On March 31, 2012, Bryan Cave’s Shanghai office held a seminar concerning transfer pricing. Two senior tax officers of the People’s Republic of China (“PRC”) were invited to make presentations. One Mr. Xia, Deputy Director of the Anti-Avoidance Division of the International Taxation Department of the Chinese State Administration of Taxation (“SAT”), presented a summary of viewpoints concerning PRC transfer pricing tax laws, regulations and practice. His points appear in the following paragraphs.  

The SAT has been advocating a three-pronged approach of “administration, services, and investigation.” “Administration” refers mainly to voluntary adjustments made to transfer pricing arrangements, after reviews of taxpayers’ disclosure forms and transfer pricing documentation, and after follow-up efforts with previously-audited taxpayers urged to “review and refine” their transfer pricing. “Services,” including Advanced Pricing Agreement (“APA”) and Mutual Agreement Procedure (“MAP”) activities, are usually initiated by taxpayers. “Investigation” includes audits and investigations.  

The Chinese tax authorities’ focus has shifted from traditional buy-sell transactions to transactions for services, intangibles, equity, and other items, and to increased enforcement. The automobile and pharmaceutical industries are key sectors for transfer pricing audits, and the SAT continues to strengthen centralized management of audits to regulate nationwide practice. The SAT requires that local tax bureaus obtain SAT approval for filing and closing cases, to ensure a uniform implementation standard and to avoid situations wherein audits of similar companies in different regions yield different results. During a transfer pricing investigation, any adjustments to operating profit due to differing levels of working capital employed might also require SAT approval. Furthermore, the SAT plans to increase joint audits of group companies and audits across selected industries, and to improve regulation of controlled foreign corporations (“CFCs”) and companies falling within China’s General Anti- Avoidance Rules (“GAARs”). Chinese tax authorities are actively involved in international collaboration regarding tax collection and management, as well as international anti-avoidance investigations. The SAT is participating in the drafting of the Practical Manual on Transfer Pricing for Developing Countries initiated by the United Nations, and will take measures against “dishonest” tax planning activities.  

Chinese tax authorities have raised several issues relevant to safeguarding the interests of developing countries. It noted that countries with emerging markets, including China, hold unique competitive advantages over developed countries. Those advantages include continuously increasing purchasing power and cheap land and labor with nearly unlimited supply. The issues raised, all of which can impact a company’s transfer pricing, include:  

Location savings. Multinational companies earn excess profits by setting up low-cost factories in China. Since such profits stem from location savings, say Chinese tax authorities, Chinese subsidiaries should be entitled to the profit.  

Market premium. As a country with an emerging market, competitive advantages, and purchasing power, China has contributed to the profitability of companies operating in the Chinese market. Chinese tax authorities believe that China should be entitled to tax excess profit derived from the China market.  

Contract Research and Development (“R&D”). In most circumstances, contract R&D companies set up in China by foreign multinationals do not own the intellectual property rights generated from the R&D activities. These companies are usually compensated for their labor costs and relevant expenses, plus they receive a modest mark-up. In some situations, the tax authorities may consider such arrangements unfair and require that the Chinese companies be able to enjoy the benefits derived from the R&D activities, especially when the R&D companies are involved in R&D decision-making.  

An important aspect of transfer pricing is which party to the transaction bears which risks, and Mr. Xia informed seminar attendees that, under PRC tax law and policy, selected enterprises established in China by multinational groups will not be responsible for market and business risks associated with the current financial crisis. Those enterprises are companies with limited functions and risks and which perform manufacturing, processing, distribution, or contract R&D activities only. They will maintain a reasonable profit margin commensurate with the functions performed and the risks undertaken.  

Mr. Xia further informed seminar attendees of numerous other updates to Chinese transfer pricing law and regulation. For starters, the interquartile range is now used in testing profitability. Enterprises with profits below the median value will be subject to having their profits adjusted to median value. Also, in evaluating whether a company’s related-party transactions comply with the arm’s-length principle, Chinese tax authorities may use either public or nonpublic information. To this end, the tax authorities are trying to obtain support and cooperation from other governmental departments.  

Amid the trend of tightening anti-avoidance rules, multinational companies should examine their tax arrangements and check whether those arrangements can be adapted to the changing tax environment in China. More and more multinational companies are applying for APAs to minimize transfer pricing risks as much as possible.