For multinational companies, dealing with either tax authorities or customs administrations can be a major headache. So how about serving two masters at the same time? Surely it would not be easy. In the cross-border business environment, it is not uncommon to see multinational companies struggling with the conflicting demands from tax authorities and customs administrations. Indeed, the conflict between transfer pricing and customs valuation is attracting attention from various stakeholders, including tax practitioners in the game. The solution to this conflict varies with countries.
In China, the transfer pricing issues are administered by the State Administration of Taxation (SAT) and its local branches, while the customs issues fall into the jurisdiction of the General Administration of Customs (GAC). The SAT and the GAC are two separate governmental agencies at the national level. China’s customs valuation rules and transfer pricing rules are similar on some basic principles, such as the arm’s length principle applicable to the transactions between two related entities. Nevertheless, there are some differences and conflicts between the two.
This article discusses the interaction of transfer pricing and customs valuation in China. The first part will explain a variety of potential conflicts between transfer pricing and customs valuation. To a certain extent, the conflicts are rooted in the divergent purposes of the SAT and the GAC. The second part is to explore possible reconciliation measures to resolve the conflicts. The documentation requirement in recent tax regulations could be helpful to customs valuation. The third part will provide a brief conclusion to the discussion.
1. Conflicts between Transfer Pricing and Customs Valuation
While it is the objective of both the SAT and the GAC to ensure that related parties are transacting with each other on an arm’s length basis, as in other countries, there is a natural tendency for the two different authorities to pursue potential adjustments in opposing directions. For example, when a Chinese company imports goods from an overseas company, the SAT would scrutinize whether the transaction value is so high that it could increase the cost of goods and reduce the taxable income from a corporate income tax perspective. Conversely, the GAC would examine whether the transaction value is too low and thereby would result in underpayment of customs duties. Setting prices that will satisfy the requirements of both the SAT and the GAC can pose a challenge for companies.
The conflicts between the two systems can materialize in the following main areas.
1.1 Target of Investigation and Valuation
Although the GAC has the right to investigate the valuation of prior transactions, it tends to focus more on transactions currently undergoing the customs declaration process. Normally the customs process does not focus on a preselected target company, but rather on a transaction-by-transaction approach. In practice, however, the GAC has developed a risk analysis system that it applies during the entry declaration review process by which it identifies goods and companies that present risks of noncompliance.
From a transfer pricing perspective, investigations generally will more often target historical transactions rather than ongoing transactions. The objective of a transfer pricing investigation is to review whether transactions of a selected target taxpayer in a certain past period are in accordance with the arm’s length principle and to make adjustment if the taxable amount in such a period is affected by a violation of the arm’s length principle. The SAT will consider the taxable income and profitability of an entity as a whole over a period of time, whereas the GAC focuses on examining the dutiable value of imported goods on a transaction-by-transaction basis. Unlike the customs valuation, the transfer pricing investigations do not commonly apply to general enterprises but to a particular target enterprise selected by the tax authorities.
1.2 Pricing Methods and Priority
The Chinese transfer pricing rules prescribe five main transfer pricing methods, including: (1) comparable uncontrolled price (CUP) method; (2) resale price method; (3) cost plus method; (4) transactional net margin method and (5) profit split method. There is no priority to these methods.
The Chinese customs valuation rules prescribe that four main methods can be used for valuation purposes. In preferred sequential order they are (1) transaction value of the identical goods method (similar to the CUP method); (2) transaction value of the similar goods method (similar to the CUP method); (3) deductive value method (similar to the resale price method) and (4) computed value method (similar to the cost plus method).
In comparison, the transfer pricing rules have more valuation methods (i.e., transactional net margin method and profit split method) than the customs. Further, no priority exists in transfer pricing methods, whereas customs valuation methods follow a sequential order. These differences may result in a company having difficulty structuring its pricing methodology to satisfy the requirements of both the tax authorities and the customs authorities. Accordingly, even if a company sets its transaction price in compliance with transfer pricing rules, it may still face a challenge and a price adjustment from the customs authorities employing a different pricing methodology, or vice versa.
1.3 Focus of Investigation
The main objective of customs valuation is to determine a reasonable dutiable value for each import transaction. The GAC normally focuses on the factors and details that may affect prices. However, the objective of transfer pricing investigations is to determine a reasonable distribution of profits earned in controlled transactions between related parties consistent with the arm’s length principle. Although the SAT also looks at the factors that may affect prices, it focuses more on the functions performed and the risks borne by related parties.
1.4 Price Comparable Selection
When the GAC applies the transaction value the identical goods method or transaction value the similar goods method, assuming multiple identical or similar transaction values, it shall select the lowest one as the basis for customs valuation under the relevant rules. Nevertheless, when the SAT applies the CUP method, multiple comparable uncontrolled prices will be considered in determining a reasonable price range. As long as the transfer price is within this reasonable price range, the SAT normally will not challenge it. If the profit level of the taxpayer is lower than the median, the SAT will make an adjustment by raising it to the median or higher.
1.5 Conflict on License Fees
Cross-border license fees are normally subject to Chinese withholding tax and business tax. Under current customs rules, however, certain license fees must be included in the customs value of the relevant goods and thus subject to customs duty. Due to a lack of necessary cooperation and information sharing, the decision made by the GAC may not necessarily be acceptable to the SAT. As such, the same license fees could be separately taxed by the SAT and the GAC, thus resulting in an issue of double taxation.
1.6 Conflict on Price Adjustments
Periodic price adjustments for transfer pricing purposes are common in China. In other words, related parties can adjust their transfer prices over a period of time to ensure transactions as a whole reflect the arm’s length principle. Nevertheless, the GAC normally does not accept periodic adjustments. Its focus is to compare the value of related party transactions to those of similar transactions between unrelated parties.
2. Reconciliation Measures
The SAT and the GAC generally focus on different aspects of related party transactions. When it comes to import/export pricing, however, they both require that all pricing information that parties submit must be objective, authentic and accurate. If both authorities were to coordinate their efforts and share information and experience, they should be able to operate more efficiently and reduce the rate of conflicting outcomes.
So far, there has been no Chinese law or regulation expressly addressing the reconciliation between transfer pricing and customs valuation. There is also no reporting of any joint audit case. Due to the lack of regulations that require the coordination and cooperation between these two government bodies, the SAT and the GAC do not have a formal system in place for cooperation and information sharing. A resulting problem is that the two authorities may make overlapping or duplicative information requests in connection with the same import or export transaction based on their respective focus. Subsequently, they could arrive at different conclusions regarding the responding company’s transfer pricing policy. As a result, taxpayers not only have to spend significant amounts of time and effort to prepare documentation based on the different requirements of the two authorities, but also need to deal with additional risks arising from the lack of cooperation between the two authorities, e.g., the conflict that arises when one authority’s final conclusion is not recognized by the other.
This may change soon, however, in connection with the SAT’s issuance of the Administration Measures of Special Tax Adjustments (Trial), which included a long-awaited contemporaneous documentation requirement. Many expect the GAC to cooperate closely with the SAT moving forward as SAT implements these measures. In addition, GAC officials reportedly have been studying the OECD transfer pricing guidelines and may introduce some of the same principles into their valuation system. The expectation is that there will be more information exchanges between the SAT and the GAC. For example, the new, related party disclosure forms in the transfer pricing rules may address the treatment of intangibles. Intangibles such as royalties for the use of trademarks are often dutiable for customs purposes, but importers often fail to declare them properly for valuation purposes. Going forward, the GAC will be likely to ask for a copy of these tax disclosure forms when conducting valuation audits. Companies should therefore ensure consistency in documentation exists in terms of what is presented to the SAT and the GAC.
In China, the interaction of transfer pricing and customs valuation remains to be an interesting subject for multinational companies and tax practitioners. The tax and customs authorities continue to maintain divergent purposes and interests. In many areas, the conflicts could cause significant financial and compliance burdens on multinational companies without any realistic relief. It is still largely unclear how the tax and customs authorities would work to solve potential conflicting positions on the same issue. The contemporaneous documentation required by the tax authorities could be a good starting point for the customs administrations to come up with some positive steps in the direction of reconciliation.