China’s State Owned enterprises (SOEs) have been expending considerable resources in developing and expanding their outward investments into the natural resource sector. This strategy has focused on securing energy and valuable resources critical to satisfying China’s growth over the last two decades. Chinese real GDP grew by approximately 9.1% in 2009[1], one of the highest GDP’s in the world. Impressive growth over long periods of time have increased the demand for oil as well as other natural resources in China. As a result, China has made it a policy to gain access to secure and stable sources of energy for future growth, which is imperative to its economic and social development.

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China is better known for exporting their labour intensive products, such as clothing and textiles, however, the resources needed to sustain their surging population of over 1.3 billion means a re-shifting of their investment strategy into the energy sector. China’s resurgence in energy investments has largely come from Chinese SOEs. The SOEs include, but are not limited to, China National Petroleum Group (CNPG), China National Nuclear Corporation (CNNC), Sinopec International Petroleum Exploration and Production Corporation (SINOPEC), and Nonferrous Metals Co., Ltd. (Minmentals).

These SOEs have independently made outbound acquisitions in the energy and mining sector. Notably, many of these acquisitions have taken place within the last eighteen months. This evidences the fast paced growth of the Chinese market. By way of example, two noteworthy outbound acquisitions include: CRCC-Tongguan Investment (Canada) Co., Ltd.’s[2] purchase of Corriente Resources Inc.[3], and Sinopec’s acquisition of Addax Petroleum Corporation. These transactions together were valued at over $10 billion in the aggregate, and illustrate on a micro level the investment needs of the Chinese.

China continues to emerge as the dominant economy in the ever growing globalized world of finance. The opportunities are abundant for businesses looking to invest in China, and vice versa, for China outbound investment throughout the world. The trend of outbound investment is readily evidenced through increased investments into the mining and energy sectors. As this trend continues to grow through the coming decade, Chinese acquisitions into the natural resource sector will become abundant, and create the need for specialized transfer pricing experts.

What is transfer pricing and why it should be of concern

Transfer pricing involves the price charged by one member of a multinational firm to related parties for the transfer of goods, services and intangibles. When Chinese corporations acquire companies outside of China, transfer pricing issues begin to arise.

International auditors around the world are increasing their audit and inspection activity of international transactions, which may lead to significant tax exposure for multinational companies operating over multiple tax jurisdictions. The increase in audit activity has resulted in more transfer pricing adjustments being raised and assessed, putting organizations at risk of double taxation - a situation where a firm pays tax in two tax jurisdictions with respect to the same income.

The transfer pricing issues and their tax implications will become more pronounced as China continues to acquire natural resource interests in more developed economies. Chinese companies should be aware of the many transfer pricing issues and consequences that will follow from their acquisitions of foreign based companies. For instance, there will often be a need to set up networks that transfer goods, services and intangibles between Chinese-based multinationals and related parties. The analysis used to determine the respective earnings of related parties for their functions, such as distribution activities, will be scrutinized. Understanding this scrutiny requires that Chinese multinationals apply transfer pricing policies that will result in arm’s length prices being implemented between related parties. Additional contentious transfer pricing issues will arise regarding royalties for the use of know-how, and the economic ownership of such know-how intangibles. Managing who contributes to valuable know-how intangibles within the natural resource sector, and who takes risks associated with their development, is key to allocating profits in the most tax efficient manner.

Chinese natural resource firms can benefit from successfully applying transfer pricing strategies, by placing the key assets, functions and risks in tax jurisdictions where they want the profits to flow.[4] Chinese firms can take advantage of transfer pricing by taking a proactive approach to placing functions, assets and risks strategically within newly acquired multinational entities in order to minimize after tax profits. For instance, if Chinese parents wanted to ensure that profits are migrated back to China from tax jurisdictions with higher tax rates such as Canada, Europe or the United States, it would be important to ensure that many of the value-added functions and intellectual property related to resource development and extraction be performed and paid for out of China. Since profits attributable to various related parties are based on the examination of the functions, assets and risks of the companies, as well as the determination of who performs value-added functions, China can repatriate much of the global profits by strategically allocating key functions and risks to the Chinese organizations.

If a China based company allows its subsidiaries in other tax jurisdictions to pay for and undertake valuable profit driving activities, this would entitle foreign tax jurisdictions to a significant share of the profits, and therefore taxes collected. Waiting to migrate intangibles and strategic functions back to China when they are more mature, and have already proven valuable, is difficult and more complex than strategically locating the functions, assets and risks when they are in the early stages of development, and under less scrutiny from tax authorities.

Conclusion

The economic growth in China has led the Chinese government to seek outbound acquisitions to secure vital resources needed to accommodate the country’s increased demand for natural resources. Chinese corporations will face an array of transfer pricing issues as they continue to purchase resourced based companies outside of its borders. Multinational corporations will continue to face increased audit risks relating to where they report intercompany profits. Well-planned transfer pricing strategies can assist in allocating profits in the most tax efficient manner by strategically placing functions, assets and risks in tax jurisdictions where Chinese parents want the profits reported. China can repatriate much of the global profits by getting the Chinese parent to assume more of the risks associated with resource development and extraction, and by performing more value added functions.