Transfer Pricing in the People s Republic of China FOREWORD It has been long awaited for the Chinese government to promulgate the contemporaneous transfer pricing documentation rules to formalize the compliance requirements on transfer pricing. It is no surprise that the rules being issued lately, as explained below, covered very extensive provisions from many different perspectives including related party definitions, tax compliance requirements on related party transactions such as annual filing and the maintenance of a full set of contemporaneous transfer pricing documentation, tax audit targets and penalty consequences of non-compliance etc. The rules, however, are only trial implementation at this stage and may be further revised by the Chinese tax authorities. As an overall indication, these rules have reflected the mindset of Chinese tax authorities of placing equal emphasis on both legal form as regards to the documentation requirements and also substance on demanding justification by taxpayers on the transfer pricing method so selected. It is clearly a step forward of the Chinese tax authorities to become more confident and sophisticated in dealing with transfer pricing issues and accordingly enterprises are facing an increasing burden to comply with these rules. Regulatory Development The new China Corporate Income Tax Law ( CIT Law ) together with its Detailed Implementation Rules ( Rules ) laid down a set of anti-avoidance special tax adjustments in Chapter 6, which has caused a series attention of the taxpayers. On 8 January 2009, the State Administration of Taxation ( SAT ) issued Guoshuifa [2009] No. 2 ( Circular ) which contained 118 articles to provide guidance on the implementation of special tax adjustments as formulated under Chapter 6 of CIT Law and Rules. This Circular is effective retrospectively from 1 January 2008. To ensure proper compliance and explore potential planning opportunities, the taxpayers should have a very precise understanding of the following areas covered under the Circular: 1. Definition of Related Parties The Circular specifically extends the related party definition to beyond investment holding and lists eight types of related party relationship. The definition is very broad which looks into factors not only share ownership (25% or more, either directly or indirectly), but also the debt financing, common management, dependence of intellectual properties, control of sales, purchases or services, etc. to determine the existence of a related party relationship. 2. Disclosure of Related Party Transactions Enterprises are required to submit the related party transactions annual reporting forms with their annual income tax filing by May 31 of the following year as enclosed in a previous tax circular Guoshuifa [2008] No.114. These annual reporting forms include: Cont d /P. 2
- 2 - Form 1 - Related party relationships Form 2 Summary of related party transactions Form 3 - Purchases and Sales Form 4 Services Form 5 Intangible Assets Form 6 - Fixed Assets Form 7 - Financing Form 8 - Foreign Investment Status Form 9 - Foreign Payments Status Please contact your HLB tax team if you need further details of these disclosure forms. 3. Contemporaneous Transfer Pricing Documentation Based on the Circular, enterprises are required to prepare contemporaneous transfer pricing documentation for the fiscal year by May 31 of the following year and maintained for 10 years. The deadline for the preparation of contemporaneous transfer pricing documentation for the year 2008 has been extended to 31 December 2009. Enterprises are required to submit their contemporaneous transfer pricing documentation within 20 days of the date of request by the tax authorities. The contemporaneous transfer pricing documentation should include detail information about the organisational structure, description of business operations, description of related party transactions, comparability analysis and selection and application of transfer pricing method. Failure to submit contemporaneous transfer pricing documentation gives the tax authorities the power to deem the enterprise s taxable income and impose further fines and surcharges. However, enterprises may be exempt from the requirement of maintaining the contemporaneous transfer pricing documentation if they meet one of the following conditions: - - annual amount of related party purchases and sales is less than RMB 200 million and annual amount of other types of related party transactions is less than RMB 40 million; or - the related party transactions are covered by advance pricing arrangements; or - foreign shareholdings are less than 50% and only engage in related party transactions with related parties in China. Cont d /P. 3
- 3-4. Transfer Pricing Methods The Circular sets out six acceptable transfer pricing methods including the Comparable Uncontrolled Price Method, the Resale Price Method, Cost Plus Method, Transactional Net Margin Method, Profit Split Method and other methods that comply with the arm s length principle. The most appropriate transfer pricing method should be selected by taking into account of factors including characteristics of the assets or services involved, functions and risks of each party involved, contractual terms, economic environment and business strategies etc. Enterprises have the flexibility to select the most appropriate transfer pricing methods. However, they have to provide substances and evidences to justify the methods adopted for their related party transactions. 5. Transfer Pricing Investigations and Adjustments The Circular laid down the common characteristics for an enterprise to be a potential transfer pricing audit target: - Significant amounts and types of related party transactions - Long-term losses, low profit or fluctuating profit pattern - Profit level lower than those in same industry - Profit level inconsistent with the level of functions performed and risks associated - Transactions with related parties registered in tax havens - Failed to prepare required contemporaneous transfer pricing documentation - Transactions are obviously not complied with arm s length principle If transfer pricing adjustment is assessed, the tax authorities will impose a supervision period of 5 years. During the supervision period, the enterprise is required to submit contemporaneous transfer pricing documentation to the tax authorities by 20 June of the following year. Also, daily interest charge based on lending rate of the People s Bank of China plus 5% penalty interest will be imposed. The penalty interest however may be waived if the enterprise has prepared and submitted contemporaneous transfer pricing documentation within the specified time limit. 6. Advanced Pricing Arrangements ( APA ) The Circular provides guidance with respect to requirements and procedures associated with APA. The APA application mechanism is generally designed to support taxpayers in agreeing a proper and acceptable pricing methodology between related parties. In order to apply for an APA, the enterprises should meet the following conditions: - Annual related party transactions of more than RMB40 million; - Comply with the related party disclosure requirements; and - Prepare, maintain and provide contemporaneous transfer pricing documentation. Cont d /P. 4
- 4-7. Cost Sharing Agreements ( CSA ) Cost sharing allows multinationals to agree to pool risks and allocate resources in accordance to the risks undertaken and benefits so generated for each participant. The CIT Law introduced the CSA concept in China for the first time and allowed the sharing of the joint development cost of intangibles and provision of services. According to the Circular, CSAs are required to register with the tax authorities within 30 days of execution of the arrangement. The CSA documentation must be submitted to the tax authorities by 20 June of the following year. Costs allocated for a CSA are not deductible in any one of the following conditions: - No commercial purpose or economic substance; - Not comply with arm s length principle; - Not comply with cost and income matching principle; - Not prepare, maintain and provide CSA contemporaneous transfer pricing documentation; or - Operation period of less than 20 years since CSA is signed. 8. Thin Capitalization Caishui [2008] No. 121 sets out the prescribed debt-to-equity ratios, which are 5:1 for financial institutions and 2:1 for others, in respect of related party financing arrangement. Any excessive interest would not be deductible unless the enterprise can provide documentation to support that the inter-company financing arrangements comply with the arm s length principle. 9. Controlled Foreign Corporations ( CFC ) According to the Circular, CFC is defined as a foreign enterprise controlled by Chinese resident enterprises or resident individuals that is located in a country which has an effective tax rate less than 50% of that in PRC (i.e. less than 12.5%), and with no distribution or reduced distribution of profits without reasonable business needs. The control refers to any one of the Chinese tax resident shareholder directly or indirectly owning at least 10% of the foreign enterprise and the Chinese resident shareholders collectively holding directly or indirectly more than 50% of the foreign enterprise. If a foreign enterprise is a CFC, the undistributed profits of CFC would deem to have been distributed as dividend to its Chinese resident shareholders and thus taxed accordingly. However, exemption would be applied to any one of the following criteria: - CFC is located in a non-low tax rate country as designated by SAT; - CFC derived income mainly from active business activities; or - CFC s annual profit is less than RMB5 million. Cont d /P. 5
- 5 - Our Comments The Circular demonstrates the tightening of transfer pricing compliance enforcement in China. definition of related parties is much broader and can be easily over-looked. The All Chinese enterprises are required to submit the related party transactions annual reporting forms with their annual income tax filing by May 31 every year. The forms are complicated and demanded for significant disclosure of related party information. The Chinese enterprises should now review their relationships with major suppliers, customers, and financers as well as the management structure with reference to the definition of related parties in the Circular for the purpose of fulfilling these compliance requirements. Apart from compliance, the Circular also requested very detail analysis in order to prepare the contemporaneous transfer pricing documentation by May 31 every year unless exemption criteria are met. To meet the deadline of 31 December 2009 for preparing the contemporaneous transfer pricing documentation for 2008, the Chinese enterprises should review their transfer pricing position, justify their pricing, perform the necessary comparability analysis and prepare the full set of documentation without further delay. The maintenance of the contemporaneous transfer pricing documentation requirement may shelter the enterprises from the 5% penalty interest and defend against future transfer pricing investigations. Finally, the taxpayers should consider the feasibility of launching an APA application to remove the uncertainties associated on transfer pricing transactions. With an APA, the contemporaneous transfer pricing documentation requirements may be exempt. The cost sharing arrangement, if properly structured, may be utilized as an effective tax planning tool to optimize the tax positions of the participants under the CSA. Our tax professions can provide guidance and work together with our clients to devise their transfer pricing policies and assist to complete the annual reporting and prepare the documentations required under the rules. If you require further assistance on your personal or corporate tax affairs, Eddy Yeung and his team at HLB Hodgson Impey Cheng Taxation Services Limited will be more than happy to talk to you. (Eddy.Yeung@hic.com.hk or +852 2110 5350) Disclaimer This information is of a general nature only and is not intended to be relied upon, nor to be a substitute for, specific professional advice. No responsibility for loss arising from acting on or refraining from action as a result of any of this information can be accepted. No reader should act on the basis of this information without obtaining independent professional advice with regard to their particular circumstances.