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Asia Transfer Pricing - China
The future of transfer
pricing in the world’s
most dynamic economy
T
he economy of the People’s Republic of China has grown at a rate that has
After almost 20 years, confounded economic theorists and made a mockery of their predictions.
The China GNP has been doubling about every eight years in real terms
China has finally passed since Deng Xiao Ping introduced the “open door” policy in 1981. While
experts have frequently predicted a slowdown (and some Cassandras even a crash),
a new income tax law. growth has instead gone from red hot to white hot, hitting 12% in some quarters. This
year China emerged as the world’s third largest economy. Other economic signals are
Glenn DeSouza of Baker also reaching new heights. In just the last three years, the stock market index soared
by over 300% and stock market capitalisation by more than 500%. Private equity (PE)
& McKenzie describes funds have made China a top priority and M&A activity is growing at 40% a year. At
the same time, foreign direct investment continues to flood in with over 40,000 new
how to deal efficiently foreign investment enterprises (FIEs) set up each year by multinationals (MNCs).
With the economy roaring ahead, China no longer needs to offer carrots to get
and intelligently with the investors. This is reflected in the passage of a relatively tough new tax law. On March
16 2007, the Law of the People’s Republic of China on Enterprise Income Tax (New
compliance burden it EIT Law) was adopted by the 10th National People’s Congress (NPC) to become
effective as of January 1 2008. The New EIT Law marks a paradigmatic shift. Under
presents the old system, foreign investors could enjoy holidays of five years or longer, a tax rate
as low as 15% and a local subsidy which gave back 40% of the tax paid. By contrast,
the New EIT Law sets a harmonised tax rate of 25% and eliminates most incentives.
The New EIT Law also stakes out a more aggressive approach to transfer pricing.
Chapter six of the New EIT Law is entirely devoted to transfer pricing and address-
es cost sharing arrangements (CSAs), intercompany reporting requirements, APAs,
attribution of tax haven income, the need for commercial substance, and thin capital-
ization. It also introduces a special interest levy on TP adjustments that goes beyond
the current interest and penalty regime.
The New EIT Law suggests that now is the time to implement a tax-saving TP pol-
icy. But a word of warning is in order. The State Administration of Taxation (SAT)
receives training from the OECD; therefore, a balanced TP policy should not only
meet China’s current TP policy but also satisfy the evolving global standards on such
issues as locally-developed intangibles (LDI) and permanent establishments (PEs).
The tax savings from a new TP policy, for example, could be wiped out by a future
PE challenge that exposes overseas profits to China taxation.
The other big news out of China this year is the expected passage of a TP manda-
tory documentation requirement. This has long been on the SAT’s agenda. Back in
December 2004, several of us were invited to meet with the SAT in Beijing to share
experiences on TP documentation in the US. In 2005, drafts of the documentation
requirement were being circulated by the SAT. The latest draft has been scaled back
and simplified but will still create a compliance burden.
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Asia Transfer Pricing - China
It is important, therefore, to understand the strategic issues raised to them by one of their tax bureaus.
options for dealing with these new developments. Below is Tables 1 and 2 identify the legislation governing transfer
also a quick master guide to the most important Chinese laws, pricing in China.
rules and circulars governing transfer pricing.
Forthcoming documentation requirement
Master guide to TP regulations The latest version of the documentation requirement has
The highest level of tax legislation in China is represented by been much simplified. It comprises just 16 articles and is
laws. The laws can be enacted only by the National People’s about five pages in length in the English translation. It
Congress (NPC), which meets in March of each year to set requires (i) a detailed TP disclosure form to be submitted
policy and pass laws. along with the annual corporate income tax return and (ii) TP
The second level of tax legislation is represented by the documentation to be made available within 30 days of a
detailed implementing rules which are issued by the State request by the tax bureau. The table summarises on the next
Council. page the key provisions of the documentation requirement.
The third level of tax legislation is represented by the cir-
culars issued by the SAT. Note that the SAT is not an enforce- How to deal with documentation
ment organisation like the IRS. Its main role is as a policy Compliance strategy
maker and oversight organisation. The formal circulars issued A transfer pricing documentation requirement in China will
by the SAT are usually designated as Guoshuifa and the SAT create a major compliance exercise since major MNCs have
will also issue less formal letter rulings, known as Guoshuihan, an average of six to eight entities requiring documentation.
which can take the form of replies by the SAT to specific The point to remember is that documentation is basically a
TABLE 1
Transfer Pricing Regulations
(as of September 2007)
Area Year Reference Issued by Comment
Basic TP regulations 1998 &2004 Guoshuifa 59 & Guoshuifa 143 SAT Foundation principles and methods
Intra-China services 2002 Guoshuifa 128 SAT TP for Chinese holding companies
Cross-border 2002 Huifa 29 SAFE Required documents to remit fees
services (and royalties)
Customs 2003 Shuling 102 GAC Royalties – conditions under which they
are subject to customs duties
Intra-China 2003 Guoshuihan 1284 SAT MAP to avoid intra-China double taxation
Mutual Agreement Procedure (MAP)
APAs 2004 Guoshuifa 118 SAT Implementation rules for advance pricing
agreements
CSA 2004 Guoshuihan 470 SAT Letter ruling on technology cost sharing
arrangements
Royalties 2004 Guoshuifa 80 SAT Obtaining business tax exemption on royalties
Cross-border MAP 2005 Guoshuifa 115 SAT MAP to avoid international double taxation
Comparables 2005 Guoshuihan 239 SAT Use of BVD database
Comparables 2005 Guoshuihan 745 SAT Conditions for using capital intensity
adjustments
Functional analysis 2007 Guoshuihan 363 SAT TP research methods including functional/
financial analysis
PE 2006 Guoshuihan 970 SAT Targets foreign companies selling into
China via dependent agents
Contract manufacturers 2007 Guoshuihan 236 SAT Contract manufacturers should earn a profit
or be targeted for audit
New income tax law 2007 Zhuxiling 63 NPC Harmonises tax rate at 25% and prioritises
transfer pricing
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Asia Transfer Pricing - China
TABLE 2
Chinese forthcoming documentation requirement
Provision Article Comment
Disclosure submission 3 Must be filed with the annual corporate income tax return
Disclosure format 3 Consists of eight elements, including terms and profitability
of related party transactions and whether documentation has
been prepared
Disclosure failure-to-file penalty 7 Failure to file will result in penalties as per Article 62 of
Tax Collection Law
Documentation format 4 Consists of seven sections; organizational structure, business
operations, transaction details, comparability analysis, best
method analysis, cost sharing if applicable, and other documents
Documentation submission 8 Must be made available within 30 days of a request
Documentation filing extension 8 Under special circumstances, a one-off extension of 45 days
will be granted
Documentation failure-to-file penalty 12-13 Special interest levy on additional tax as per Article 49 of EIT
Law and Article 157 of EIT Rules. Also right to deem income
Submission language 6 Should be prepared in Chinese
Document authentication 10 Must be stamped with so-called official chop and signed by
person in-charge. Overseas documents should be certified by
notary or CPA
APA exemption 5 Taxpayers with APA are exempted from preparing documentation
False information penalty 9 Penalties as per Article 70 of the Tax Collection Law and Article
96 of the Tax Collection Regulation
Confidentiality 15 Tax authorities cannot disclose the documentation information
to a third party
Effective date 16 January 1 2008
compliance exercise not a value-added exercise, so more is Finding Chinese comparables
not better. Lenovo, which acquired IBM’s personal computer (PC) busi-
The following strategy is recommended to create efficien- ness in 2005, is the most famous electronics company in
cies and establish control of the documentation process. China. It enjoys a commanding 36% share of the China PC
• Categorise entities by risk. The classification can be based market and is the official IT supplier for the 2008 Olympic
on a few simple parameters such as profit rates, and prior Games. But if you were to screen the BVD database for
audit history Chinese companies you would not locate Lenovo as a Chinese
• Provide only lean documentation for low-risk entities. company because Lenovo is incorporated and listed in Hong
For a low-risk entity (such as a contract manufacturer Kong.
earning a 5% profit), only the simplest of functional As that example illustrates, finding comparables in China
analysis followed by defensible benchmarking is is not straightforward. Presented below are some guidelines
needed. on where to find comparables:
• Share benchmarking results. Where entities perform the • Internal comparables. Other entities within the group who
same function, the benchmark results should be shared perform the same function.
across the group to ensure consistency and create • Chinese-listed companies. Includes companies on
efficiencies. Shanghai and Shenzhen exchanges.
• Use special factor analysis for high-risk entities. For a • H-share companies. Companies incorporated in China and
high-risk entity, it will be necessary to mount a defence listed in Hong Kong. H-share companies include the
of its position. Resources should be invested to explain largest companies in China, namely China Construction
why this entity has fallen short of the benchmarks. Bank, Bank of China, PetroChina and China Life.
• Take ownership. Electronic versions of the documenta- • Red chip companies. Companies incorporated in Hong
tion and benchmarking should be kept and the internal Kong and listed on Hong Kong but whose parent is incor-
staff should be trained to perform annual basic updates. porated in China. The largest red chip is China Mobile.
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Asia Transfer Pricing - China
Other famous red chips include Lenovo and COSCO. • Use of predefined comparable sets. Instead of starting
• Nasdaq companies. Many famous Chinese hi-tech compa- every search from square one, the expert user should
nies are listed on Nasdaq, including Shanda, Ctrip, access databases such as Top 500 Asian contract manufac-
Sohu.com and Netease. turers, Top 50 Greater China distributors, and Top 100
• Other overseas companies. Some Chinese companies are Asian outsourcing firms.
listed on Singapore, Tokyo and other overseas exchanges. • Use of largest possible samples. When the sample size is
These companies are generally not significant. less than 30, the results are unreliable and should be cor-
• State Owned Enterprises (SOEs). There are about 155 roborated by the results from the larger population set.
SOEs directly under the national government and about • Highest quality of original data. Data obtained directly
135,000 are provincially and municipally controlled. from original sources like the China Securities Regulatory
Reliable published financial data is not available Commission (CSRC) or the company’s website is more
• Private Chinese companies. There are over four million pri- reliable than data from third-party databases.
vate companies but published data is generally not available. • Full-spectrum financial analytics. Reliance on a single prof-
• Asian comparables. Companies from Taiwan, Singapore, it level indicator (PLI) should be replaced by the use of
and Asian countries are sometimes acceptable to the multiple PLIs such as operating margin, Berry Ratio, and
Chinese tax authorities, but not Australia, Japan, Korea, value-added cost mark-up.
and India. (However, global comparables can be used to • Advanced statistics. Exclusive reliance on the interquartile
illustrate industry specific returns and provide corrobora- range should be augmented by using the many available
tive value.) statistical tools such as Tukey quartiles, trimmed means,
• Secret comparables. The SAT is committed to using public variance analyses, correlations, and regressions.
comparables for bilateral APAs. But in TP audits, the tax- • Integrated comparables. The system should have the capa-
payer may be confronted by the local tax bureau with secret bility to include internal and external comparables, with
comparables that can even be other FIEs in the same zone. external comparables including both onshore and offshore
Table 3 below profiles the alternative sources for Chinese companies.
comparables.
Second-generation China benchmarking system Opportunities and vulnerabilities
The benchmarking systems used in China were developed There are a few excellent planning ideas regarding China.
about eight years ago and are characterised by use of small • Export toll processing. Exports from China can be con-
samples (often less than 10) and simplistic statistics. A sec- ducted using turnkey contract manufacturing (jin liao jia
ond-generation Chinese benchmarking system would have the gong) or toll processing (lai liao jia gong). The essential dif-
following characteristics: ference between the two is that in toll processing the for-
TABLE 3
Potential comparables for China benchmarking
(as of August 24 2007)
Market Type Number Market cap ($ billion) PE
Internal comparables Similar entities within the MNC NA NA NA
Shanghai A 842 2299 58
Shanghai B 54 16 50
Shenzhen A 619 667 70
Shenzhen B 55 18 28
Hong Kong H-Share 145
(for example, Bank of China)
Hong Kong Red Chip 96
(for example, Lenovo)
Hong Kong Total 1206 2163 19
NASDAQ International 76 (for example, Shanda) About 75
Chinese private Private company. No data More than four million
is published
Chinese State-Owned More than 135,000 NA NA
Acceptable Asian Singapore, Taiwan and Asian About 4,000 NA NA
countries
10 www.internationaltaxreview.com
Asia Transfer Pricing - China
eign principal retains title to the imported materials and Biography
processed products at all stages. Usually in both models,
the Chinese entity is compensated on cost base and since Glenn DeSouza
the cost base of the toll model is much smaller fewer prof-
its are reported in China. Thus tolling provides the most Baker & McKenzie
tax-efficient (from an income tax standpoint) way to man- Unit 1601, Jin Mao Tower
ufacture in China. 88 Century Avenue, Pudong
• Import sales agents. MNCs can sell their overseas products Shanghai 200121, PRC
into China by using a buy-sell distributor or a sales agent. Tel: + 86 21 6105 5966
Generally speaking, a limited risk sales agent receives a fee Mobile: +86 1376 456 4976
(either cost plus or commission), which is usually much Email: glenn.desouza@bakernet.com
smaller than the margin earned by a full-fledged distribu-
tor. There are risks in implementing a sales-agency model
in China, especially if the customers want to buy in local Glenn DeSouza is leader of China transfer pricing (TP) services at Baker &
currency and do not have their own import rights. McKenzie. DeSouza came to China in 1999 and was the first full-time
• Cost-sharing arrangements. This tool is used to minimise transfer pricing expert to be based in mainland China. Previously, DeSouza
indirect taxes. By paying the overseas parent a cost-sharing also served as the Asian regional TP leader for a big-four firm and a member
contribution as opposed to a royalty, the FIE can potentially of their global TP executive committee.
avoid the 10% withholding tax and a 5% business tax (BT) DeSouza has conducted several hundred projects in China, which include
to which a royalty is subject. The New EIT Law specifically highly successful audit defences, advance pricing agreements and cash
endorses CSA (as does the documentation requirement). repatriation strategies. His clients cover almost all industries and include the
Investors should stay tuned on this opportunity. largest US, European and Japanese multinationals.
• Profit stripping. For products manufactured and sold in As the first PhD Economist expert in China, DeSouza developed the original
China, profit stripping by stepped-up royalties, fees and tools and databases for China-specific benchmarking and trained tax officials.
commissions may be possible if the current profit rate is DeSouza was consulted by the State Administration for Taxation (SAT) with
significantly more than the arm’s-length standard and regard to their forthcoming documentation requirement and has participated
overseas entities are providing technology, intangibles along with the OECD in the SATs annual training meetings at Yangzhou.
and services. DeSouza’s recent articles include “Master Guide to Chinese TP Regulations”,
“How Much Profit Should You Earn in China?” and “IP in China New Tax
Vulnerabilities Opportunities.” He has received various awards including from the National
In developing a China TP plan the investor needs to be aware Association of Business Economists in the US and from the SAT.
of the following risks:
• PE. An important risk for a foreign principal using a sales
agent to sell into China is the PE risk. Clearly, employees
should not negotiate prices or sign contracts. The recent gibles such as customer relationships where the local FIE
SAT circular concerning a foreign company (Hong Kong) has made significant investments.
using a dependent agent to sell into China indicates a grow-
ing awareness of this issue on their part. Lessons to learn
• KERTS/SPF. In studying the attribution of profits to a PE, The New EIT Law and the forthcoming documentation
the OECD has developed the concept of Key requirement have elevated the importance of TP in China.
Entrepreneurial Risk Taking (KERT) functions also now In summary, there are three main messages for dealing with
known as Significant People Functions (SPF). For example, these developments.
a MNC with all its key executives in China will find it .
Assess your China TP Jack Welch famously remarked that
harder to argue that the Chinese entity is just performing “if you want to be the world leader, you must be the leader in
routine functions at no risk if the risk-making decisions are China” and China is regarded by many CEOs as their number
being made in China. This can lead to the SAT ignoring the ,
one priority. But in the case of TP many MNCs have a better
contract and looking at the economic substance. strategy and documentation for Australia and Canada than
• Local intellectual property (IP). MNC products are sold they do for China. This disconnect should be addressed by a
under their Chinese names such as Ke Kou Ke Le for Coke thorough assessment of the situation. It should also be noted
and Ji Bai Li for Cadbury. Who owns these names if all the that companies who do this assessment sometimes find that
marketing investments have been deducted locally and if they are actually allocating too little profit to China, a situa-
the FIE incurred losses making these investments? Similar tion that bodes ill for the future.
concerns could be raised about other local marketing intan- Take ownership of documentation. Given that MNCs in
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Asia Transfer Pricing - China
China need to prepare documentation for a large number of
entities, China documentation is a major compliance exercise
and needs to be handled efficiently and consistently.
Develop world-class TP plans. SAT maintains an intense
dialogue with the OECD and has made no secret of its aspi-
ration to learn and adapt international practices. Therefore, a
defensible TP policy should also satisfy the evolving global
standards. The amount of profit booked in China should be
commensurate with its economic substance and its contractu-
al obligations.
12 www.internationaltaxreview.com
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