Implications of the New Transfer Pricing Guidelines in China and Practical Measures for Multinationals to Adopt in 2009
There have been seismic developments in the transfer pricing field in China in the past year with the promulgation by the State Administration of Taxation (SAT) of the following important legislation and guidance:
• "The Corporate Income Tax Law of the People's Republic of China" (hereinafter referred to as the "Corporate Income Tax Law") issued on 16 March 2007 and effective from 1 January 2008;
• "The Implementation Regulations of the Corporate Income Tax Law of the People's Republic of China" (hereinafter referred to as the "Implementation Regulations of the Corporate Income Tax Law") published on 11 December 2007;
• "Annual Reporting of Related Party Transactions" otherwise known as Guo Shui Fa  No. 11 4, issued on 17 December 2008, detailing the related party disclosure forms that will be required to be completed and submitted by taxpayers along with their 2008 tax return on or before 31 May 2009; and
• "The Implementation Regulations of Special Tax Adjustments" released in Guo Shui Fa (2009) No 2 on 9 January 2009, (hereinafter referred to as the "STA Guidelines").
The end result of these key documents is a modern and comprehensive transfer pricing system for China, although certain areas require further clarification, and uncertainty remains over the consistency of enforcement of the rules from one province to another. Taxpayers can expect further guidance to be released in the coming months and years to continue the development of China's transfer pricing regime.
Other articles in the recent past have described in detail the content of the new rules in China. The purpose of this article is to reflect on these current developments and offer some insights on what they should mean for multinationals currently operating in China or considering investment there.
QUANTITY & QUALITY OF INFORMATION AVAILABLE TO TAX AUTHORITIES
The amount of information that will be required to be presented on an annual basis by taxpayers to the tax authorities is huge. The release of Guo Shui Fa  No. 11 4 requires every taxpayer to submit nine very detailed forms along with their tax return if they have entered into any related party transactions during the tax year under review. It is important to note that the thresholds applicable to transfer pricing documentation do not apply in respect of these disclosure forms – every taxpayer with any related party transactions will need to submit them, and the deadline remains 31 May 2009 in respect of the 2008 year.
The forms that will be required are as follows:
• Annual Reporting of Related Party Transactions – Associated Parties
• Annual Reporting of Related Party Transactions – Transaction Summary
• Annual Reporting of Related Party Transactions – Sales and Purchases
• Annual Reporting of Related Party Transactions – Services
• Annual Reporting of Related Party Transactions – Transfer of Intangible Assets
• Annual Reporting of Related Party Transactions – Transfer of Fixed Assets
• Annual Reporting of Related Party Transactions – Financing
• Annual Reporting of Related Party Transactions – Outbound Investments
• Annual Reporting of Related Party Transactions – Outbound Payments
Many multinationals will need to make changes and enhancements to their IT and accounting systems to enable this type of detailed information to be produced on a reliable and timely basis. To assist multinationals in this process, the Transfer Pricing Associates (TPA) group has developed an MS Excel version of the disclosure forms in English and Chinese that will be suitable for multinationals of all sizes to capture, communicate and record the information quickly and efficiently. Taxpayers should be aware that failure to submit the forms along with the tax return will constitute grounds for initiation of a transfer pricing audit, as well as giving rise to a fine.
Based on experiences in countries other than China that have advised the Chinese authorities over the past 5-10 years in the development of their transfer pricing system, taxpayers in China can look forward to the SAT using this detailed information to risk assess taxpayers – in other words, to classify taxpayers as either high, medium or low risk of transfer pricing investigation. The factors that the SAT will apply have already been spelt out in Chapter 5 of the STA Guidelines as follows:
• Significant amounts or many different types of related party transactions
• Long-term losses, marginal profits or fluctuating profits
• Profit levels lower than the industry norm
• Profit levels lower than fellow group companies
• Profit levels not in accordance with functions performed or risks borne
• Transactions with related parties in tax havens
• Failure to declare related party transactions or prepare relevant tranfer pricing documentation
• Enterprises that "obviously" disobey the arm's length principle
In addition, contract manufacturers (so-called "solefunction manufacturers") that are operating at a loss face a particularly high risk of transfer pricing audit and adjustment since the release of Guo Shui Han No. 236  – a circular issued by the SAT to local tax bureau officers instructing them to investigate such companies.
Therefore, multinationals should ensure that their scarce resources in terms of time and money are devoted to those areas of highest risk. This can be achieved through an objective assessment of transfer pricing risk, by considering the following types of risk factor:
• Prior audit history
• Any advance pricing arrangements in place
• Size of transactions
• Types of transactions
• Location of transacting entities (tax havens)
• Profitability of transacting entities (vs industry norms/ other entities in the company's group)
• Whether existing documentation is available
• Whether benchmarking was carried out
• Tax differentials between jurisdictions of transacting entities
• Whether tax treaty protection is available
Through a more or less scientific methodology, it is possible to decide which areas require the greatest amount of work – higher risk transactions (e.g. royalties, sale of goods to a loss-making distributor) or higher risk entities (e.g. loss-making manufacturers) should receive a higher priority in terms of allocation of time and budget for preparing documentation and other supporting analysis. This will involve the identification of internal resources to handle the project, or selection of external service providers to provide assistance within the budget allocated.
CURRENT & FUTURE AUDIT TARGETS
The above information will enable the SAT and local auditors to devote tax investigation resources to those areas deemed to provide the highest chances of large transfer pricing adjustments and additional tax collections. This is likely to take place on an industry by industry basis – the SAT will likely advise local auditors to identify a particular industry which as a whole represents a high risk of tax leakage for the country, and systematically carry out investigations of the larger players in that industry first of all. Then, using the knowledge of the industry issues acquired from those initial audits, the SAT is likely to advise local auditors to carry out investigations of the other key players in the same industry. The particular industries that could be targeted initially could be those involving significant intellectual property, potentially including local marketing intangibles.
Transfer pricing adjustments in the past years have concentrated on manufacturers, with the adjustment made to the mark-up applied to costs. Hence, the amount of the adjustments made has been relatively modest by international standards. However, the SAT and local auditors are becoming more confident in pursuing larger adjustments by focussing on higher value issues, such as the potential presence of local marketing intangibles, to justify a significantly higher return in China. The development of local intangible assets by China manufacturers led multinationals to apply the contribution profit split method.
This tougher and more targeted approach to tax investigations and transfer pricing enforcement will be boosted by the establishment of the large enterprise tax administration department in the SAT, and by the fact that the former head of transfer pricing for China has been transferred into that new department. Larger enterprises can expect to be investigated from an anti-avoidance and transfer pricing perspective sooner rather than later.
PUTTING DOCUMENTATION INTO CONTEXT
Under the STA Guidelines, comprehensive transfer pricing documentation should be prepared by all taxpayers for each year from 2008 unless one of the following exemptions applies:
• Entities whose total number of annual domestic and cross-border related party transactions lie below certain thresholds – tangible goods transactions (such as purchase and sale of raw materials, components and finished goods) worth less than RMB 200 million and intangible goods transactions (such as royalties, service fees and loan interest) of less than RMB 40 million
• Entities whose related party transactions are all covered by an Advance Pricing Agreement (APA)– although there will be limited documentation obligations under the terms of the APA
• Entities that are not majority foreign-owned and do not have any cross-border related party transactions. Hence, wholly or majority foreign-owned enterprises are subject to the documentation requirements even though they only have domestic related party transactions, unless one of the other exemptions applies
The transfer pricing documentation should be in place by the time for submitting of the tax return for the year in question, which is normally 31 May in the following year. However, as a concession, the deadline for taxpayers to comply with the documentation requirement for the 2008 year will be extended to 31 December 2009.
Taxpayers that fail to prepare the transfer pricing documentation when required to do so will clearly face an increased risk of transfer pricing review and audit, and if transfer pricing adjustments are made, they will be subject to an additional 5% interest penalty. Such interest and penalties can become very substantial when transfer pricing adjustments relate to a number of years, and taxpayers should be aware that no correlative relief is available under double tax treaties for such interest and penalties.
It is important to emphasize that, even if taxpayers are not required by the STA Guidelines to prepare transfer pricing documentation, they are still highly recommended to do so in a number of circumstances, such as:
• The taxpayer company has characteristics that subject it to a high risk of transfer pricing audit and investigation, such as being a loss-making manufacturer or a distributor achieving net margins lower than the industry norm
• The taxpayer operates in a high-risk industry or is part of a large multinational group that faces a high risk of a transfer pricing audit
• The taxpayer discloses unusual or suspicious related party transactions or transfer pricing methods when completing the obligatory related party disclosure forms
• The taxpayer is exempt for the 2008 year due to the thresholds on related party transactions, but expects an increase in the amount of related party transactions in future years. In this case, it is highly recommended to carry out a documentation exercise for the 2008 year in order to capture the industry and functional analysis information for future use, because such information can be lost over time as employees change employers and memories fade
Taxpayers should bear in mind that transfer pricing adjustments can be made, and additional tax and penalties levied, by the SAT to include years when documentation may not have been strictly required – the limitation period is up to 10 years, and the interest and penalties will not be capable of correlative relief under any double tax treaties.
The article reviews transfer pricing regulatory and enforcement developments in China in 2014. It is evident that the Chinese tax authorities have become more and more sophisticated and experienced on transfer pricing administration, audit and investigation. The impact of global developments, in particular the targeting of BEPS at the OECD level, has further strengthened the resolve of the Chinese tax authorities to deal with the risk to China revenue that transfer pricing creates.
To avoid potential tax audit risks, it is advisable that taxpayers take positive and proactive steps to address the practical issues relating to the actual operation of the transfer pricing legislation, and to manage their transfer pricing documentation obligations and audit risks in the Chinese business environment. This is important now but will become essential in 2015 when the BEPS rollout continues and concepts such as CbC reporting are introduced.
CREATING VALUE FROM TRANSFER PRICING ANALYSIS
Taxpayers should therefore approach the new transfer pricing regime in China with utmost caution. While this will involve a certain level of investment in terms of management time and resources, appointment of external advisers to assist in the process and so on, it is important in these difficult economic times to maximise the value derived from the economic analysis carried out and the documentation created, while reducing costs as far as possible.
Master file approach to documentation
A master file approach to documentation in China makes a great deal of sense for many reasons; it reduces the time taken to meet the compliance burden, eliminates inconsistencies, avoids duplication of effort and cost, and ultimately reduces the risk of transfer pricing audits, adjustments and double taxation.
In brief, the master file approach in the China context is to prepare core elements of transfer pricing documentation centrally, such as:
• Analysis of the overall business context and industry
• Functional analysis in respect of each type of entity, such as manufacturer, distributor, service provider and so on, provided that the multinational operates a centralised business model where the activities of each type of entity are broadly similar
• Classification of each type of entity for transfer pricing purposes in accordance with the responsibility centre concept the Organization for Economic Cooperation and Development (OECD) Guidelines and the China regulations
• Identification of the inter-company transactions involving the entities in China
• Selection of the most appropriate transfer pricing methodologies for each type of inter-company transaction, in accordance with the OECD Guidelines and China's regulations
• Benchmar k ing analyses us ing the databases recommended by the SAT in respect of each type of transaction and/or type of entity Once the China master file has been prepared in this way, preparing documentation for each specific entity becomes relatively simple. This would involve:
• Limited additional functional analysis work to confirm the nature of the specific entity's activities and the accuracy of the functional analysis information included in the master file
• Selection of the relevant sections of the master file report to be included in the entity-specific report, such as classification of the entity, identification of the inter-company transactions, selection of the transfer pricing methodology and benchmarking
• Financial analysis of the specific entity's performance to enable conclusions to be drawn as to the specific entity's compliance with the arm's length principle. It is important to appreciate that the master file is in itself not designed to satisfy the documentation requirements of any specific entity. Rather, it is a stepping stone to allowing the maximum amount of leverage in the preparation of multiple specific entity reports on a highly efficient, consistent and cost effective basis.
Many multinationals manage their global and regionaltransfer pricing compliance burden in this fashion, and a
similar approach to the China market is recommended – either as an extension of a global or regional master file, or as a separate standalone exercise. However, it is important to mention that reliance on a global master file will not suffice to satisfy the documentation requirements in China, as a certain amount of China – specific content is required.
Development of templates
It should be possible to develop documentation templates in the first year that documentation is prepared, and to leverage from those in future years in order to minimize additional costs. The Transfer Pricing Associates group has developed such templates including master file documentation, China standalone reports together with relevant Appendices and, as mentioned above, the related party transaction disclosure forms in electronic format.
Global multinationals are likely to continue the trend of insourcing their extensive transfer pricing documentation and tax compliance requirements, and the need to prepare China transfer pricing documentation will provide this trend with added impetus.
In a global survey of leading multinationals carried out by the Transfer Pricing Associates group in 2008, it was found that the majority of respondents would consider increasing their in-house transfer pricing activities to include routine documentation, which in turn would reduce external support costs. However, constraints in terms of in-house experience and resources remain. To the extent that insourcing is possible in light of the availability of resources, this will minimise the costs of satisfying the China transfer pricing documentation requirements.
Early identification of risks
The preparation of transfer pricing documentation for China should be accompanied by a detailed review of all potential transfer pricing risk areas, so that the multinational can take appropriate action to minimize those risks before they become reality. This should form an integral part of all transfer pricing documentation exercises, and can result in significant value being derived by the multinational concerned.
Identifying opportunities to minimise overall effective rate of tax
Similarly, the transfer pricing documentation exercise can help identify opportunities for achieving a different profit allocation between different entities in a company group while complying with the arm's length principle and in compliance with the provisions of the Corporate Income Tax Law. This may be achieved by simply correcting a non-arm's length transfer pricing system, or by altering the functions, assets and/or risks sufficiently to justify the of a different transfer pricing method or a different classification of one or more entities in the group. Such restructuring must be supported by the economic reality and business substance, in order to avoid challenges by the tax authorities under the STA Guidelines and the general anti-avoidance rules.
The recent developments in China's transfer pricing regime should put multinationals of all sizes and industries on notice of a rapid increase in transfer pricing enforcement activities by the SAT and local tax auditors. The documentation process should not be viewed as a purely compliance process, as it can deliver significant benefits in the long run in terms of reduced risks and identification of opportunities to lower the overall effective tax burden.
No reproduction is allowed without permission.
Douglas Fone（Duff & Phelps）
TEL：+61 (0)410 678 605;
Dr Jian Li
TEL：(21) 65557117; MOBILE： +86 1391 815 5492;
Kunda Tax Consulting (Shanghai) Limited