Introduction

China has been an economic wonder over the last decade. The country has been able to achieve astonishing economic expansion while simultaneously keeping inflation in check. As the world economy becomes increasingly globalized, countries need to ensure that their international tax laws and practices are seen as transparent. Failure to institute legislation that is deemed transparent by international investors serves to increase uncertainty and helps drive investors away. Generally speaking, tax systems which allow firms to understand what is expected of them and the consequences associated with not complying with tax laws, will serve to improve the economic climate for international investors.

Transfer pricing can serve as a tool used by companies to reasonably assign profits to lower tax jurisdictions by strategically locating functions, assets and risks. China has viewed many foreign nationals with suspicion. Consequently, firms should know what to expect and how to avoid full-blown transfer pricing audits in the first place. Recent developments in China demonstrate that they have increased their level of transparency with respect to their transfer pricing documentation. This is good news for the international business community.

Overview of Chinese Economy and Focus on Transfer Pricing

The Chinese economy is growing at a very impressive rate, some may argue this is unsustainable. The value of Chinese produced goods and services is estimated to be approximately $6.991 trillion dollars in 2007.1 More impressively however, is the growth in GDP. In 2007 alone, the Chinese economy grew at a rate of 11.4%, a rate unheard of in developed economies such as the United States, Germany, Britain and Canada.

The Chinese economy depends heavily on government intervention. While enjoying impressive growth, governments are needed to fill the void where private sectors are unwilling or unable to provide needs, goods and services, such as infrastructure programs. As the Chinese economy further grows, develops, and integrates into the world economy, it will need to rely on a more expansive and comprehensive tax system that can generate higher levels of tax revenue in good economic times. Chinese tax authorities have increased their audit activity considerably over the last few years to rein in firms that use transfer pricing to move profits outside of China. According to Chinese tax authorities, more than 50% of foreign companies investing in China are reporting losses due to aggressive transfer pricing. Tax authorities in China are required to audit at least 30% of entities identified as "key targets" each year.2 The need to collect revenues comes on the backdrop for a real need to improve transparency with respect to transfer pricing regulation. The Chinese government has viewed international trade, and transfer pricing in particular, as a top priority, focusing heavily in this area.

The trend toward increased globalization has, and will, continue to put pressure on nation states to increase transparency and clarity regarding transfer pricing legislation and issues. While developed nations such as the United States, Canada and other G7 countries have relatively transparent and clear regulations regarding transfer pricing matters, developing countries are beginning to "catch up." China and other developing countries have recently undertaken progressive transformations of their transfer pricing regulations, due in part to their desire to attract investments and to more fully integrate into the world economy. China, in particular, is enjoying much success in attracting the investments of foreign multinationals; and improving transparency is fundamental for maintaining this momentum.

The development of new transfer pricing regulations serves amongst other things to increase certainty and transparency (and therefore attractiveness) of investing in a particular tax jurisdiction. This can be illustrated mathematically using the following Net Present Value (NPV) equation: see original document

where -C0 is the upfront costs of investing, Ct is the after tax cash flow, r is the discount factor (or measure of risk) and T is the number of periods the investment project is to last.

Increased uncertainty surrounding transfer pricing legislation will serve to increase the discount factor, r, which will reduce the NPV of a project, and decrease the attractiveness of investing in a particular tax jurisdiction. Therefore, it is in a developing country's best interests to increase certainty regarding transfer pricing legislation.

The Transfer Pricing Landscape In China

The Chinese Tax Authority has been increasing the transparency and sophistication of its transfer pricing rules and regulations. On March 21, 2008, the SAT selectively circulated a comprehensive final draft dealing largely with transfer pricing issues, entitled "The Regulation of Special Tax Adjustments (Trial)". In terms of transfer pricing, the draft comments on a number of issues including Ownership Threshold, Criteria for Advance Pricing Arrangement ("APA") Application, Contemporaneous Documentation, Transfer Pricing Threshold, and Information Disclosure. The level of detail and specifics found in the draft points to a growth sophistication of the Chinese tax system, as well as filling a need to improve transparency.

The draft sets to out to improve transparencies surrounding various issues in transfer pricing in China. Issues discussed include (but are not limited to) :

  • Thresholds for ownership when determining control between related parties (suggesting that 20% ownership in related party affiliates is the important threshold level).
  • For those taxpayers wishing to have an APA, a typical applicant is encouraged to apply if such companies have at least 10 years of operating history in China.
  • Taxpayer must prepare transparent documentation that is contemporaneous in nature, and then submit them to the bureau when requested. All documentation must be submitted in Chinese, including any intercompany transactions.
  • Chinese tax authorities have suggested that it is strongly preferred that returns attributable to tested parties operating in China reflect the median return determined by the set of comparables.  

While many concerns may exist surrounding several of the issues suggested above, the attempt by the Chinese tax authorities to address such issues in a transparent way suggests that the Chinese tax authorities are serious about improving their tax system and transparency.

Common Audit Triggers in China

Many firms and practitioners creating transfer pricing documentation often attempt, as their primary goal, to avoid costly transfer pricing penalties. What should a taxpayer do with respect to transfer pricing documentation? Two things must occur, both of which are interrelated.

First, the taxpayer must ensure that those creating this documentation are skilled in covering off on all of the transfer pricing issues, such that the auditor cannot logically conclude that reasonable efforts were not made.

Secondly, the transfer pricing documentation must properly address the economic substance of each transaction, which may produce results that reduce the risk of a full-blown transfer pricing audit occurring in the first place. While some issues will exist that will naturally increase the likelihood of audits, other factors that are well within the control of multinationals must be properly handled. Failure to handle these issues in a correct manner will increase the probability of an audit.

In China, taxpayers drawing increased scrutiny include those that (1) have a significant amount of related party transactions, (2) report losses for more than two consecutive years, (3) report a sudden and materially lower margin, (4) expand operations despite reporting low profitability or losses, and (5) report lower margins than other companies in the same industry.

Persistent Losses and High Variances in Profits and Industry Norms

Persistent losses experienced by a related party can often trigger a Chinese audit. While it is entirely possible that a related party can experience reoccurring losses or increased volatility in profit levels, the fact that transfer pricing can result from this outcome, raises the suspicions of tax authorities. It is often the case that parties operating in China may be more routine in nature within specific industries, and thus should not see a significant variance in their profits year after year. Firms deemed routine in nature are thus unlikely to report losses for more than two consecutive years or report sudden and material changes in operating margins.

Depending on the characterization of the tested party, a risk taking entity could incur negative and reoccurring losses, though this should be reversed in better economic times. If it is determined that a related party should earn negative profits (i.e. for instance, if it is a significant risk taker that is experiencing a downturn in the economy or engaged in market penetration strategy for instance), those creating the transfer pricing documentation must sufficiently articulate this in order to show reasonable efforts, and to mitigate the risks of a full-blown audit.

As a rule, profits attributable to a tested party should not be below industry norms. If the returns attributable to a tested party are outside the realm of economic reasoning, and below industry norms, this may increase the suspicion of tax authorities and may result in a full-blown transfer-pricing audit.

Volume Transactions

Chinese companies that have significant dollar value transactions with related parties operating in other tax jurisdictions are likely to be considered for an audit. In such a case an audit may be unavoidable. However, great care must be taken to ensure that the right economic model is used to address such a trend. For instance, would it be the case that a related party operating in China would be willing to accept lower returns on higher volume transactions? Or is it the case that it would require a higher mark-up as volume transactions increase. Any transfer pricing documentation would need to address these important issues.

Conclusion

As the above article has mentioned, China has significantly increased their audit activity relating to transfer pricing. Great care must be taken to ensure that companies are compensated for their functions, assets and risks, while making sure profits do not deviate considerably from industry norms. In order to lessen the likelihood of Chinese audits, companies should ensure that their transfer pricing reflects trends within their business and industry. This will likely avoid attracting the attention of the tax authorities and reduce the likelihood of a full-blown audit. Furthermore, Chinese tax authorities strongly prefer that margins reflect the median, and not the lower quartile of a given range derived from comparable companies. Finally, should a manufacturing plant sell its products to third-parties domestically and related parties internationally, the taxpayer should ensure that domestic margins are similar to margins for products sold internationally.