Transfer-pricing challenges in China

Author: | Published: 1 Jul 2005
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China, once a closed and isolated country, has integrated rapidly into the world economy in recent years. As a result, China has become a significant segment in the global supply chain as a low-cost source of products for export; and has grown into a significant market in its own right for many multinational enterprises (MNEs). While China's interest in attracting foreign business has historically trumped its interest in transfer pricing, the expected expiration of tax holidays and an increased interest in protecting its tax revenue base have led to increasing transfer-pricing enforcement in recent years. Even more aggressive enforcement can be expected in the future.

While encouraging foreign investment, China has also pursued regulatory policies designed to encourage local sourcing and the transfer of technology and know-how to China. As intangible assets that were originally developed in Japan, Europe and the US are used in China, the Japanese, European and US tax authorities can be expected to insist that arm's length payments and/or sufficient profits from China flow back to the Japanese, European or US owners of these intangible assets.

Determining the values of such payments, however, is complicated by China's underdeveloped infrastructure, which poses logistical challenges that have encouraged local operations to become more self-sufficient. Furthermore, China's ever changing business environment often caused the Chinese entities of MNEs to perform more functions, assume more risks and deploy more assets than originally anticipated. This in turn has reduced the ability of foreign MNEs to limit the profits of their Chinese affiliates because of higher profit expectations from the Chinese tax authorities.

These two competing factors suggest that companies with significant operations in China need to pay careful attention to better balance the expectations of tax authorities inside and outside of China. If the taxable income reported in China is substantially lower than the total profits derived from the Chinese operations, the suspicions of the Chinese tax authorities may be aroused. Conversely, if the profits are higher than those of a routine entity carrying out the same functions, the tax authorities of the parent company may ascribe such excess profits to intangibles contributed by the parent. Thus, MNEs need to defend themselves against potential audits by Chinese tax authorities while at the same time considering the possibility of adjustments ascribed to the parent company by tax authorities outside of China.

Business environment

The Chinese business environment presents special challenges for MNEs for at least three reasons. First, as the Chinese economy continues to grow at a rapid pace, more and more MNEs are starting to report profits from the Chinese market. Moreover, if external factors such as market fragmentation, logistical challenges, and lack of intellectual property protection increase the functional and risk profiles of Chinese entities more than originally anticipated by their parent companies, this may increase the taxable income expected by the Chinese tax authorities. Finally, as MNEs penetrate new areas beyond the more developed coastal regions, their Chinese entities may create unique local intangibles; thereby, increasing the importance of locally developed intangibles while reducing the reliance on transferred intangibles from the parent company.

Second, the Chinese market is highly volatile. Thus, Chinese operations may have profits that fluctuate significantly from year to year in response to risks such as rising input costs (for example, steel and energy), increasing local competition, currency revaluation pressures, and operational risks (for example, inventory, labour, logistics, and quality control). Such fluctuations in operating results increase the likelihood that one or the other of the two tax authorities at issue will question the company's transfer-pricing practices.

Finally, the lack of intellectual property protection and rampant counterfeiting may present unusual challenges. The most obvious issue raised by the lack of intellectual property protection is the consequent reduction in the value of intangibles contributed by the parent company, and the likely unwillingness of tax authorities of the parent company to recognize any such erosion in value. A second and equally disturbing possibility is the development of potential (CUPS) or (CUTS) that may support very low prices. The lack of intellectual property protection may tempt the Chinese tax authorities to use comparables that are not necessarily reflective of the controlled relationship (for example, to use generic price/profits to determine the prices/profits of branded goods.)

Tax regulations

Chinese tax regulations are complex, ever changing and therefore hard to predict. For MNEs to manage their transfer-pricing issues effectively, it is essential for them to understand the key features of these tax regulations. Chinese domestic enterprises and foreign invested enterprises (FIEs) are subject to different sets of tax laws and regulations. However, there are various incentives for FIEs including tax reduction, tax holidays, and tax refunds, as well as incentives to import equipment, transfer technology and conduct R&D in China. Such incentives are only available for a limited time, however.

Multinational enterprises often face substantial indirect tax issues such as value-added tax, business tax, consumption tax, and customs duties when doing business in China. These taxes are frequently much more important than income tax, particularly given the existence of a tax holiday. However, a short-term focus on these factors may wind up limiting future flexibility and may become costly when the tax holiday expires. Foreign exchange restrictions in China may pose further challenges in transfer-pricing planning such as allocation/repatriation of funds.

The Chinese government is preparing for another round of tax reforms, which is expected to take place in the next two years. Under its WTO commitments, China has aimed to eliminate policies that are unfavourable to foreign investors while ensuring that domestic enterprises are not unfairly disadvantaged. The new corporate income tax rate for both domestic enterprises and FIEs may be lowered from 33% to within a range of 25% to 28%. Tax incentives may be granted on an industry basis, as opposed to the corporate status of an enterprise, as is the case now. As a result, transfer-pricing planning should be aligned with these anticipated tax reforms.

Transfer-pricing enforcement

Transfer-pricing enforcement has historically occurred at the local rather than national level and, until relatively recently, local jurisdictions have often been more concerned with providing a favourable business environment than in the collection of income taxes. However, with the recent release of several circulars relating to transfer pricing, the Chinese tax authorities are moving to protect China's tax revenue base by limiting actual or perceived tax avoidance due to transfer-pricing abuse. As part of this effort, the State Administration of Taxation (SAT) has urged both state and local tax authorities to enhance transfer-pricing audits and ensure compliance, and has suggested targeting companies that are:

  • suffering continuous losses;
  • incurring low profits or losses but continuously expanding their business;
  • showing an irregular profit or loss pattern;
  • avoiding tax liabilities through transactions with related parties in tax havens; and/or
  • avoiding tax liabilities through thin capitalization.

Finally, SAT is re-emphasizing joint nationwide transfer-pricing audits on high-risk taxpayers. Simultaneous audits are being performed by tax authorities on multiple legal entities belonging to the same group throughout China. In 2004, 21 provincial/city level tax authorities were required to select one or two potential audit targets and submit them to the SAT for joint nationwide audit. (The SAT issued circular Guoshuihan [2004] No 370 on March 25 2004 to all the subordinate tax bureaux to notify its objectives and requirements for the anti-tax-avoidance/transfer-pricing audit in 2004. In that circular, 21 provincial/city level tax authorities were required to select one or two potential audit targets and submit them to the SAT for joint nationwide audit in 2004.)

Proactive approach needed

A number of MNEs now have significant and rapidly growing operations in China. China's unique business and regulatory environment encourages both the transfer of intangibles from the parent company and the development of significant local capabilities. As the profits generated by the Chinese subsidiaries of MNEs grow, there is significant room for adjustments initiated by the tax authorities auditing both the offshore parent companies and the local Chinese subsidiaries.

Accordingly, MNEs with significant operations in China should take a proactive approach to transfer pricing in China in which transfer-pricing policies are aligned with the MNE's long term business/operational strategy. Transfers of intangible assets and changes in operational responsibilities should be carefully analyzed and documented to help maximize the likelihood of the consistent valuation/pricing of such intangibles by tax authorities in China and authorities outside China. Advance pricing agreements could be considered to avoid unreasonable expectations by tax authorities on both sides of the transaction.

The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP.

The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.