant to the functions performed or risks assumed by the enterprise, or does not meet the business needs of the service recipient.

• Any other services that cannot bring direct or indirect economic benefit to the service recipient, or the service recipient would be unwillingly to pay for it or perform it for itself.

No reproduction is allowed without permission.

Dr Jian Li（Kunda Tax Consulting (Shanghai) Limited）
MOBILE： +86 1391 815 5492
EMAIL：j.li@kundachina.com
Jian is a Senior Partner at Kunda Tax Consulting (Shanghai) Limited with more than 15 years’ experience in transfer pricing consulting. He provides transfer pricing services in the Greater China region, in both English and Chinese.