Transfer Pricing in China, Second Edition

China Briefing The Practical Application of China Business For further volumes: http://www.springer.com/series/8839 ht...

Author: Chris Devonshire-Ellis | Andy Scott | Sam Woollard

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China Briefing The Practical Application of China Business

For further volumes: http://www.springer.com/series/8839 http://www.asiabriefingmedia.com

Dezan Shira & Associates is a specialist foreign direct investment practice, providing business advisory, tax, accounting, payroll and due diligence services to multinationals investing in China, Hong Kong, India and Vietnam. Established in 1992, the firm is a leading regional practice in Asia with seventeen offices in four jurisdictions, employing over 170 business advisory and tax professionals. We also provide useful business information through our media and publishing house, Asia Briefing.

Chris Devonshire-Ellis Andy Scott Sam Woollard •

•

Editors

Transfer Pricing in China Second Edition

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Editors Chris Devonshire-Ellis Andy Scott Sam Woollard Dezan Shira & Associates Asia Briefing Ltd. Unit 1618, 16/F., Miramar Tower, 132 Nathan Road, Tsim Sha Tsui Kowloon, Hong Kong People’s Republic of China e-mail: [email protected]

ISBN 978-3-642-16079-0

e-ISBN 978-3-642-16080-6

DOI 10.1007/978-3-642-16080-6 Springer Heidelberg Dordrecht London New York Published by Springer-Verlag Berlin Heidelberg 2011 Ó Asia Briefing Ltd. 2009, 2011 This work is subject to copyright. All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Springer. Violations are liable to prosecution under the German Copyright Law. The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Cover design: eStudio Calamar, Berlin/Figueres Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com)

About China Briefing’s Business Guides

Thank you for buying this book. China Briefing’s publications are designed to fill a niche in the provision of information about business law and tax in China. When we decided, several years ago, to commence this series, we did so in the knowledge that much of such intelligence regarding China was expensive, or contradictory. Much also did not adequately address the real on-the-ground issues faced by multinational businessmen—the practical knowledge that must be part of the armory of any business dealings in emerging markets. This guide is designed to deal with this gap and is aimed at providing both the regulatory background as well as detailed information concerning China business with a firm eye on the practicalities of turning a profit and remaining in compliance on the mainland. Accordingly, we have tried to make these guides informative, easy to read and inexpensive. To do so, we have engaged not a team of journalists or academics, but the services of respected legal and tax professionals to assist us. For this book, the text has been provided by Transfer Pricing Associates, a global firm that specializes in transfer pricing. The firm has developed a complete methodology for managing transfer pricing that uses a multidisciplinary perspective covering management control, economics, legal, tax, finance and cost accounting. We thank them for their assistance with this work. This book was compiled and written by Steven Carey and edited by Andy Scott; with cover design by Chris Wei and layout by Chris Wei and Becky Jian. At China Briefing, our motto is ‘‘The practical application of China business,’’ we hope that you feel we have accomplished this within these pages. Asia Briefing Publications Hong Kong

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Contents

An Introduction to Transfer Pricing in China . . . . . . . . . . . . . . . . . .

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Designing and Implementing a Transfer Pricing System . . . . . . . . . . .

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Transfer Pricing Disclosures and Documentation . . . . . . . . . . . . . . . .

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Transfer Pricing Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . .

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Transfer Pricing Audits and Enforcement . . . . . . . . . . . . . . . . . . . . .

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Other Transfer Pricing Topics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Appendices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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An Introduction to Transfer Pricing in China

Transfer pricing is a reality for any multinational company. Tax authorities need to protect their revenue base and are actively enforcing the arm’s length principle for pricing of intra-group transactions. Recent developments in China, including the release of comprehensive transfer pricing regulations in early 2009 and more rigorous enforcement in 2010, have sent a very clear signal that the mainland is no exception to this rule. This means that detailed transfer pricing documentation is required and that companies need to disclose related party information on tax returns, as well as prepare themselves for possible audits. If designed and implemented early in a business life, a transfer pricing system can complement and support an MNC’s business model and commercial objectives, as well as optimizing its global effective tax rate. This book explores transfer pricing, providing practical guidance on what is best practice transfer pricing design, how to document your related party transactions, how to manage overall transfer pricing risk and how to defend your position in the event of scrutiny.

1 China’s Economy and Trade China’s phenomenal growth and increasing prominence in the world economy are well known and documented. As the largest developing country in the world, China has become an increasingly important part of the international economic community. Measured by total gross domestic product, China became the second largest economy in the world in 2010, behind only the US and ahead of Japan. Foreign-invested enterprises have become the major driver behind the expansion of global trade in China. From 1990 to 1997, FIE imports constantly exceeded exports, thanks in large part to the import of capital equipment and technology. Since 1998 however, the situation has reversed and FIEs are now able to generate sufficient production, enabling China to recognize significant and growing trade

C. Devonshire-Ellis et al. (eds.), Transfer Pricing in China, China Briefing, DOI: 10.1007/978-3-642-16080-6_1, Asia Briefing Ltd. 2011

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surpluses. It was only in 2008 and 2009 and the onset of the global economic slowdown that China’s trade surplus has begun to decline as a percentage of GDP. China’s major trading partners are listed in the table below.

1 2 3 4 5 6 7 8 9 10

Exports

Imports

United States Hong Kong Japan South Korea Germany Netherlands United Kingdom Singapore India Australia

Japan South Korea Taiwan United States Germany Australia Malaysia Brazil Thailand Saudi Arabia

Source: PRC General Administration of Customs

2 China’s Tax System The primary tax authority in China is the State Administration of Taxation (SAT). The SAT is a ministry-level organization, which is immediately affiliated with the State Council and takes control of taxation from a strategic, regulatory and oversight perspective. Within the SAT, the International Tax Department is responsible for anti-tax evasion. The SAT has established state tax bureaus in every province, autonomous region and special municipality. These tax bureaus are responsible for the collection and administration of taxes that generate revenue for the central government as well as taxes that generate revenue shared by the central and local governments. The local tax bureaus, on the other hand, are responsible for the collection and administration of taxes that generate revenue only for their respective local governments. The SAT announced in July 2008 that it was engaging in a significant restructuring exercise. Under this restructuring, the Large Enterprise Tax Administration Department (LEAD) was formed to focus on large enterprises (a term not yet defined). The International Taxation Department will remain in charge of transfer pricing policy, bilateral advance pricing arrangement (BAPA) and mutual agreement procedures (MAP). The expectation is that this change will bring about higher levels of compliance from large taxpayers as well as establish stronger communication channels between large taxpayers and the SAT. The number of staff focused on transfer pricing at the SAT level is very small—understood to be less than ten—and historically there have been inconsistencies in the interpretation and application of transfer pricing principles at the provincial, state and local levels. Through an extensive training process as well as

2 China’s Tax System

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the release of detailed circulars and guidance on transfer pricing, the SAT has been able to manage this resource constraint and ensure that transfer pricing is more systematically and consistently enforced in the future. The SAT indicated in March 2009 their intention to develop around 500 transfer pricing specialists over the next 3 years.

3 Transfer Pricing Transfer pricing concerns the prices charged between associated enterprises established in different tax jurisdictions for their intercompany transactions. Multinational enterprises are growing in number and complexity and are increasingly integrating their global operations. As a result, they transfer large quantities of goods and services among operating subsidiaries in different countries as well as engage in a range of transactions relating to services, intangible property and financing activities. The pricing system for such transfers across borders within multinationals creates considerable managerial and tax problems due to its direct effects on the profits of both parties and the taxable revenue of all countries involved in the transactions. The diagram figure below gives an overview of the types of activities and the corresponding inter company transactions that are defined within transfer pricing.

The Arm’s Length Principle The OECD Transfer Pricing Guidelines provide that the ‘‘arm’s length principle’’ should be used to establish the price of transactions between associated enterprises. The guidelines require a comparison between what the taxpayer has done and what an independent party would have done under the same or similar circumstances.

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The arm’s length standard is applied by comparing controlled transactions with transactions between independent enterprises based on ‘‘economically relevant characteristics.’’ Comparability is achieved if: • No differences between the controlled and uncontrolled transactions exist • The differences that do exist do not materially affect the condition being examined • Reasonably accurate quantitative adjustments can be made to eliminate the effect of any differences The arm’s length principle uses the behavior of independent parties as a guide or benchmark to determine the allocation of income and expenses in dealings between related parties. In seeking price comparisons for the product flow between the two associated companies A and B, Company A may use its own sales to an unrelated company as the benchmark. If such transactions are unavailable, the next best approach is to investigate sales of similar products between completely independent companies in the open market.

The Increasing Prominence of Transfer Pricing Transfer pricing legislation has been rising in prominence for several decades. The first instance came from the United States’ interest to protect the U.S. tax base from erosion as presence of Japanese MNC’s distribution operations increased. Japan soon reciprocated and Australia and other countries closely followed with transfer pricing legislation and investigation. The issue then gained wider recognition in Europe with several countries introducing legislation and enforcement regimes. Asia, with the exception of Japan, has been a little slower to recognize transfer pricing as a significant issue, which is partly a reflection of its economic development level and need to attract foreign investment. However, in the last 5 years this position has changed dramatically. Most Asian countries (including Singapore, Hong Kong, Indonesia, Malaysia, Thailand, Vietnam, India and South Korea) now have transfer pricing guidelines in place and are beginning to enforce them, in some cases very actively and vigilantly.

4 Transfer Pricing in China A number of factors, global and China-specific, have brought the transfer pricing issue to the forefront of the SAT’s attention. These include: • The increasing globalization of the Chinese economy and increasing significance of imports and exports as a proportion of GDP • The tendency for FIEs in China to rely on intellectual property and services provided by overseas related parties

4 Transfer Pricing in China

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• The introduction of tough transfer pricing regimes in China’s key trading partners • Accession to the World Trade Organization in 2001 has resulted in a reduction in tariff rates, which creates greater revenue pressures • General Tax policy changes including introduction of dividend withholding tax and uniformity of the corporate tax rate to 25% as of January 1, 2008, increased the incentive for MNCs to use transfer pricing to influence effective tax rates • The tendency for FIEs in China to declare operating losses—over 50% are in this category; the perspective of the Chinese authorities is that a large part of these losses can be attributed to transfer pricing The tougher economic climate that is facing China and the world will most likely put even greater emphasis on scrutiny of transfer pricing practices, as the levels of business transactions and spending decline and the SAT needs to compensate for generally lower tax revenue from other sources.

5 Transfer Pricing Regulatory Timeline The following is a summary and timeline of the development and enforcement of the transfer pricing regime in China: • Transfer pricing legislation was first introduced in 1991 by the National People’s Congress under the Income Tax Law of the People’s Republic of China for Foreign-invested Enterprises and Foreign Enterprises. Under Article 13 of the law, the tax authorities had the right to make reasonable adjustments if transactions were not carried out at arm’s length, and thus result in a reduction of taxable income • On April 23, 1998, the SAT issued comprehensive transfer pricing regulations entitled ‘‘Tax Administration Rules and Procedures for Transactions between Related Parties’’ (SAT Circular No. 59). This circular contains 52 articles and 12 chapters which standardized transfer pricing examination and audit procedures. These regulations were reflected and amended in [Guo Shui Fa (2004) No. 143] • On September 20, 2004, the SAT issued the ‘‘Implementation Rules for Advance Pricing Agreements for Transactions between Related Parties’’ [Guo Shui Fa (2004) No. 118]. The implementation rules set out detailed guidelines on Advance Pricing Agreement (APA) procedures • On February 28, 2007, the SAT issued Guo Shui Han (2007) 236 to state their position with respect to the expected profitability of the FIEs and foreign enterprises in China which undertake a sole-function of manufacturing for their overseas parent companies • On March 16, 2007, the Corporate Income Tax Law of the People’s Republic of China (State Council Order No. 63 of People’s Republic of China) was passed and came into effect from January 1, 2008. The new CIT Law repealed the 1991 Income Tax Law for FIEs and FEs and includes a range of measures designed to

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•

•

•

•


strengthen transfer pricing compliance and enforcement in China, as well as a range of other measures including thin capitalization, controlled foreign companies and anti-avoidance regulations. The regulations relevant to transfer pricing are contained in chapter titled Other Transfer Pricing Topics of the legislation. This was followed by the release of the ‘‘Implementation Rules of the Enterprise Income Tax Law in People’s Republic of China,’’ promulgated by State Council on December 6, 2007 On March 27, 2007, the SAT issued Guo Shui Han (2007) No. 363 stipulating specific documents and information to be submitted by enterprises and the locallevel tax bureaus to the SAT during transfer pricing audits On April 2, 2008, the SAT released the ‘‘Draft Administrative Regulations of Special Tax Adjustment (Trial)’’ to begin an extensive period of feedback and discussion on the form of the final version of the regulations Guo Shui Fa (2008) No. 114, issued on December 17, 2008, detailed the related party disclosure forms that will be required to be completed and submitted by all taxpayers with any related party transactions along with their 2008 tax return on or before May 31, 2009 Finally, the SAT released the ‘‘Implementation Measures of Special Tax Adjustments (Trial Version)’’ [Guo Shui Fa (2009) No. 2] (China Transfer Pricing Regulations), which repealed Guo Shui Fa [2004] No. 143 and Guo Shui Fa [2004] No. 118. These transfer pricing regulations are the first comprehensive document from the SAT incorporating provisions on contemporaneous documentation requirements as well as other aspects of transfer pricing, including guidance for conducting audits and investigations, thin capitalization, controlled foreign corporations, APAs and cost sharing agreements

The table below provides a list of each chapter of China’s Transfer Pricing Regulations and the relevant section of this book where they are discussed in further detail.

1 2 3 4 5 6 7 8 9 10 11 12

China’s transfer pricing regulations

Chapter reference

General provisions Reporting of related party transactions Administration of contemporaneous documentation Transfer pricing methods Transfer pricing investigations and adjustments Administration of advance pricing arrangements Administration of cost sharing agreements Administration of controlled foreign corporations Administration of thin capitalization Administration of General Anti-Avoidance Corresponding adjustments and international consultation Legal obligations

– 3 3 2 5 6 6 – 6 – 5 5

Designing and Implementing a Transfer Pricing System

Undoubtedly the introduction of transfer pricing documentation requirements and detailed tax return disclosures has dominated the transfer pricing discussion in China recently, and this will be discussed in detail in chapter titled Transfer Pricing Disclosures and Documentation. However, what is often overlooked is the need to design and implement the optimal transfer pricing system well ahead of focusing on documentation. Giving appropriate time for this early in the business cycle helps to ensure that the transfer pricing system is the most tax effective, consistent with the business model and commercial objectives, and documented efficiently. It will also help mitigate and manage transfer pricing risk exposure. With this in mind, this chapter is focused on the design of an optimal transfer pricing system as well as selecting and applying an appropriate transfer pricing methodology. The Transfer Pricing Associates group has applied a framework referred to as the Transfer Pricing Process. The Transfer Pricing Process addresses transfer pricing and the business risks around it as a business process by allowing the MNC to link how it operates its business to a transfer pricing system in a simple and logical way. The process is captured in the diagram below.


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Each of the four boxes in the transfer pricing process is discussed in more detail in the following sections.

Box 1: Identify the Relevant Business Context Every industry is different and even within the same industry, each company has a very different strategy, internal organization, brand, and objectives as well as function, asset and risk profile. Identifying this business context as early as possible assists in closing the gap between the business reality and the perspective of the various tax authorities. This process combines internal and external sources of information to draw a concise picture of the MNC’s business, the industry in which it operates and the key functions of each of the group companies. Given that it is vital for tax authorities to acquire a solid understanding of the business of an MNC before starting to investigate and scrutinise its transfer pricing system, Box 1 is a crucial step in the transfer pricing process. Broadly speaking, Box 1 consists of the industry analysis and functional analysis, each of which is discussed below.

Industry Analysis The OECD Transfer Pricing Guidelines as well as the transfer pricing regulations of all countries, including China, recognize that external economic factors can impact the transfer pricing between related entities. For this reason, the guidelines suggest that it is useful to include in transfer pricing documentation an analysis of the taxpayer’s industry. Specifically, an industry analysis should include: • Macroeconomic factors impacting the industry • Description of the key characteristics of the industry, such as: – – – – – –

growth rates (historical and forecast) barriers to entry success factors regulatory framework level of competition key players and market shares.

• Market forecasts and anticipated impact on companies in the industry For example, the global economic crisis in 2008 and 2009 and performance of the macro economy would go a long way towards explaining the low profitability of an entity during this period; that is, to demonstrate that reasons other than non-arm’s length transfer pricing are responsible for the profitability of the company.

Box 1: Identify the Relevant Business Context

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From a tax authority perspective, industry trends help them identify suitable cases for a transfer pricing risk review. Also, once the tax authority has carried out a transfer pricing review or audit in respect of one taxpayer in a particular industry, it has often been the case that the tax authority will use the industry knowledge acquired from that review in order to carry out reviews and audits of other players in the same industry. The types of information contained within an industry analysis are available in external resources such as: • • • •

analyst reports industry research reports annual reports of major players in the industry general media and other information typically available on the internet.

Functional Analysis The other key aspect of Box 1 of the Transfer Pricing Process is the functional analysis. The functional analysis is an overview of the key activities performed by the entity, the assets used and risks borne. It provides a perspective on the role of the entity in the total value chain of the group. Each business is unique in terms of the combination of functions, assets and risks. The following table gives an indication, as an example only, of the types of functions to be included in a functional analysis, as well as the associated assets and risks. Functions

Assets

Risks

Management

Office equipment, know-how Patents Supplier lists Know-how, factory Brand Brand, customer lists Warehouse Office equipment

Market risk

R&D Procurement Manufacturing Marketing Sales Logistics Finance and administration

R&D risk Inventory risk Capacity risk, product liability risk Market risk, marketing risk Market risk, credit risk Freight risk, inventory risk Foreign exchange risk

So what is the best way to complete the functional analysis? Speaking to key personnel to understand their key roles and responsibilities and how each division interacts with one another within the company (often referred to by practitioners as ‘‘the functional analysis interview’’) also allows the MNC to gain a better insight to its business, the industry and key responsibilities of different companies in the group. In most cases, the head of each business division can provide: • an overview of the value chain • an explanation of their roles and responsibilities and interaction with other functions and group entities

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• decision making processes within the group and risks borne • relevant industry information and trends as they impact the company The functional analysis is an aspect of a transfer pricing report that companies can potentially perform themselves with little or minimal support from an advisor, assuming the company has internal resources and sufficient expertise available. If an advisor is engaged, the critical point is to ensure that at least one internal person is nominated to coordinate the process and be actively involved. This ensures that the project runs efficiently which saves costs but, perhaps even more importantly, enables a knowledge transfer from the advisor to the company’s internal team. This intangible will ensure that the process can be streamlined in the future, and more importantly that the report is implemented is intended.

Box 2: Design and Implement the Transfer Pricing System The design of a transfer pricing system determines the appropriate return for each of the group companies as well as ensures the alignment of the transfer pricing system with the business model and commercial objectives. The roles and responsibilities captured for each of the group entities (through the functional analysis) address, from a management accounting perspective, the parameters for determining the success or failure of performing each activity. From a tax perspective, the same process enables the allocation of the operating margin to each of the group companies in the value chain. In the design of a transfer pricing system, the concept of ‘‘responsibility centers’’ is useful. The purpose of this concept is to link the business reality and the way the MNC does business to the appropriate method of compensation for each group company. The concept of responsibility centers looks at transfer pricing as a steering and controlling instrument, which is being used by the MNC to ensure that each of the group companies focus on their own roles and responsibilities. Each set of attributes reflecting a certain role and responsibility profile can, more or less, be matched with one of the following labels: • • • • •

Investment center Profit center Cost center Revenue center Expense center1

In the following section, a practical illustration is provided of how these concepts can be applied to various common operating structures in China in respect of 1 Although often referred to interchangeably, expense centers differ from cost centers in that the activities of the former tend to be core in nature while the activities of the latter tend to be non-core in nature.

Box 2: Design and Implement the Transfer Pricing System

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procurement, manufacturing and distribution operations (note: this classification is important as it greatly simplifies the transfer pricing methodology selection process). Appendix 1 contains the Manual for Responsibility Centers.

Procurement Option 1—Services Model: Cost Center Under a service model, the purchasing unit performs only services of a coordinating and otherwise supportive nature. The purchasing unit does not take ownership of the materials and assumes a low level of risks.

The responsibility profile of the purchasing unit is a cost center, and the service fee is determined using the cost plus method.

Option 2—Commission Agent Model: Revenue Center Under a commission agent model, the purchasing company develops activities with some value added, basically related to market intelligence. Like the service model, the purchasing company does not take ownership of the inventory and assumes a low level of risk. The responsibility profile of the purchasing unit is usually a revenue center, and the transfer pricing policy is based on a commission fee calculated as a percentage of the purchase value.

Under this option it is also possible that some volume discounts or other forms of purchasing-related bonuses will be recognized by the purchasing company. The

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purchasing company will need to allocate these amounts to the entities proportionately for which the purchases are being made, at appropriate intervals.

Option 3—Buy/Sell Model Under a buy/sell model, the purchasing unit develops activities with a high added value. Among the activities performed are market intelligence, inventory and manufacturing management, quality control, finance and logistics. The purchasing company takes ownership of the materials purchased and usually assumes inventory, exchange and logistics risks. The responsibility profile of the purchasing unit is usually a profit center, and the transfer pricing policy is designed with reference to savings achieved.

Manufacturing Option 1—Toll Manufacturer: Cost Center Under a toll manufacturing model, the toll manufacturer performs a processing function on behalf of a related party principal and does not take title to raw materials. It holds only minimal intangibles related to the manufacturing processes and is rewarded through a toll manufacturing fee calculated as a mark-up on processing costs, which is paid by the manufacturing principal. Such entities are classified as cost centers.

Box 2: Design and Implement the Transfer Pricing System

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Option 2—Contract Manufacturer: Cost Center The contract manufacturing model is similar to the toll manufacturer, except that the contract manufacturer does take title to raw materials and may be involved in procurement of such materials. Finished goods are sold to the manufacturing principal and priced to enable the contract manufacturer to earn an arm’s length mark-up on total costs. Contract manufacturers are also classified as cost centers.

Option 3—Fully Fledged Manufacturer: Profit Center The fully fledged manufacturer is responsible for sourcing materials, undertaking production and potentially selling to third parties on its own risk as well as to related party distributors. It bears a range of risks related to pricing and markets and owns intangibles related to the manufacturing process, products and potentially brands. Such entities are classified as profit centers.

Distribution Option 1—Sales Representative/Sales Agent: Cost/Revenue Center A sales representative or sales agent is responsible for understanding the local market, identifying customers and negotiating sales. Such entities do not take title to finished goods and the legal and typically physical flow is from the related party

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entity. They therefore bear no risk on inventory and receivables but may bear some market risk. They are either remunerated on a cost-plus basis (cost center) or on a commission based on notional sales generated (revenue center).

Option 2—Full Risk Distributor: Profit Center At the other end of the distributor spectrum is the full risk distributor. Such entities purchase from related party manufacturers and are fully responsible for holding inventory, logistics, local marketing and sales. They bear market, inventory, credit and other risks consistent with these functions. In the responsibility center matrix they are classified as profit centers.

A limited risk distributor has the same transaction and goods flow as a full risk distributor, however it generally bears a more limited range of market, inventory and other risks. Such entities are classified as revenue centers. From the examples above, it should be noted that the classification of responsibility centers is based on the underlying economic reality with strong reference to the functions, assets and risks assumed by the entity. The use of the responsibility center concept provides a clear and logical framework for analysis and overcomes the confusion from the typical labels used in transfer pricing such as ‘‘limited risk distributor,’’ ‘‘commissionaire’’ and ‘‘contract R&D provider’’ which typically do not explain all business models and their underlying economic reality. Once the multinational group’s business process has been analyzed and the various group companies have been classified in this way, the transfer pricing policy as well as the choice of transfer pricing methodology becomes clear.

Box 3: Documentation of the Transfer Pricing System

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Box 3: Documentation of the Transfer Pricing System Box 3 involves the preparation of transfer pricing documentation, which broadly consists of the following elements: • Industry analysis—to place the functional analysis in the context of the industry in which the multinational group operates • Functional analysis—description of the key transactions, functions, assets and risks of the entity under review, to enable the classification of the entity and guide the selection of transfer pricing methodology • Design of the system, and selection of the most appropriate transfer pricing methodology • Benchmarking using the most appropriate methodology—normally involving searches of financial databases Preparation of transfer pricing documentation in the China context is discussed in some detail in chapter titled Transfer Pricing Disclosures and Documentation. Below, one specific type of documentation—the transfer pricing master file—is discussed in detail.

The Transfer Pricing Master File Many MNCs adopt a coordinated approach to the preparation of transfer pricing documentation since this is easier to administer and considerably more cost-efficient in practice than preparing documentation on a local country-by-country basis. The coordinated approach involves creating a ‘‘master file’’ that contains the ‘‘core’’ elements of transfer pricing documentation that are generally required by all tax authorities around the world as part of their transfer pricing regulations. The origins of the master file were in Europe. In 2002, the EU Joint Transfer Pricing Forum (JTPF), was set up and in 2003 the OECD requested the JTPF to address regional transfer pricing documentation requirements. According to the JTPF, the preparation of a large number of separate and unique sets of transfer pricing documentation on a per-country basis, as a consequence of different documentation requirements within the EU, is not a cost effective proposition. EU member states argued that they often are unable to examine transfer prices due to noncompliance by taxpayers with documentation requirements. In practice a master file for Europe and even globally has proven to be a feasible alternative to more traditional country-by-country regulations regarding transfer pricing documentation. In the case of China, if an MNC has multiple entities throughout China, it is possible to apply the master file concept to create one central report which can then be efficiently converted into entity-specific documentation if needed. Once the core documentation has been prepared, it generally satisfies 70–80% of the requirements of each of the tax authorities in the countries in which the

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multinational does business. If a particular country requires transfer pricing documentation prepared specifically in respect of the local entity, this can be done easily and cost effectively by utilizing the information and documentation already prepared as part of the master file, with some amendments to render it specific to the local entity, and perhaps with—some additional economic analysis. The key benefits for multinationals in adopting a master file approach: • Ensures a consistent approach to the classification of group companies, selection of methodologies and economic analysis • Considerably ease the maintenance and updating on an ongoing basis—multinationals are better able to take control, and stay in control, of their transfer pricing systems • Enhance efficiency since multinationals only need to prepare specific local documentation where the regulations require it or in the event of a high transfer pricing risk

Transfer Pricing Software In recent years an increasing tendency has emerged amongst large MNCs to use software products to create transfer pricing documentation packages. The automation of the documentation process will become increasingly important as the compliance burden for MNCs grows, as more countries introduce mandatory documentation requirements. It is important to recognize that the investment in such software would typically be most viable for larger MNCs with multiple entities in China and globally as well as the required in-house resources to implement and coordinate the relevant input into the software. Software can create considerable efficiencies in transfer pricing compliance and should be seen as one component of the transfer pricing process.

Transfer Pricing Methods The following are the recognized transfer pricing methods in the OECD Transfer Pricing Guidelines as well as in China: • • • • • •

Comparable Uncontrolled Price Method Resale Price Method Cost-plus Method Transactional Net Margin Method Profit Split Method Other appropriate methods that comply with the arm’s length principle

The selection of an appropriate transfer pricing method should be guided by the level of comparability of data used and the reliability of the results. The following are descriptions of the accepted transfer pricing methods.

Transfer Pricing Software

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Comparable Uncontrolled Price Method (CUP) The CUP method takes the prices that are charged by arm’s length parties or to non-related parties in conducting the same or similar transactions with the related party transactions as the arm’s length price. The CUP method is potentially applicable to all types of related party transactions. The CUP method requires a high level of comparability and if available would generally provide the best benchmark of an arm’s length price for a related party transaction. However, in practice, it is rare to find a reliable CUP outside of commodity or financial services products with a publicly listed price. The CUP can either be applied on an internal or external basis. Each is illustrated below:

When considering other methods, which require an analysis of gross margins or net margins, special attention should be paid to the differences of functions and risks, contractual terms and other factors that might impact the profit margin of comparable uncontrolled transactions, such as manufacturing, processing, installing and testing functions, market and foreign exchange risk, value and useful life of machinery and equipment, use and value of intangible properties, business experiences, accounting treatment, and management efficiency. If significant differences exist between the related party transaction and unrelated party transaction, it is essential to consider whether an adjustment is feasible and if not, consider the use of another method.

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Resale Price Method The resale price method is relevant to goods rather than services, where the arm’s length price for the goods purchased from a related party is determined by deducting the gross profit of a comparable uncontrolled transaction from the resale price to nonrelated parties for goods purchased. The resale price method is usually used in the situation where the reseller performs only simple processing or resale of goods. The formula is as follows: Arm’s Length Purchased Price ¼ Resale price to non-related parties ð1 Gross margin of comparable uncontrolled transactionÞ Similar to the CUP, the resale price method can be applied on an internal or external basis. Each is illustrated below:


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The potential problems with the application of the resale price method using external data are the availability and reliability of data in respect of the gross margins being achieved by third parties in comparable circumstances as well as the different accounting policies that may be adopted by companies in accounting for expense items as either a cost of goods sold or as an operating expense, which can distort the results considerably. Cost Plus Method Under the cost plus method, the arm’s length price reflects the full cost of the underlying goods or services plus a gross profit mark-up. The cost plus method is usually applied to the related party transactions of manufacturing (particularly on a toll or contract basis) as well as the provision of services. The formula is as follows: Arm’s Length Price ¼ Reasonable cost ð1 þ cost plus margin of comparable uncontrolled transactionÞ The application of the cost plus method is illustrated in the diagrams below. As with the other methods, it can be applied internally or externally.

Transactional Net Margin Method The TNMM refers to the use of net profit margins from comparable uncontrolled transactions in setting or testing the net operating margin from a related party

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transaction. The TNMM is usually applied to the related party transactions of sales, transfer and usage of tangible goods, provision of labor services, and transfer of intangible assets. The types of profit level indicators that are typically referred to are: • • • • •

Return on equity Return on sales Mark-up on total costs Return on assets/capital employed Berry ratio (gross margin/operating expenses)

The selection of an appropriate profit ratio will be based on the primary driver of the profitability of the entity. For a manufacturer, return on assets may be more relevant, while for a distributor, the return on sales may be more logical. In practice the TNMM is very widely used by both taxpayers and tax authorities. It overcomes the need for exact product comparability, avoids the concern regarding availability of gross margin data and cost classifications and, from a tax authority perspective, is the indicator that directly determines the amount of tax to be paid.

Profit Split Method fThe profit split method refers to the methodology where the total profit on a transaction is allocated to each associated enterprise according to their respective contributions. The profit split method is usually applied in cases where the related party transaction is highly integrated and difficult to evaluate the operating result separately. There are two kinds of profit split method: (1) general profit split method; and (2) residual profit split method. The general (or ‘‘contribution’’) profit split method splits profit among associated enterprises according to the functions performed, risks borne and assets held, particularly intangible assets, which are contributed by each entity. The residual profit split method requires the identification of the routine profit for an entity as a first step. Any remaining profit is then split based on each party’s contribution to the earning of the non-routine profit e.g. ownership of intangibles. The application of the profit split method requires a careful analysis of the functions performed, risks borne and assets used by each associated enterprise as well as the allocation of cost, expense, earnings, and capital between associated enterprises involved in the transaction

Other Methods If the methods stipulated above cannot be applied separately, combined methods or other methods consistent with the arm’s length principle may be used. However,


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in the context of China, with a developing transfer pricing regime, it is difficult to envisage how unfamiliar methods may be interpreted by the tax authorities. It is recommended that they are at least supported by a more recognized method to the extent possible.

Link with Responsibility Center Profile The table below provides, as an example only, a link between the business model, responsibility center profile and choice of transfer pricing methodology. Although each case is different it may serve as a useful reference point in methodology selection. Functions

Model

Responsibility center

Price setting/profit checking method

Procurement

Sourcing Procurement agent Full risk procurement Toll Contract Full risk Agent Limited risk Full risk

Cost center Revenue center Profit center Cost center Cost center Profit center Revenue center Revenue center Profit center

Cost plus/TNMM TNMM TNMM/profit split Cost plus/TNMM Cost plus/TNMM TNMM/profit split TNMM Resale price/TNMM TNMM/profit split

Manufacturing

Sales

Economic Analysis Once the methodology has been selected, the economic analysis, or application of that methodology, must be undertaken. The application of the cost plus, resale price and TNMM on an external basis involves the use of commercial databases such as those created by Bureau van Dijk (for practical purposes, it should be noted that the license fees to access such databases mean that it is generally not feasible to perform this part of the analysis inhouse). Tax authorities generally also have access to such databases and may also develop their own based on tax return and other non-public data. In China, Article 20 of Guo Shui Fa (1998) No. 59 required tax authorities to establish a transfer pricing database that should contain income tax return data, market prices of main commodities, trade and industrial profitability ratios, borrowing and lending interest rates as well as structural and managerial information of multinational enterprises. The ruling stipulates that the database should be

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shared within the tax administration system and should not be available to the public. Such data is referred to as ‘‘secret comparables’’ and, when used to adjust a taxpayer’s profitability, is widely considered to be unreasonable as the taxpayer does not have sufficient information to defend themselves. There have been some mixed signals from the SAT on whether such ‘‘secret comparables’’ will be used significantly in China. In a welcome move, the agency issued Guo Shui Han (2005) No. 239 recommending that taxpayers conduct their own comparability studies using the financial databases published by Bureau van Dijk. In practice, it is likely that a search of the Bureau van Dijk databases carried out in accordance with OECD best practice and fully and accurately documented will strongly discourage the use of secret comparables by the investigating tax bureau. However, in the China Transfer Pricing Regulations the possibility of the tax authorities using such data is again mentioned, so in this case it is uncertain how this will be applied in practice.

Capital Intensity Adjustments This refers to the practice of adjusting the profitability of the comparable companies to equate them to the same proportionate level of receivables, payables and inventory as the tested party. Such adjustments are widely used by tax authorities and taxpayers around the world, particularly in the US context. However, in July 2005 the SAT released Guo Shui Han (2005) No. 745 stating that local tax authorities should not use capital intensity adjustments in carrying out comparability studies, unless there is strong support for doing so. It is likely that the SAT has taken this position due to the prevalence of state-owned Chinese companies that may be used as comparables, with abnormally high levels of working capital (especially inventory holdings), with the result that capital intensity adjustments could result in benchmarking results with unacceptably low profit ranges, or even losses.

Box 4: Transfer Pricing Controversy Management The premise of the transfer pricing process is that by designing and implementing a system that supports your business model (Boxes 1 and 2), and documenting such system in a comprehensive and timely manner (Box 3) the risk of issues in Box 4 is greatly mitigated. There are always potential conflicts that can arise between tax authorities and taxpayers, leading to some common questions:

Box 4: Transfer Pricing Controversy Management

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• Can the losses of an entity be explained by reference to its function, asset and risk profile? If the entity is classed as a contract manufacturer, is it earning consistent routine profitability? • Did the group company really provide any intra-group services to the recipient company, and if so, did the services benefit the recipient group company, and if so, is the charge commensurate with the benefit received such that a third party would have been willing to pay the charge? • Since the brand name was built up by the local group company, why should it pay a royalty to the so-called legal owner of the brand? Chapter titled Transfer Pricing Audits and Enforcement further discusses the transfer pricing audit environment in China and how to best manage this process if and when it arises.

Transfer Pricing Disclosures and Documentation

This chapter addresses the compliance obligations in China in relation to transfer pricing, namely the identification and disclosure of related party transactions in the tax return and preparation of contemporaneous transfer pricing documentation.

1 Identifying Related Party Transactions The China Transfer Pricing Regulations have application to related party transactions. ‘‘related party’’ is defined in the China Transfer Pricing Regulations as any of the following: • One entity directly or indirectly holds a total of 25% or more of another entity’s shares; a third party owns or controls, directly or indirectly, 25% or more of the shareholdings in both enterprises—the calculation of indirect holding should be made through multiplying with share proportion of each layer; however, if one entity holds over 50% of the shares of the other entity of next layer, it would be deemed as it holds 100% at this layer • Debts owed by one enterprise to another enterprise (except a third party financial institution) exceed 50% of the enterprise’s capital, or 10% of the total debts owed by one enterprise is guaranteed by another enterprise (except a third party financial institution) • More than half of one enterprise’s senior management personnel (including the board of directors and the general manager), or at least one of the executive members of the board of directors are appointed by another enterprise, or two enterprises with more than half of their senior management personnel or more than one executive director is appointed by a same party • One enterprise’s normal production and operation activities are dependent on intangibles licensed from another enterprise (including industrial property rights or patented technology)


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• The purchase of raw materials or spare parts by one enterprise is under the control of or must be supplied by another enterprise (such control includes control over prices and terms of transactions) • One entity’s provision or receipts of services is determined by another enterprise • One enterprise has actual control over the other enterprise’s production, operation, and trading activities through relationships associated with other interests (including family relationships) Thus it is important to review closely any transactions conducted to determine if any of the above definitions may be applicable; it is not simply a case of applying the traditional share ownership thresholds.

2 Tax Return Disclosures From the 2008 tax year1 (tax return lodgment due May 31, 2009), when filing annual tax returns, enterprises involved in related party transactions should prepare and submit the following documents: • • • • • • • • •

Annual Annual Annual Annual Annual Annual Annual Annual Annual

Reporting Reporting Reporting Reporting Reporting Reporting Reporting Reporting Reporting

of of of of of of of of of

Related Related Related Related Related Related Related Related Related

Party Party Party Party Party Party Party Party Party

Transactions—Associated Parties Transactions—Transaction Summary Transactions—Purchases and Sales Transactions—Services Transactions—Intangible Assets Transactions—Fixed Asset Transfers Transactions—Financing Transactions—Outbound Investments Transactions—Outbound Payments2

Copies of the forms are contained in Appendix 2. These disclosure forms require all taxpayers with related party transactions to disclose a large amount of detail concerning their related party transactions including details of amounts and types of related party transactions, the level of documentation available and methodology used to test the arm’s length nature of the transactions, and the level of profitability on these transactions.

1 Prior to the 2008 tax year companies with related party transactions were required to file a specific disclosure form (either Form A or B) with their annual corporate income tax returns within 4 months after the year end. These forms include only basic information about their related party transactions, such as the identities of the related parties, and the type and amount of the transactions entered into with each of the related companies. 2 This form is only applicable for Chinese resident companies with investments outside China. In general it is unlikely that an FIE would be involved in all transactions, so as a practical matter there will be fewer than nine forms to complete.

2 Tax Return Disclosures

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The significance of these forms as a risk assessment tool for the tax authorities should not be overlooked. Article 31 of the China Transfer Pricing Regulations states: Desktop reviews shall mainly be based on using the information collected from annual tax filings such as the Annual Corporate Income Tax Returns and the Annual Reporting Forms for Related Party Dealings.

It is therefore critical that the forms be completed accurately and with a sufficient level of detail. From a practical perspective it is worthwhile considering the introduction of systems and procedures to enable the information to be captured efficiently and accurately in future years to minimize resources needed to meet this obligation. The experience in other jurisdictions is that such forms act as the primary screening tool for tax authorities to conduct their initial identification of targets for transfer pricing investigation and will provide a very efficient means for the tax authorities to manage their limited resources available in the area of transfer pricing.

3 Circular 363 In advance of the release of the China Transfer Pricing Regulations, to increase the quality of functional and financial analysis conducted on related party transactions during transfer pricing audits, in March 2007 the SAT issued Guo Shui Han (2007) 363 stipulating specific documents and information to be submitted by enterprises and the local level tax bureaus to the SAT during transfer pricing audits. The information request consists of the following: • Enterprise Function and Risk Analysis Form—to be completed by the taxpayer • Enterprise Functional and Risk Analysis Characterization Form—to be completed by the in-charge tax authority • Enterprise Intercompany Transactions Financial Analysis Form—to be completed by the in-charge tax authority The Enterprise Function and Risk Analysis Form are contained in Appendix 2. During the audit the tax authorities may request the taxpayer to complete the ‘‘Form of Enterprises Comparability Factor Analysis’’ while the tax authorities will complete the ‘‘Related Party Relationships Assessment Form’’ and ‘‘Enterprise’s Comparability Factors Analysis Assessment Form’’.

4 Contemporaneous Transfer Pricing Documentation The China Transfer Pricing Regulations have, for the first time in China, introduced a mandatory requirement for taxpayers to prepare and retain detailed transfer pricing documentation to support the arm’s length nature of their related party transactions.

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Such a requirement has been debated amongst policy makers, taxpayers and practitioners for several years and its release has been widely anticipated. This section discusses which entities need to comply with the requirement and what needs to be included in contemporaneous transfer pricing documentation.

Who must Comply? The China Transfer Pricing Regulations3 provide three specific exemptions from the preparation of contemporaneous documentation: • Annual amount of related party tangible goods transactions is below RMB200 million and the amount of related party intangible goods transactions is below RMB40 million4 • The transactions are covered by an APA • The foreign shareholding is below 50% and the enterprise only transacts with domestic related parties

The Documentation • Needs to be completed by May 31 of the year following the tax year, e.g. for the tax year ended December 31, 2010, the due date is May 31, 2011 • Needs to be in Chinese • Must be provided within 20 days of a request • Must be retained for 10 years from June 1 following the relevant tax year The combined effect of the above requirements is that the documentation obligations are genuinely contemporaneous. It is not possible to provide detailed documentation within 20 days of a request if it has not already been prepared in advance, particularly given the request can go back 10 years. In any event, documentation prepared at the time or shortly after the transactions take place is considerably more persuasive to a tax authority than documentation prepared at a later point when the relevant information and personnel may not be available. Such documentation is the only accepted method of giving the tax authorities a clear understanding of the transfer pricing model and commercial realities of the business of a taxpayer. Most significantly, it is the best means of presenting the 3

Article 15. In the case of toll manufacturers, the amount declared on the relevant customs documentation is the relevant test. Intangible goods transactions include service fees, royalties and financing expenses/revenues. 4

4 Contemporaneous Transfer Pricing Documentation

29

company’s case to the local tax bureau’s staff in a favorable light, with a view to avoiding a lengthy and costly transfer pricing audit. It is important to emphasize that, even if taxpayers are not required to prepare transfer pricing documentation, it may still be highly recommended to do so in the following circumstances: • The taxpayer has characteristics that render it at high-risk of transfer pricing audit and investigation, such as being a loss-making manufacturer or a distributor achieving net margins lower than the industry norm (discussed in chapter titled Transfer Pricing Audits and Enforcement) • The taxpayer operates in a high-risk industry or is part of a large multinational group that is at high-risk of a transfer pricing audit • The taxpayer discloses unusual or suspicious related party transactions or transfer pricing methods when completing the obligatory related party disclosure forms • The taxpayer is exempt for the year 2010 due to the thresholds on related party transactions, but future years are expected to see an increase in the amount of related party transactions—it can be highly recommended to carry out a documentation exercise for the year 2010 in order to capture the industry and functional analysis information for future use, as such information can be lost over time as employees change and memories fade. It should also be noted that local tax bureaus have the discretion to adjust the thresholds for needing documentation downwards for taxpayers in their jurisdiction, so it is important to monitor local tax rulings and notices for this purpose Transfer pricing adjustments can be made, and additional tax and penalties levied, by the tax authorities, to include years when documentation may not have been strictly required—the limitation period is up to 10 years, and the interest and penalties will not be capable of correlative relief under any double tax treaties.

What is Contemporaneous Documentation? Chapter 3 of the China Transfer Pricing Regulations sets out what is required to be included in contemporaneous transfer pricing documentation. The requirements to a large extent follow those in other jurisdictions as well as those of the OECD, however, they also stipulate a greater level of detail in respect of the whole value chain of the organization.

Organizational Structure The first category of information relates to details on the overall group structure. By requesting this information, the authorities are seeking to understand not only

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the structure of the China-based entity but that of the overall group. This enables them to some extent to analyze the whole value chain to be comfortable that the proportion of profit recognized in China is reasonable. The specific information requested is • Relevant organizational and ownership structure of the group • Description of the changes in the relationship between the enterprise and its related parties in the tax year • Description of the related parties with whom the enterprise has transactions, including the name, legal representative, composition of high level management, registered address and address of business operation of related parties; details of family members of related individuals; and identification of related parties with direct influence over the pricing of related party transactions of the enterprise • Description of the types of relevant income tax, applicable tax rates and the applicable preferential tax treatments of each related party

Description of Business Operations The second set of information relates primarily to the industry and functional analysis described in some detail in chapter titled Designing and Implementing a Transfer Pricing System. From this information the tax authorities will form a picture of where the company is positioned within its industry, the activities undertaken by the entity in China, the ownership of any intangible assets as well as the level of risk borne. This sets the scene for the economic analysis performed. The specific information consists of the following: • Business overview of the enterprise, including a summary of the enterprise’s development and changes, a summary of the industry in which the enterprise operates and its development, major economic and legal issues affecting the enterprise and the industry such as business strategy, industrial policy, and restrictions facing the industry, etc., industry chain of the group, and the enterprise’s position within the industry chain • Composition of the principal business operations of the enterprise, revenue from principal business operations and its proportion to total revenues, profit from principal business operations and its proportion to total profits • Description of the related parties with whom the enterprise has transactions, including the name, legal representative, composition of high level management such as directors and managers, registered address and address of business operation of related parties; and the name, nationality, country of residence, and composition of family members of related individuals; and identity of related parties with direct influence over the pricing of related party transactions of the enterprise


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• Description of the types of relevant income tax, applicable tax rates and the applicable preferential tax treatments of each related party • Analysis of the enterprise’s market position and relevant competitive environment of the market • The internal organizational structure of the enterprise, relevant information of the functions performed, risks borne and assets employed by the enterprise and its related parties involved in the related party transactions, which the enterprise shall use as a reference in filling out the ‘‘Form of Enterprise’s Function and Risk Analysis’’ • Consolidated financial statements of the group. The enterprise may extend the preparation of this information depending on the fiscal year end of the group. However, such information has to be prepared no later than December 31 of the year following the year in which the related party transactions occur

Description of Related Party Transactions Various details on the related party transactions are required for the completion of this section of the report. This enables the tax authority to understand the exact nature of the transactions in order to understand the selection of transfer pricing methodology and arm’s length level of profitability. Specific information consists of the following: • Description of the type of related party transactions, relevant parties engaged in these transactions, timing, amount, currency of settlement, and terms and conditions of the transactions • Description of the trading mode of related party transactions, changes in the tax year, and reasons for the change • Description of the transaction flow, including information flow, physical flow and cash flow, at each level, and discussion of similarities to and differences from transactions with unrelated parties • Description of intangible assets involved in the related party transactions and their effect on pricing • Copies of contracts or agreements relating to the related party transactions, and descriptions of the implementation of these contracts or agreements • Analysis of the major economic and legal factors influencing the pricing of related party transactions • Segmentation of sales, costs, expenses, and profits on transactions with related parties and transactions with unrelated parties. If these items cannot be segmented directly, they need to be segmented based on certain reasonable allocation key(s) together with an explanation of the allocation key(s) selected. The enterprise shall use the above as a reference in filling out the ‘‘Form of Enterprise’s Annual Related Party Transaction Financial Analysis’’

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Comparability Analysis This section requires the provision of information on the comparable companies or transactions selected, to enable the tax authority to form a conclusion on the arm’s length nature of the transactions. The information consists of the following: • Considerations of the comparability analysis, including the characteristics of the assets or services involved in the transactions, functions and risks of the parties engaged in the transactions, contractual terms, economic environment, and business strategies • Relevant information regarding functions performed, risks borne, and assets employed by comparable companies • Description of comparable transactions, such as the physical attributes, quality and efficacy of tangible assets; normal interest rate, amount, currency, term, guarantee, credit standing of the lender, term of repayment, and interest calculation method, etc., under the financing arrangement; nature and level of services; type of intangible assets and the form of intangible asset transactions, right to use the intangible assets obtained from the transactions, and income from using the intangible assets • Source of comparables information, selection criteria and the reason for setting these criteria • Adjustments made to comparables data and the reason for these adjustments

Selection and Application of Transfer Pricing Method This section requires the taxpayer to document the selection of a transfer pricing methodology used to test its profitability, as well as the application of that methodology through economic benchmarking. The information requested is as follows: • Selection of transfer pricing method and the reason. If the profit split method is selected, contribution to the overall group profits or the level of residual profits should be explained • Description of how comparables information support the selected transfer pricing method • Assumptions and decisions made in the process of determining comparable uncontrolled price or profit • Determination of comparable uncontrolled price or profit based on application of proper transfer pricing method and the result of comparability analysis, and explanation to the compliance with the arm’s length principle • Other information supporting the application of selected transfer pricing method One issue that has arisen recently in the context of an economic analysis is the type of comparable companies to be selected for inclusion. The typical starting


33

point is to search for publicly listed companies in China operating in the same industry as the taxpayer. In the majority of cases where this produces a very small sample size the taxpayer can either expand the search to include (a) listed companies from other Asia Pacific countries; or (b) private companies in China. The first approach has traditionally been used as there is greater confidence on the reliability of the financial information; however, the downside of this approach is that the companies tend to be less comparable as they are large MNCs that perform a range of activities and operate in very different economies to a Chinese taxpayer. The other approach is to rely on private company data from China and the region. We understand that the SAT are currently trialing databases that provide access to private company data, and the regulations specifically state that ‘‘Both publicly available information and non-public information can be used during analysis and evaluations’’.5 The current practice, and tax bureau preference, is to use public companies only, although this may change as the integrity of private company data improves going forward.

5 Managing the China Compliance Burden: Transfer Pricing Master File As covered earlier, the transfer pricing master file is an efficient means of managing a heavy transfer pricing compliance burden. In addition to being used on a global or regional basis, it can also be useful in a China context. In cases where an MNC has multiple operations in various provinces of China performing similar functions, it serves as a more efficient means of preparing documentation. Typically in such cases, one industry and functional analysis would be prepared through interviews with a ‘‘representative’’ entity. In relation to benchmarking, to the extent that there is product and functional similarity, one benchmarking study would be prepared. These elements would represent the basis of a master file document. To the extent that the entities fall within the threshold for needing separate documentation, a streamlined exercise can be undertaken to convert the master file to legal entity reports. This would involve an interview to validate the functional analysis and other minor changes in content and format of the document.

5

Article 37.

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6 Tips for Preparing Documentation It is evident from the above that the contemporaneous documentation requirement will place a significant burden on many taxpayers in China. It is important to plan and manage this information collection and documentation as efficiently as possible to avoid excessive costs and time commitment; as well as ensuring maximum benefit is derived from the documentation in addition to fulfulling a compliance obligation. The following are some tips to assist and to gain maximum benefit from this process: 1. Plan ahead and begin the process as early as possible—it is always easier to collect information and document the business model as close as possible to the period rather than years after the event 2. Identify internal resources to be involved in the documentation process. Understand what can realistically be in-sourced and what parts will need the help of an external advisor. MNCs should obtain a few quotes for external advisors, rather than relying on your existing tax advisor or auditor, as costs (and quality) of transfer pricing service can vary considerably from advisor to advisor 3. Develop appropriate templates and tools to simplify and standardize aspects of the process (which will take some time in the first year but will save considerable time going forward) 4. If a MNC has multiple entities in China, the use of a master file approach should be considered 5. Use the economic analysis in the documentation on a prospective basis to set intercompany prices going forward 6. Combine the documentation process with a risk assessment of the China entities to highlight areas that may need further attention and close monitoring 7. Utilize the documentation and risk assessment process to identify opportunities to lower the effective tax rate of the group in an arm’s length and defensible manner

Transfer Pricing Risk Management

This chapter provides a framework for the assessment and, most importantly, management of transfer pricing risks across the business model and transfer pricing process.

1 Sources of Transfer Pricing Risk Transfer pricing risk arises not only in respect of transfer pricing audits and penalties but in all stages of the transfer pricing process. In Box 1, lack of clarity of the business model creates misalignment between business reality and the transfer pricing system, which can mean entities are remunerated in a manner inconsistent with their function and risk profile. For example, not clearly defining roles and responsibilities and remunerating a sales agent on a cost plus basis will not be consistent with the commercial objective of maximizing sales. In such case, a commission based transfer pricing model may be more appropriate. The risk inherent in Box 2 is that economic, legal and accounting realities are not aligned and that the economic reality (how the business actually operates) is not reflected in the legal agreements and the accounting statements. One risk that this can give rise to is permanent establishment risk if, for example, the sales staff are negotiating, concluding and signing contracts (legal reality) on behalf of an entity resident in another jurisdiction and this is not consistent with the operational/economic allocation of functions, risks and profits between those entities. Box 3 risks are well documented and understood, consisting of penalties for not complying with transfer pricing compliance obligations. These are discussed in chapter titled Transfer Pricing Disclosures and Documentation. Box 4 refers to the risk of facing a transfer pricing investigation or audit. This is obviously very disruptive to an entity, in addition to the potential penalties and interest if the audit results in a transfer pricing adjustment.


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These risks are displayed in the diagram

2 Transfer Pricing Risk Assessment As can be seen from the above, transfer pricing risk is becoming an increasingly significant and critical issue for MNCs and SMEs alike. Introducing systems to assess (and therefore manage) these risks is an essential part of any transfer pricing strategy. Transfer pricing risk assessment can take a number of forms: • For subsidiaries of an overseas parent company, a single country risk assessment can be carried out, normally focusing on the amount and quality of the transfer pricing documentation, the size and nature of the cross-border related party transactions, and the profitability or otherwise of the local entity • For global multinational groups in respect of one transaction type, such as the recharge of head office management service costs, a country risk assessment can be undertaken to judge transfer pricing risk on a reasonably objective and defensible basis in order to support the amount of tax reserve in the parent company’s consolidated accounts • For global MNCs preparing consolidated accounts in accordance with U.S. GAAP, compliance with Financial Accounting Standards Board Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes, requires a structured and reasonably objective approach to the recognition of uncertain tax positions on a global basis and measurement of the amount of tax benefit that is more likely than not to be supported on tax authority audit

3 Transfer Pricing Risk Management Transfer pricing risk management takes many forms and has already been discussed in different sections of this book. Referring to the transfer pricing process, various chapters of this book have set out a framework for managing these risks through the correct design, documentation and implementation of a transfer pricing system.

3 Transfer Pricing Risk Management

37

• Chapter titled Designing and Implementing a Transfer Pricing System has addressed the preparation of a functional and economic analysis (Box 1) as well as proper transfer pricing system design (Box 2) • Chapter titled Transfer Pricing Disclosures and Documentation considers the preparation of compliant transfer pricing documentation and related party disclosures on the tax return (Box 3) • Chapter titled Transfer Pricing Audits and Enforcement will review the transfer pricing audit environment in China and provide practical guidance on avoiding and managing a transfer pricing audit (Box 4) The table, as an example, provides a spectrum of transfer pricing risk ratings based on the complexity and magnitude of particular transactions, and the type of support/documentation that may be appropriate to support it. For example, for a simple recharge of costs of US$1 million, an invoice may be sufficient, while at the other end of the spectrum sale of goods to loss makers in 10 different countries with a total amount of US$100 million would require the full range of documentation including a master file, local customization of the master file and potentially a separate paper to defend the commercial reasons for the losses. Most transactions will lie between these two extremes, but it does indicate a clear nexus between the risk profile and type of supporting information recommended.

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The most critical point about transfer pricing risk management, and a theme that has been reinforced in other sections of this book, is that it impacts on every aspect of the business model and transfer pricing process. Consideration of the potential transfer pricing risks needs to be an integral part of business model and transfer pricing system design, documentation and implementation. Applying the tools and processes explained in this and other chapters of this book will help ensure such risks are effectively and consistently identified and mitigated.

Transfer Pricing Audits and Enforcement

In cases where MNCs have not prepared transfer pricing documentation, and also in cases where documentation is in place, there is a risk that the tax authorities will select the company for an audit. This chapter considers the transfer pricing investigation and audit environment in China and provides practical guidance to help MNCs prepare for and navigate through this process.

1 Overview Transfer pricing audits have existed in China for some time, although their intensity and scale has markedly increased over the last five years. Most of the audits conducted to date have focused on tangible goods transactions, in particular those relating to contract manufacturing. However, recently there have been more high profile audits involving intangibles and this trend will continue as the SAT recognises the significance of intangibles in the value chain of any MNC. This has exposed royalty payments to a very high risk of scrutiny and, in line with developments at the OECD, transfers of intangibles and business restructuring are beginning to come under scrutiny.

Industry Focus One interesting development in the China audit environment has been a focus on particular industry groups. SAT officials receive very detailed training from a variety of industry and transfer pricing specialists at intensive week long training sessions in order to ensure they are equipped to undertake complex and rigorous audits of certain industries. To date this has included three


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industries – pharmaceutical, banking and automotive – where the SAT has identified potential for significant gains in tax revenue. Some of the critical issues discussed during the automotive session in June 2010 included: • Local marketing intangibles: if a foreign invested entity performs sophisticated marketing functions in China, the SAT may take the view that these lead to the creation of local marketing intangibles (which need to be rewarded with higher profitability) • Location savings: there is uncertainty about whether some or all of the cost savings gained by a multinational being able to produce in China at a lower price than abroad should be recognised in the China entity or the overseas parent. This concept is increasingly becoming the focus of debate between taxpayers and the Chinese tax authorities in the transfer pricing audit process • China market premium: the success of the car industry in China enables cars to be sold at a premium in this market relative to international markets. The issue here is how to quantify this market premium and which party should enjoy the benefit of it • Outbound royalty payments: when a new manufacturing venture is established in China, the transfer of design and manufacturing know-how usually gives rise to a royalty payment. Deductibility of royalty payments (and to a lesser extent service fees) has always been an issue of contention in China and this is particularly apparent in the automotive industry • Companies incurring losses: this is also a serious concern as many manufacturers in the automotive industry incurred significant losses in 2008 and 2009

Local Documentation Reviews During the second half of 2010 the SAT advised the local tax bureaux to collect and review a percentage of transfer pricing documentation prepared by taxpayers in their jurisdiction for both the 2008 and 2009 years. This was an extensive undertaking that imposed compliance obligations on companies including those that may not have been above the transaction threshold. Following these reviews, the summary information was collated and submitted to the central SAT to enable assessments of the quality of documentation, high risk industries/transactions, etc. It is clear that this process has been used to gather detailed information on taxpayers so they can be targeted for audits in 2011, while also serving as a means of beginning to educate the local tax bureaux staff on transfer pricing compliance.

2 Audit Targets

41

2 Audit Targets The SAT has provided a very transparent list of audit targets to the local tax authorities, which has been evolving over the last few years. Local tax bureaus have been instructed to select the following key targets for transfer pricing investigation and audit1: • Enterprises which have significant amount of or various types of related party transactions • Enterprises which have been in long-term consecutive losses, low profitability, or fluctuating profit-and-loss situations • Enterprises whose profit levels are lower than those in the same industry • Enterprises showing an obvious mismatch between their profit levels and their functional and risk profile • Enterprises which have business dealings with related parties in tax havens • Enterprises which have not complied with the reporting of their related party transactions or preparation of contemporaneous documentation • Enterprises obviously violating the arm’s length principle The final category appears to be a catch-all provision to pick up any other transactions that are not caught within the specific criteria above. In addition to the above guidelines, contract manufacturers have particularly come under scrutiny.

Circular 236 As a response to the fact that a large proportion of contract manufacturers have been reporting losses despite having a limited function and risk profile, the SAT has identified such companies as specific audit targets. Entities with the following characteristics are being and will continue to be targeted: • Sole function of manufacturing based on the overall business plans and production orders of overseas parent companies • Overseas parent companies or other affiliates are wholly responsible for operating policy, product R&D and sales • Do not bear the associated risks and losses arising from ineffective policies, under-utilization of production capacity and slow market demand There is an expectation that such entities earn a consistent (but potentially relatively low) level of profitability and are not subject to market or capacity risks. If this is not the case, they are very likely to come under scrutiny from tax authorities. 1

China Transfer Pricing Regulations, Article 29.

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3 The Audit Process Once an entity has been selected for transfer pricing audit, the tax authorities are entitled to request any information (in writing) relevant to the pricing of related party transactions.2 This may include: • The enterprise’s foundation approval documents, including Articles of Association, business and tax registration certificates, investment and operational contracts, feasibility studies, annual financial statements, internal audit reports, account books and vouchers, commercial contracts and other relevant documents • Financial information, including profits/losses on sales of assets, rates of return on investments, sales revenues, cost of sales and operating expenses, interest rates, and prices paid for the acquisition or use of tangible and intangible property Once this information is reviewed the tax officer will then determine whether there is a need for further scrutiny through a more detailed field audit. Transfer pricing audit fieldwork is carried out by the county or municipal level tax bureau, but all transfer pricing audit settlement determinations must be approved by the SAT. The China Transfer Pricing Regulations3 specify the following rules and process for tax authorities in carrying out a field audit: 1. A field investigation team must comprise at least two persons 2. Field investigators shall produce a ‘‘Tax Inspection Permit’’ and issue a ‘‘Tax Inspection Notice’’ when conducting field investigations 3. In accordance with relevant legal proceedings, field investigators may raise inquiries, request accounting records, and conduct on-site verifications 4. Field investigators raising inquiries shall prepare a ‘‘Record of Inquiries (Investigation)’’, and inform the enterprises under investigation of their legal obligations if they fail to truthfully provide the information required. The ‘‘Record of Inquiries (Investigation)’’ shall be verified and confirmed with the enterprises under investigation 5. Field investigators requesting accounting records shall, in accordance with Article 86 of the Tax Collection Regulations, prepare a ‘‘Notice for Requesting Accounting Records’’ and a ‘‘List of Requested Accounting Records,’’ and follow the relevant legal proceedings. The requested information including book of accounts and vouchers should be kept properly and returned to the enterprises within the legal time frame 6. Issues identified and information obtained during field investigation shall be described in the ‘‘Record of Inquiries (Investigation)’’ by investigators. The ‘‘Record of Inquiries (Investigation)’’ shall be signed by at least two investigators and verified and confirmed with the enterprise under investigation where necessary, or if the enterprise under investigation refuses to verify and

2 3

Article 56 of the New Tax Administration Law promulgated on May 1, 2001. Article 32.

3 The Audit Process

43

confirm, the ‘‘Investigation Record’’ can be signed and filed for record by at least two investigators 7. Notes, tape recordings, videos, photographs and copies of original documents or information can be taken when requesting relevant information associated with the case. However, sources and original record keepers must be quoted. The notes, tape recordings, videos, photographs and copies obtained shall be sealed or stamped, and labeled with ‘‘checked against original documents’’ by the original record keepers or providers 8. Witnesses, if needed, shall be informed of their legal obligations if they do not truthfully provide the information requested. Testimony and information provided shall be signed or sealed by the witnesses In addition, tax authorities are able to request relevant information from the enterprise under investigation, its related parties and other enterprises relevant to the investigation of related party dealings.4 In such cases it will issue a ‘‘Tax Investigation Notice.’’ This means that besides the party under investigation, any company considered comparable is required to provide any information requested by tax authorities. It is assumed that in such cases this information will not be used by tax authorities to also investigate the ‘‘comparable’’ party. In the event that information on overseas entities and transactions is required, the tax authorities may request this through the exchange of information provisions in the respective tax treaties, which may need to be notarized by the taxpayer. During the audit, the tax authorities may request the taxpayer to complete the ‘‘Form of Enterprises Comparability Factor Analysis’’ while the tax authorities will complete the ‘‘Related Party Relationships Assessment Form’’, the ‘‘Related Party Transactions Assessment Form’’ and ‘‘Enterprise’s Comparability Factors Analysis Assessment Form.’’ With the release of Circular 363, many companies in a number of provinces and municipalities such as Beijing and Tianjin have received inquiries from local SAT regarding the transfer pricing matters. Furthermore, the Beijing State Tax Bureau has recently issued notices requesting detailed information on related-party transactions to over 400 foreign-invested enterprises that are required to respond to the notice with the required information within 10 days of receipt of the notice, otherwise a penalty will apply.

4 Concluding the Audit The China Transfer Pricing Regulations5 outline a very clear process for completion of the audit and proposing the adjustment. Although written from the perspective of the tax authority, these guidelines should provide a clear indication 4 5

Article 43 of the CIT Law and the implementing regulations of the CIT Law. Article 43.

44


of the appropriate protocols to be followed by the tax authority and enable better preparation from the taxpayer. 1. Prepare a preliminary special tax investigation adjustment proposal based on simulations, evaluations and comparability analysis 2. Negotiate with the enterprise under investigation based on the preliminary special tax investigation adjustment proposal. Both the tax authorities and the enterprise shall designate a principal negotiator. Investigators shall keep a ‘‘Record of Negotiation Content,’’ which shall be signed and confirmed by the principal negotiator from each party. If the enterprise refuses to sign on the record, the record can be signed and filed for record by at least two investigators 3. If the enterprise disagrees with the preliminary special tax investigation adjustment proposal, it shall provide further information within the time period specified by tax authorities. Tax authorities shall carefully review the additional information provided, and make assessment determination in a timely manner 4. Tax authorities shall issue a ‘‘Preliminary Special Tax Investigation Adjustment Notice’’ to the enterprise based on the assessment determination. The enterprise shall respond in writing within 7 days upon receiving the notice if it disagrees with the preliminary adjustment, or it will be deemed to have agreed to the preliminary adjustment notice. Upon receipt of the enterprise’s response in disagreement with the notice, tax authorities shall further assess the case and negotiate with the enterprise 5. Tax authorities shall make conclusions on the final adjustment, and issue a ‘‘Special Tax Investigation Adjustment Notice’’ to the enterprise

5 Income Adjustments Once the audit is completed, if the tax authority concludes that an adjustment is required it can deem an enterprise’s taxable income in accordance with Article 44 of the CIT Law, based on one of the following methods: • • • •

By reference to the profit margin of the same or similar type of enterprises Based on the enterprise’s cost-plus reasonable expenditures and profit By reasonable proportion of the consolidated profit of the related party group Through other reasonable methods

If considered appropriate, an adjustment to the profitability will be made based on an arm’s length range of results from the comparable companies. Typically in transfer pricing adjustments the interquartile range of results (from 25th to 75th percentile) is applied, given that no comparable is ever going to be perfect. However, taxpayers should be aware that the interquartile range is a new concept in China transfer pricing. The China Transfer Pricing Regulations indicate that if the profitability of the tested party falls below the median, tax authorities shall

5 Income Adjustments

45

adjust in principle to the median of the interquartile range of comparable results, while if making the adjustments to bring the results of controlled transactions to fall within the arm’s length range would reduce the tax liability in China, such downward adjustments are not allowed.6 It is unsure how rigorously this standard will be enforced, particularly as there are genuine and valid economic reasons why profitability can and should fall below the median of a sample. The advice is that if there are valid and defensible reasons for targeting a point such as the lower quartile of the range, these should be thoroughly documented in the transfer pricing report and vigorously defended by the taxpayer.

6 Appeals Procedure The key overriding point is that it is always recommended to resolve any transfer pricing (or tax) dispute through negotiation wherever possible. However, if this fails, an appeal can be made to the tax authorities with additional supporting documentation within 60 days for an administrative appeal. A decision on the appeal must be made within 60 days. The tax authorities may reevaluate their adjustments and consult further with the taxpayer and advisers if deemed necessary. After reviewing the additional information and submissions by the taxpayer, the tax authorities will issue a notice of audit decision, at which point in time the outcome is generally regarded as being final. If the taxpayer is still not satisfied with the decision, it is possible to start legal proceedings in the People’s Court within 15 days of receiving the decision. However, before commencing the appeal process, the taxpayer is obliged to pay the assessed tax, penalty and interest. When contemplating taking this final step, the taxpayer should consider carefully the potential damage to the relationship with the tax authority, the realistic chances of success, the broader reputation of the firm as well as the cost of litigation.

7 Penalties and Interest The new CIT Law introduces for the first time a special interest levy on all antiavoidance tax adjustments, including transfer pricing adjustments. This is the first time that interest has been imposed on transfer pricing adjustments and a clear signal of how seriously the SAT is taking this issue. The interest rate is the RMB loan base rate published by the People’s Bank of China.

6

Article 41.

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In addition, a penalty of 5% of the tax adjustment will be applied, although this will not be the case if contemporaneous documentation is prepared in accordance with the requirements, or if the taxpayer has an exemption from providing documentation but provides other relevant information.7 Typically, such interest would not be classified as ‘‘tax’’ under the terms of double tax treaties, so even if there is a treaty in place between the countries involved in the transaction that is subject to the adjustment, it would not be possible to claim relief from the interest charged on a transfer pricing adjustment. Furthermore, if the MNC does not adjust its accounts to reflect a receivable from the other related party for the excess price charged, the amount of the adjustment will also be treated as a deemed dividend which, if the other party is a foreign enterprise, will be subject to dividend withholding tax. Also, if the excess income received by the foreign affiliate is interest or royalty income, then there will be no recovery of the interest or royalty withholding tax already paid.

8 Corresponding Adjustments Chapter 11 of the China Transfer Pricing Regulations is devoted to corresponding adjustments and international consultation through the mutual agreement procedure (MAP) in the double tax agreements, which is a clear indication that the SAT appreciates the importance of this in any transfer pricing adjustment. However, as this is a new concept, it should not be taken for granted that such adjustments will be automatically triggered in all transfer pricing cases. A regulatory framework for MAP has been set out by the SAT in Guo Shui Fa (2005) No. 115, which lists the situations in which a Chinese taxpayer may apply for MAP and provides a list of the information required for the MAP application. The key considerations from the final guidelines are as follows: • To apply for the corresponding adjustment involving related parties in a country (region) which has a tax treaty with China, a formal written application shall be submitted, along with an ‘‘Application for launching Mutual Agreement Procedures’’ to both the SAT and the in-charge tax authorities, and provide relevant information such as the copy of transfer pricing adjustment notice issued to the enterprise or its related parties • The application should be submitted within 3 years from the day the transfer pricing adjustment notice is received • The SAT shall engage in discussions and negotiations with the competent authority of the other treaty country and provide the outcome in writing to the enterprise through the in-charge tax authorities • Corresponding adjustments do not apply to situations involving non-deductible interest expense or interest expense deemed as dividend distribution 7


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9 Tips for Managing a Transfer Pricing Audit The following are some useful practical tips in the event that it is necessary to prepare for and negotiate an audit: • Prepare documentation well in advance to maximize the chances of avoiding an audit and to be fully prepared in case one does occur • Based on the transfer pricing process in chapter titled (Designing and Implementing a Transfer Pricing System), ensure that the legal, economic and accounting realities are fully aligned and that a best practice transfer pricing system is designed and implemented, supported by the legal agreements, invoices and financial statements • Maintain a professional and co-operative relationship with the auditors from the outset • Identify the team with responsibility for handling the transfer pricing audit, and be clear over the respective roles and responsibilities • Keep a detailed record of the information requested by the tax authorities and ensure the tax authorities do the same • Be aware that the auditors will almost certainly want to interview key staff members, in order to verify to some extent the functional analysis information presented to them by the transfer pricing documentation; select the most appropriate staff members and brief them thoroughly in advance • Ensure a member of the tax/finance team is present at all interviews and, if appropriate, an external advisor as well (and keep a detailed record of all discussions) • Inform and involve the head office where appropriate, they may have gone through the process in other countries and understand the arguments and best way to respond • Consider working with external transfer pricing specialists to ensure that risk areas are identified as early as possible, so that technical arguments and additional documentation and economic analysis can be prepared in advance • Understand the situation from the perspective of the tax authority; they will have deadlines and possible revenue targets to meet; understanding this enables the negotiating strategy to be optimized • Identify possible outcomes of the audit to understand the financial impact; this will be a powerful tool in any settlement negotiation • Investigate the possibility of seeking corresponding adjustments under the MAP procedures • Bear in mind the possibility of an APA application (discussed in Chapter titled Other Transfer Pricing Topics) to encourage the auditors to close off the prior year audit and move forward on a collaborative basis • Think very seriously before proceeding to appeal or litigate

Other Transfer Pricing Topics

This chapter addresses two transfer pricing tools that will continue to grow in prominence in China in coming years—advance pricing arrangements (APAs) and cost sharing agreements (CSAs)—as well as thin capitalization, an important broader consideration on inter-company financing.

1 Advance Pricing Arrangements One proactive instrument to reduce transfer pricing risks and possible adjustments imposed by the tax authorities is an APA, which is an arrangement between tax authorities and the taxpayer in respect of the pricing of transactions for a number of years in the future. An APA provides an important mechanism for taxpayers to obtain certainty that their transfer pricing policies and procedures meet the arm’s length standard. The availability of APAs in China was first announced in 1998 by Circular 59, ‘‘Tax Administration Rules and Procedures for Transactions between Related Parties.’’ It was short on detail and had limited application. China corrected these deficiencies in introducing its policy for APAs in 2004 in Guo Shui Fa (2004) No. 118, ‘‘Implementation Rules for Advance Pricing Arrangements for Transactions between Related Parties.’’ This document gave detailed regulations on the application, evaluation, consultation, signing, and even follow-up on the advance pricing of transactions involving associated enterprises. This has been taken a step further in the China Transfer Pricing Regulations. The regulations provide greater standardization of APA procedures and aim to ensure that tax authority resources are only devoted to APAs when there is an economic benefit to China to justify the effort and resources required to negotiate an APA. The SAT released its first-ever annual APA report on 31 December 2010 which provides some useful statistics on APAs concluded to date and is further evidence of the focus the SAT is giving to APAs. C. Devonshire-Ellis et al. (eds.), Transfer Pricing in China, China Briefing, DOI: 10.1007/978-3-642-16080-6_6, Asia Briefing Ltd. 2011

49

50


Interesting findings were as follows: • From 2005 to 2009, Chinese tax authorities concluded and signed 41 unilateral APAs and 12 bilateral APAs, and there are still several APAs under examination. Interestingly, the trend has been towards bilateral APAs (which exceeded unilateral APAs for the first time in 2009) • 62 percent involved transactions for tangible goods, 19% for intangibles and 19 percent for services; • Almost 60 percent were negotiated and finalized in less than one year; • 60 percent involved the TNMM, 26 percent the cost plus method, 7 percent the CUP, 3.5 percent profit split and 3.5 percent other methods The China Transfer Pricing Regulations indicate that the following criteria should be satisfied in order for a taxpayer to be eligible for an APA: • annual related party transactions over RMB40 million • compliance with the related party disclosure requirements • prepare, maintain and provide contemporaneous documentation in accordance with the requirements1 Interestingly, the criteria have been relaxed considerably from the draft transfer pricing guidelines, where a RMB100 million threshold was applied and the taxpayer was required to have a 10 year history of tax compliance in China. In addition, the guidelines include reference to having a pre-filing meeting conducted on an anonymous basis for the taxpayer to gain some comfort on the validity of the APA before disclosing detailed information. These measures are a clear indication that the SAT leaders have paid close attention to the feedback on the draft guidelines and adopted a more open and positive stance towards APAs. One positive development in the guidelines is that there is considerable scope for negotiation on the rollback of the APA to the ‘‘open’’ years assuming the business model is broadly similar. This is particularly good news for taxpayers wishing to avoid a protracted audit and confrontational discussion with the tax authorities. The diagram below shows a flowchart of the unilateral APA application and negotiation process.

1

Article 48.

1 Advance Pricing Arrangements

51

Procedures for APA

Pre-filing Meeting The first step is for the taxpayer to submit a Letter of Intent which may then lead to a pre-filing meeting. During the pre-filing meeting, the following information should be discussed: • • • • • •

years to be covered related parties and transactions involved overview of the enterprise’s business operations in prior years functional and risk profile of related parties involved in the arrangement intention to use the approach to address prior years any other relevant factors2

As noted, this presents an opportunity to discuss the MNC’s business with the tax authority and form an opinion on whether an APA is the best option to manage transfer pricing risk. This can now be conducted on an anonymous basis, such ‘‘no names’’ meetings are common in other jurisdictions with APAs and are an effective means of managing any perception that the tax authority will use the information disclosed inappropriately, such as to audit previous years results. As such, it is often more appropriate for an advisor to represent the taxpayer in such discussions. If the meeting is successful and the two parties reach agreement, within 15 days the tax authority will inform the taxpayer to proceed with the formal lodgment through issuing a ‘‘Notice of Formal Meeting of the Advance Pricing Arrangement.’’ If unsuccessful, a ‘‘Notice of Rejection of Advance Pricing Arrangement

2


52


Application by the Enterprise’’ along with rejection reasons will be issued, also within 15 days.

Formal Application The taxpayer then has 3 months3 to prepare formal documentation together with the ‘‘Formal Application Letter for Advance Pricing Arrangement’’ and submit to tax authorities.4 The documentation package should include the following items: • group and organizational structure, related party relationships and transactions • financials for the most recent 3 years, and information on product performance and assets (including intangible and tangible assets) • types of related party transactions and tax years to be covered • allocation of functions and risks among related parties, including business arrangements and financial results such as profit levels • proposed transfer pricing methodology, calculation method and supporting information • market conditions, including industry development trend and competitive environment • annual information on business scale, business result forecasts and business plans for the period covered under the advance pricing arrangement • disclosure of potential double taxation issues and other relevant issues in relation to domestic and international laws and tax treaties Within 5 months of receiving the above, the tax authority will examine and review the application and request any additional supporting information needed to form their conclusions.5 The scope of examination and evaluation conducted by tax authorities shall mainly cover the following: • • • • • •

overview of historical operations functional and risk profile comparable information assumptions transfer pricing methodology and calculation method expected arm’s length price or profit range

3 An extension may be granted to lodge the application under exceptional circumstances if the taxpayers submits the ‘‘Application for Extension for Submitting the Formal Application for Advance Pricing Arrangement.’’ 4 China Transfer Pricing Regulations, Article 51. 5 Tax authorities may also extend this period in exceptional circumstances for up to 3 months by issuing a ‘‘Notice of Extension for Examination and Evaluation of the Advance Pricing Arrangement’’ to the taxpayer.


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Tax authorities, within 30 days of reaching their conclusion, will arrange further discussion and negotiation with the taxpayer. If agreement is reached, the draft APA is submitted to the SAT for review and final approval.6 It is then signed by legal representatives of both the tax authority and taxpayer.7

Monitoring and Supervision Once the APA is implemented, a comprehensive monitoring and supervision mechanism is in place to ensure compliance with its terms and conditions. The following are the key considerations8: • During the term of the advance pricing arrangement, the enterprise shall maintain a complete record of relevant documents and information (including accounting records and other relevant records), which shall not be lost, damaged or transferred • The enterprise shall also file an annual compliance report in relation to implementation of the advance pricing arrangement to tax authorities within 5 months after the end of each tax year • Tax authorities regularly (normally semi-annually) investigate the enterprise’s compliance status. Major areas for investigation include the following: whether the enterprise complies with the provisions and requirements in the advance pricing arrangement; whether the information provided for negotiations of the advance pricing arrangement and the annual compliance report reflect the actual operations of the enterprise; whether the basis for transfer pricing methodology and calculation method is correct; whether the assumptions in the arrangement are still valid; whether the application of transfer pricing methodology by the enterprise is consistent with the assumptions made • If tax authorities discover a general violation of the advance pricing arrangement, they shall, depending on the circumstances, handle the violation and terminate the advance pricing arrangement where appropriate. In case of any concealment or rejection to implement the advance pricing arrangement by the enterprise, the advance pricing arrangement shall be considered invalid by tax authorities from the beginning • During the term of the advance pricing arrangement, if actual operating results of the enterprise fall outside of the expected range of prices or profits under the arrangement, tax authorities shall, upon obtaining approval from tax authorities at the next higher level, adjust the actual operating results to be within the range of prices or profits under the arrangement

6 7 8

Article 53. Article 54. Article 56.

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• During the term of the advance pricing arrangement, if there are substantial changes that have affected the implementation of the advance pricing arrangement, the enterprise shall report these changes to tax authorities in writing within 30 days, with detailed explanations to the impact of these changes on implementation of the advance pricing arrangement and all relevant information. If the enterprise cannot report such changes within the specified time frame due to non-subjective reasons, an extension of up to 30 days is allowed • Within 60 days upon receiving the written report from the enterprise, tax authorities shall examine and handle the case, including assessing the change of situations, discussing with the enterprise regarding revisions to the provisions and relevant conditions of the arrangement, or taking reasonable measures to amend or even terminate the arrangement depending on the impact of the changes on the implementation of the advance pricing arrangement. Upon the termination of the original advance pricing arrangement, tax authorities and the enterprise may re-negotiate and sign a new advance pricing arrangement in accordance with the provisions of this chapter • For advance pricing arrangements signed by both the state and local tax bureaus with the enterprise, the enterprise shall, during the term of the advance pricing arrangement, file the annual compliance report and the report specifying substantial changes to both the state and local tax bureaus. The state and local tax bureaus shall conduct joint inspection and examination on the enterprise’s compliance status

Renewal of APA The taxpayer has the option of applying for a renewal of an APA by submitting an application for renewal 90 days prior to expiry together with an ‘‘Advance Pricing Arrangement Renewal Application’’ along with reliable supporting evidence to confirm that there are no substantial changes to the facts and conditions in the existing advance pricing arrangement and that the enterprise has been in full compliance with the provisions and requirements in the APA. Tax authorities shall reply in writing regarding whether the case is accepted within 15 days upon receiving the application for renewal, and issue a ‘‘Reply Letter on the Application of the Renewal of the Advance Pricing Arrangement’’ to the enterprise. After receiving the application, tax authorities shall review and evaluate the application documents, and negotiate with the enterprise to draft the new APA. The tax authorities shall complete the renewal process in accordance with the mutually agreed time, place and other relevant matters in relation to the renewal. For APAs involving two or more provinces, autonomous regions, or directlyadministered municipalities and cities specifically designated in the state plan, or involving both the state and local tax bureaus, the SAT shall organize and


55

coordinate the process. The enterprise can directly submit a letter of intent to the SAT.9

Confidentiality Both tax authorities and the enterprise have the duty to keep confidential all information obtained during the whole process of the APA including pre-filing meeting, formal negotiation for signing, examination and analysis, etc. Tax authorities shall record in writing all the meeting discussions with the enterprise, and prepare a list of documents exchanged during each meeting indicating the number of copies and the contents of information provided, to be signed or stamped by the principal negotiator from both parties.10

Bilateral and Multilateral APAs Although their numbers are low, bilateral and multilateral APAs are clearly becoming an increasingly popular measure of managing transfer pricing risk and this is reflected in the attention devoted to them in the China Transfer Pricing Regulations. There are a few additional steps involved in the application process in the case of bilateral and multilateral APAs. The key ones are highlighted below: • The written letter of intent and pre-filing meeting discussion shall include the following: – request by the enterprise for arrangement of a pre-filing meeting with relevant competent tax authorities of the other treaty country – overview of business operations of related parties involved in the arrangement and their related party transactions in prior years – the transfer pricing methodology and calculation method in the APA proposed to the relevant competent tax authorities of the other treaty party • The enterprise shall submit the ‘‘Formal Application Letter for Advance Pricing Arrangement’’ and the ‘‘Application of Launching Mutual Agreement Procedures’’ to both the SAT and the in-charge tax authorities; the SAT shall then arrange negotiations and discussions with relevant competent authorities of the other treaty countries for bilateral or multilateral APAs—if all parties can reach an agreement, a draft APA shall be prepared according to the memorandum of negotiation 9 10

Article 58. Article 60.

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• Representatives authorized by the SAT and relevant competent tax authorities of the other tax treaty parties shall officially sign the bilateral or multilateral APA upon reaching an agreement on the contents of the draft bilateral or multilateral APA; the in-charge tax authorities shall sign the ‘‘Bilateral (Multilateral) Advance Pricing Arrangement Implementation Agreement’’ with the enterprise in accordance with the signed bilateral or multilateral APA

2 Cost Sharing Agreements A cost sharing agreement (or cost contribution arrangement) is defined as ‘‘a framework agreed among business enterprises to share the costs and risks of developing, producing or obtaining assets, services, or rights, and to determine the nature and extent of the interests of each participant in those assets, services, or rights.’’11 The basis of a CSA is that each party to the agreement contributes to the costs of development of the intangible or provision of the service and is able to benefit from it through exploitation of the intangible or use of the service. One or more parties may register the intangible (legal ownership) while economic ownership will be split between all contributors. The contribution should be in proportion to the expected benefits received. CSAs have many potential benefits in that they: • can be an effective means of raising the necessary funding for a particular initiative where it may not be otherwise available in one group company • avoid the need to pay royalties for accessing the intangible at a later stage • enable the risk of R&D activity with an uncertain outcome to be spread • may assist in satisfying requirements for tax incentives for high technology activities in certain jurisdictions it is also possible for a new party to enter into an existing CSA and enjoy its benefits, in such cases all existing parties need to be in agreement and a buy-in payment is calculated.

CSAs in China In 2004, the SAT recognized CSAs when it released a private tax ruling providing that under certain conditions, not only are outbound research and development cost sharing payments tax deductible for FIEs, but the payments will also not be subject to withholding tax. 11

OECD Guidelines, para 8.3. Note in the US context the term ‘‘cost sharing agreement’’ refers only to a cost contribution arrangement involving joint funding of R&D activity only.

2 Cost Sharing Agreements

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Article 41 of the CIT law formally introduces the concept of CSAs as follows: Costs associated with joint development or transfer of intangible assets, or with the provision or receipt of labor services shall be allocated based on the arm’s length principle when computing taxable income (Article 41).

Chapter 7 of the China Transfer Pricing Regulations provides further detail on CSAs and the general tone is considerably more positive than the draft guidelines, in particular the requirement for pre-registration of an CSA has been removed. The focus is on CSAs in respect of R&D activity and this is clearly where the SAT will be devoting their resources. However, it does allow for service-related CSAs in respect of group procurement or group marketing planning.12 Some other significant factors from Chap. 7 of the China Transfer Pricing Regulations are as follows: • The CSA must be submitted to the SAT within 30 days of completion of the agreement • Compensating adjustments can be made to the extent that there is a mismatch between the cost shared and benefits received • An APA can be requested to cover a CSA • During the term of the CSA, contemporaneous documentation relating to the CSA must be provided to the SAT by June 20 of the following year

Contents of a CSA The main contents of a cost sharing agreement shall include the following: (1) Name of participants, their country (region) of residence, related party relationships, and the rights and obligations under the agreement (2) Content and scope of intangible assets or services covered by the cost sharing agreement; the specific participants performing research and development activities or service activities under the agreement, and their respective responsibilities and tasks (3) Term of the agreement (4) Calculation methods and assumptions relating to the anticipated benefits to the participants (5) The amount, forms of payment, and valuation method of initial and subsequent cost contribution by the participants, and explanation of conforming with the arm’s length principle (6) Description of accounting methods adopted by participants and any changes (7) Requirements on the procedure and treatment for participants entering into or withdrawing from the agreement 12


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(8) Requirements on the conditions and treatment of compensating payments among participants (9) Requirements on the conditions and treatment of amendments to or termination of the agreement (10) Requirements on the use of the results of the agreement by non-participants

Ongoing Compliance Obligations During the term of the agreement the following documents should be prepared and maintained: (1) Copy of the cost sharing agreement (2) Other agreements among participants for the implementation of the cost sharing agreement (3) Use of the results of the agreement by non-participants, the amount of payment, and the form of payment (4) Changes to the participants under the cost sharing agreement in the year, including the names of new participants or the participants who have withdrawn from the agreement, their country (region) of residence, related party relationships, and the amount and form of the buy-in and buy-out payment (5) Descriptions of amendments to or termination of the cost sharing agreement, including the reasons for amendments or termination, and the treatment or allocation of existing results from the agreement (6) Total cost incurred under the cost sharing agreement during the year and the cost structure (7) Cost allocation among participants during the year, including the amount of cost paid, form of payment, recipient of the payment; and the amount, form and participants of compensations paid or received (8) Comparison of actual benefits in the year against the anticipated benefits under the agreement, and the adjustments made accordingly

3 Thin Capitalization The SAT had been aware of the issue of thin capitalization in the PRC for some time and introduced measures to address this in the 2007 CIT Law. The CIT Law stipulates that when the ratio of debt to equity investment that an enterprise receives from its related parties exceeds a specified ratio, the portion of interest expense connected with that debt paid to related parties would be considered non-deductible for tax purposes (also referred to as the ‘‘formula based’’ approach).

3 Thin Capitalization

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Debt investments, as cited in Article 46 of the CIT Law, refer to financing that an enterprise has directly or indirectly acquired from related parties, and the enterprise is required to repay the principal and make interest payment or financing that requires other compensation of an interest payment nature. Debt investments indirectly acquired from related parties by an enterprise include: • Debt investments made by related parties but through unrelated third parties • Debt investments made by unrelated third parties, with related parties providing guarantees and assuming joint and several liability • Other debt investments having the nature of liabilities indirectly acquired from related parties Equity investments, as cited in Article 46 of the CIT Law, refer to investments which an enterprise received without being required to repay the principal and make interest payments, while investors have the proprietary rights of the net assets of the enterprise. The provisions of the CIT Law regarding thin capitalization raise plenty of questions which will need consideration by multinational corporations. These include: • Whether to rely on the formula-based approach or the ‘‘arm’s length approach’’ for the purposes of determining the specified ratio to assess the deductibility and nondeductibility of the related party interest expense?

Debt to equity ratio = the sum of monthly average debt financing acquired from related parties in a year/the sum of monthly average equity financing: Whereas: Monthly average debt financing acquired from related parties = (Monthly opening balance of debt financing acquired from related parties ? Monthly closing balance)/2 Monthly average equity financing acquired from related parties (including domestic funding) = (Monthly opening balance of equity financing ? Monthly closing balance)/2 Equity financing is the accounting amount of equity recorded in the Balance Sheet. If equity is less than the sum of paid-up capital and capital reserve, then equity financing equals to the sum of paid-up capital and capital reserve. Meanwhile, if the sum of paid-up capital and capital reserve is less than the equity, then equity financing is equal to equity. Interest expense, as cited in Article 46 of the CIT Law, includes interest, guarantee fee, mortgage fee and other expenses that share the nature of an interest payment which is directly or indirectly incurred for debt financing from related parties.

60


• Can the test be applied on a year-on-year basis on the same loan given that the formula approach is based on the debt and equity amount as reflected in the balance sheet? • Can the test be applied on a loan-on-loan basis, and what would the treatment be if there are several related party loans—which can be achieved on a combination of formula and arm’s length basis with appropriate structuring of the loan arrangements? • Are intercompany trade payables which attract interest considered debt investments for the purposes of determining the thin capitalization position of a multinational entity? On September 19, 2008, the Ministry of Finance and SAT jointly published a circular, Caishui (2008) No. 121 setting out the prescribed debt/equity ratio and other relevant rules. The circular specifies the debt:equity ratio of 2:1 for nonfinancial entities and 5:1 for financial institutions.

Alternative Approach: The Arm’s Length Debt Test As an alternative to the formula based approach, taxpayers may elect to use the arm’s length debt approach to the extent its related party interest expense exceeds the specified ratio. To rely on this alternative test however will require contemporaneous documentation demonstrating that a set of relevant factors such as amount of loan, interest rate, terms and financing terms support the fact that the loan amount fall within the arm’s length principle. The regulations do not provide any examples of how a taxpayer can apply these factors to finally arrive at a result that meets the arm’s length principle. Given the complexity of the application of this rule, in the short term, China is likely to see taxpayers shying away from the use of the alternative test. However, if this is placed in the ‘‘too hard’’ basket, then the alternative arm’s length debt test which is seen as a concession to taxpayers may have little practical application. For taxpayers wishing to seek the application of this alternative test, guidance can be obtained from other OECD countries which have established guidelines and rulings on this topic. An approach that is commonly used is to make reference to methodology applied by independent credit rating agencies and independent loan transactions in the market place to determine what an arm’s length debt to equity funding ratio should be. This method on its own presents a different set of problems—in particular whether the arm’s length ratio should be a reflection of what an independent borrower is able to borrow (borrower’s perspective) or whether an independent investor would likely invest in the business (lender’s perspective). Clearly, further guidance is needed on the application of thin capitalization rules and definitions. However, it is clear that the tax authorities are becoming increasingly concerned about and should factor into any decisions regarding the funding of related party investment into China.

Appendices

1 Manual for Responsibility Centers This appendix describes the common types of responsibility centers from a practical perspective and establishes the relationship with transfer pricing and the choice of OECD transfer pricing methods. It can be used as a mechanism to get from the findings of a functional analysis to choices of transfer pricing methods that are valid from economic and management control perspectives, and thus more acceptable for tax purposes in an OECD context.

The Use of the Responsibility Centers Concept to Structure an Organization In principle, the Board of Management has the authority to make decisions within a multinational enterprise. Decisions by the highest management level within an enterprise about delegation of this authority or decentralization will be influenced by the following four factors: • • • •

maximum span of control the management style concerning the control and steering of the MNC transaction costs the strategy and the business model applied by the MNC

By delegation of its authority, the top management will determine how a manager to whom authority is delegated will be compensated and/or how the manager will be steered and controlled. For example, the Management Board of a Japanese MNC gives the sales director of its Chinese sales company the task to double turnover within a period of three years. In this case, one can opt to give the sales director a bonus on the basis of (a) solely the doubling of turnover, or (b) a minimum required level of

61

62

Appendices

profitability of the sales company. The choice between a revenue center (situation a) and a profit center (situation b) depends on the four factors above. Also, in making this choice, it is important to what degree the Chinese sales company is considered able to manage and control the functions and risks related to situation b. This information can generally be obtained on the basis of the traditional functional analysis techniques as described in the OECD transfer pricing guidelines. In summary, no cases are the same in practice in respect of the choices of roles and responsibilities. However, in order to structure the analysis of an existing situation, a number of tools are given below, describing the features of the most common types of responsibility centers. The descriptions address the following variables: • The relationship between inputs and outputs of the responsibility center which determines the label. A responsibility center can in practice consist of a department, a business unit, a legal entity, or a geographical unit • A description of the type of activities which are common per responsibility center • A number of examples per responsibility center • The steering and control concept per responsibility center • The most common compensation method, both from a management and a tax perspective • The legal framework

Practical Descriptions of Responsibility Centers The following schedules are illustrations of the classification of certain activities as an expense center, cost center, revenue center, profit center or investment center. In addition to the usual analysis of functions, risks and the use of assets per part of the MNC, the responsibility center label adds a more process-oriented view on to the MNC, whereby one tries to identify (a) roles and responsibilities within a MNC and (b) value-added decisions.

Appendices

Expense centers a. Relationship input/output b. Type of activities

c. Examples d. Steering/control

e. Common transfer pricing policy

f. Legal framework

63

• • • • • • • • • • • • • • •

inputs are expressed in Euros, outputs in units output level and cost standards not or hard to determine strategically or operationally necessary (almost) exclusively performed for group mostly core highly creative, non repetitive tasks, e.g. core research corporate strategy department, e.g. strategic marketing determine expense/cost level (= budget) monitor actual expenses/cost per department / account focus on quality of processes, people and technology applied actual cost are charged or allocated to recipient (budgeted costs +/variances) actual cost/benefit ratio is frequently reviewed profit margin is meaningless from a managerial point of view profit margin will be required for tax purposes mostly development contract or service level agreement

Cost centers (= engineered expense centers) a. Relationship ‘input’/ • inputs are expressed in Euros, outputs in units ‘output’ • output level and cost standards can be determined b. Type of activities • operational activities, managed by principal entity • mostly performed for group • mostly non-core c. Examples • subcontracting of manufacturing activities • facility management activities • supporting activities of treasury department • IT system maintenance activities d. Steering/control • determine cost standards/targets per product etc. • monitor actual costs per product etc • analyze controllable and non-controllable variances • focus on cost/quality relationship • allows benchmarking of equivalent activities e. Common transfer • standard cost times actual volumes are charged pricing policy • sometimes non-controllable variances are settled • to apply a profit mark-up creates ‘pseudo profit center’ • profit margin could be applied from a managerial point of view • profit margin will be required for tax purposes, unless a third party would not be able to charge a mark-up f. Legal framework • mostly service level agreement Revenue centers a. Relationship ‘input’/ ‘output’ b. Type of activities

• • • • •

inputs and outputs are expressed in Euros output level and cost level not directly related market/customer driven activities mostly performed for external customers mostly core (continued)

64

Appendices

(continued) (continued) c. Examples d. Steering/control e. Common transfer pricing policy f. Legal framework Profit centers a. Relationship ‘input’/ ‘output’ b. Type of activities


e. Common transfer pricing policy f. Legal framework Investment centers a. Relationship input/ output b. Type of activities


e. Common transfer pricing policy1 f. Legal framework

• • • •

sales and distribution activities determine and monitor revenue levels maximize quantities or prices allocation of (contribution) margin of sales revenue

• mostly service level agreements (e.g. distribution company) • • • • • • • • • • • • •

inputs and outputs are expressed in Euros output level and cost standards can be determined market/customer driven activities mostly performed for external customers mostly core distribution activities speculative activities of treasury department determine price levels and cost standards per product monitor turnover, costs and profits per product analyze variances focus on profit contribution and quality external/market price times actual volumes are charged operating profit margin should, as primary way of measuring profitability, provide an adequate return on capital employed for • mostly service level agreement with cost centers

• • • • • • • • • • •

inputs and outputs are expressed in Euros relates profits to assets/underlying capital (= input) capital market/customer driven activities mostly performed for shareholders/MNC as a whole core intellectual property owners (return on investment on R&D) determine minimum required return on investment monitor capital employed and profits per product analyze variances on return on investments focus on sustaining long term profitability of MNC EVA or RONA/ROCE measures should allow monitoring an adequate return on investment • remuneration based on residual income • wide variety of legal agreements (if any)

1 Note that an investment center might not always be a party to inter-company transactions. An example is where an investment center is placed in a holding company that only receives dividends as income. Sources: Robert N. Anthony and Vijay Govindarajan, Management Control Systems, 2001, 3rd edition Horngren, Datar and Foster, Cost Accounting — A Managerial Emphasis, 2003, 11th edition Robert Simons, Performance Measurement & Control Systems for Implementing Strategy, 2000

Appendices

65

Example of responsibility centers and inter-company transactions

2 Related Party Transaction Disclosure Forms 1. 2. 3. 4. 5. 6. 7. 8. 9.

Annual Annual Annual Annual Annual Annual Annual Annual Annual

Reporting Reporting Reporting Reporting Reporting Reporting Reporting Reporting Reporting

of of of of of of of of of

Related Related Related Related Related Related Related Related Related

Party Party Party Party Party Party Party Party Party

Transactions—Associated Parties Transactions—Transaction Summary Transactions—Purchases and Sales Transactions—Services Transactions—Intangible Assets Transactions—Fixed Asset Transfers Transactions—Financing Transactions—Outbound Investments Transactions—Outbound Payments

66

Appendices

Form 1: Related Party Relationships Name of related Taxpayer’s ID parties number

Country/ Address Legal region representative

Type of related party relationship

Instructions

1. Taxpayer’s ID Number: Fill in the taxpayer’s ID number of the related parties applied in their country or region. 2. Country/region: Fill in the name of country or region where the related party is located. 3. Address: Fill in the registration address and operating address of the related entity, or the related individuals’ residential address. 4. Type of related party relationship: Fill in types of relationship in A, B, C etc. in accordance with the following. Multiple choices are applicable in case of more than one type of relationship. A. One party directly or indirectly owns 25 percent or more shares of the other party; 25 percent or more shares are commonly owned either directly or indirectly by a third party; where one party owns shares of the other party through an intermediary and the party owns 25 percent or more shares of the intermediary, the percentage held indirectly is calculated by the percentage of the other party’s share owned by the intermediary. B. Debt provided to one party (except independent financial institution) by the other party accounts for 50 percent or more of the debtor’s paid-in capital, or 10 percent or more of the debt is guaranteed by the other party (except independent financial institution). C. Fifty percent or more of one party’s high level management (directors or managers), or one or more executive directors are appointed by the other party, or the abovementioned personnel of both parties are appointed by a third party. D. Fifty percent or more of one party’s high level management (e.g., directors or managers) are also the high level management (e.g., directors of managers) of the other party, or one (or more) executive director(s) is (are) also the executive director(s) of the other party. E. Business operations of one party rely on the industrial patent, technology know-how or other licensed intangible properties provided by the other party. F. Buy–sell transactions of one party are controlled by the other party. G. Receipt or provision of services is controlled by the other party. H. Where one party has effective control over the other party’s business operations and transactions, or other relationships arising from mutual interests, such as relationships that grant to the other party similar economic interest entitled to the main shareholders even the other party does not reach the shareholding percentage level for category A, and relationships like family members or relatives.

Purchases of materials/goods Sales of goods/materials Provision of services Receipt of services Transfer in of intangible assets Transfer out of intangible assets Transfer in of fixed assets Transfer out of fixed assets Accrued interest income Accrued interest expense Total

Type of transactions % 5 = 4/1

Amount 4

Amount 2 = 4+7

1

% 3 = 2/1

Overseas related party transactions

Related party transactions

Total transaction amount

1. Have contemporaneous documents been prepared for the current year? 2. Is the preparation of the contemporaneous documents exempted for the current year? 3. Is a cost sharing agreement in place (signed) for the current year?

Form 2: Transaction Summary

% 6 = 4/2

Amount % 7 8 = 7/1

(continued)

% 9 = 7/2

Domestic related party transactions

Yes h No h Yes h No h Yes h No h

Appendices 67

Currency Unit: RMB Yuan (accurate to 0.01) Form 2: Transaction Summary Instructions 1. This form is the summary of Form 3 to Form 7. All the transaction amounts, except transaction amounts for ‘‘others’’, are the sum of corresponding transaction amounts from Form 3 to Form 7. The correlations are as follows: (1) Column 1 ‘‘Purchase of materials/goods’’ = Item 1 of Form 3 ‘‘Purchases and Sales’’; Column 4 ‘‘Purchase of materials/goods’’ = Item 4 of Form 3 ‘‘Purchases and Sales’’ Column 7 ‘‘Purchase of materials/goods’’ = Item 7 of Form 3 ‘‘Purchases and Sales’’ (2) Column 1 ‘‘Sale of goods/materials’’ = Item 8 of Form 3 ‘‘Purchases and Sales’’ Column 4 ‘‘Sale of goods/materials’’ = Item 11 of Form 3 ‘‘Purchases and Sales’’ Column 7 ‘‘Sale of goods/materials’’ = Item 14 of Form 3 ‘‘Purchases and Sales’’ (3) Column 1 ‘‘Provision of services’’ = Item 1 of Form 4 ‘‘Services’’ Column 4 ‘‘Provision of services’’ = Item 4 of Form 4 ‘‘Services’’ Column 7 ‘‘Provision of services’’ = Item 7 of Form 4 ‘‘Services’’ (4) Column 1 ‘‘Receipt of services’’ = Item 8 of Form 4 ‘‘Services’’ Column 4 ‘‘Receipt of services’’ = Item 11 of Form 4 ‘‘Services’’ Column 7 ‘‘Receipt of services’’ = Item 14 of Form 4 ‘‘Services’’ (5) Column 1 ‘‘Transfer in of intangible assets’’ = Column 1 of Form 5 ‘‘Intangible Assets’’ Column 4 ‘‘Transfer in of intangible assets’’ = Column 2 of Form 5 ‘‘Intangible Assets’’ Column 7 ‘‘Transfer in of intangible assets’’ = Column 4 of Form 5 ‘‘Intangible Assets’’ (6) Column 1 ‘‘Transfer out of intangible assets’’ = Column 6 of Form 5 ‘‘Intangible Assets’’ Column 4 ‘‘Transfer out of intangible assets’’ = Column 7 of Form 5 ‘‘Intangible Assets’’ Column 7 ‘‘Transfer out of intangible assets’’ = Column 9 of Form 5 ‘‘Intangible Assets’’ (7) Column 1 ‘‘Transfer in of fixed assets’’ = Column 1 of Form 6 ‘‘Fixed Assets’’ Column 4 ‘‘Transfer in of fixed assets’’ = Column 2 of Form 6 ‘‘Fixed Assets’’ Column 7 ‘‘Transfer in of fixed assets’’ = Column 4 of Form 6 ‘‘Fixed Assets’’ (8) Column 1 ‘‘Transfer out of fixed assets’’ = Column 6 of Form 6 ‘‘Fixed Assets’’ Column 4 ‘‘Transfer out of fixed assets’’ = Column 7 of Form 6 ‘‘Fixed Assets’’ Column 7 ‘‘Transfer out of fixed assets’’ = Column 9 of Form 6 ‘‘Fixed Assets’’ (9) Column 4 ‘‘Accrued interest income’’ = Column 8 of Form 7 ‘‘Financing’’ Column 7 ‘‘Accrued interest income’’ = Column 8 of Form 7 ‘‘Financing’’ Column 4 ‘‘Accrued interest expense’’ = Column 7 of Form 7 ‘‘Financing’’ Column 7 ‘‘Accrued interest expense’’ = Column 7 of Form 7 ‘‘Financing’’ (10) ‘‘Others’’ refers to the amount rendered by the other types of business operations expect the above. 2. ‘‘Have contemporaneous documents been prepared for the current year?’’ Tick the ‘‘Yes’’ box if contemporaneous documentation has been prepared for the current year, otherwise check the ‘‘No’’ box. 3. ‘‘Is the preparation of the contemporaneous documents exempted for the current year?’’ Tick the ‘‘Yes’’ box for those that qualify for one of the exemption categories, otherwise select the ‘‘No’’ box. 4. Is a cost sharing agreement in place (signed) for the current year?’’ Tick the ‘‘Yes’’ box if in place, otherwise tick ‘‘No.’’

68 Appendices

Appendices

69

Form 3: Purchases and Sales

Instructions 1. ‘‘Total amount of purchases’’: Fill in the amount of purchase of tangible goods for the filing year, such as raw materials, semi-finished products, materials (products), except fixed assets, construction materials and low-value consumables. 2. ‘‘Total amount of sales’’: Fill in the amount of sale of goods/materials for the filing year. 3. ‘‘Toll processing’’: Fill in the amount of tolling service charge received. 4. ‘‘Country/region’’: Fill in the name of the country or region of the overseas related or unrelated parties. 5. ‘‘Pricing method’’: refers to the following: (1) comparable uncontrolled price method; (2) resale price method; (3) cost plus method; (4) TNM; (5) profit split method; (6) others. Fill in the corresponding number; if ‘‘6’’ is selected, specify the method in the column ‘‘Notes.’’

70

Appendices

Form 4: Services

Instructions 1. ‘‘Service revenue from overseas’’: Fill in the amount of revenue generated from provision of parties overseas. 2. ‘‘Service payment to overseas’’: Fill in the amount of payment to overseas for the receipt of services. 3. ‘‘Country/Region’’: Fill in the name of the country or region where the overseas related or unrelated party is located. 4. ‘‘Pricing method’’: refers to the following: (1) comparable uncontrolled price method; (2) resale price method; (3) cost plus method; (4) TNM; (5) profit split method; (6) others. Please fill in the corresponding number; if ‘‘6’’ is selected, please specify the method in the column ‘‘Notes.’’

Total

Use rights Ownership

Use rights

Item

Land use Patent Non-patent technology Trademark Copyright Others Subtotal Patent Non-patent technology Trademark Copyright Others Subtotal

Form 5: Intangible Assets

1=2+3+4+5

Total transaction amount Related party transaction amount 4

Related party transaction amount 2 Unrelated party transaction amount 3

Domestic

Overseas

Transfer in

(continued)

Unrelated party transaction amount 5

Appendices 71

Land use Patent Non-patent technology Trademark Copyright Others Subtotal Patent Non-patent technology Trademark Copyright Others Subtotal

Currency Unit: RMB Yuan (accurate to 0.01)

Total


Use rights

Item

(continued)

6 = 7 + 8 + 9 + 10

Total amount

Related party transaction amount 7

Overseas

Transfer out



Domestic Unrelated party transaction amount 10

72 Appendices


Use rights

Item

Plants and buildings Airplanes, trains, ships, machinery, mechanical apparatus and other equipment used in manufacturing Apparatus, tools, furnishings used in connection with manufacturing and business operations Transportation vehicles other than airplanes, trains and ships Electronic equipment Others Subtotal Plants and buildings Airplanes, trains, ships, machinery, mechanical apparatus and other equipment used in manufacturing Apparatus, tools, furnishings used in connection with manufacturing and business operations Transportation vehicles other than airplanes, trains and ships Electronic equipment Others Total

Form 6: Fixed Assets

1=2+3+4+5

Total transaction amount Related party transaction amount 2

Overseas

Transfer in


Domestic Related party transaction amount 4

(continued)


Appendices 73

Plants and buildings Airplanes, trains, ships, machinery, mechanical apparatus and other equipment used in manufacturing Apparatus, tools, furnishings used in connection with manufacturing and business operations Transportation vehicles other than airplanes, trains and ships Electronic equipment Others Subtotal Plants and buildings Airplanes, trains, ships, machinery, mechanical apparatus and other equipment used in manufacturing Apparatus, tools, furnishings used in connection with manufacturing and business operations Transportation vehicles other than airplanes, trains and ships Electronic equipment Others Total

Currency Unit: RMB Yuan (accurate to 0.01)


Use rights

Item

(continued)

1=2+3+4+5

Total amount Domestic Related party transaction amount 4



Overseas

Transfer out


74 Appendices

Name of domestic related party

Country/ Region

Inward

Inward

Outward

Interest rate

Outward

Financing amount

Financing amount

Currency

Currency

Country/ Region

Financing start and end date

Interest rate

Interest payable

Financing start and end date

Guarantee fee percentage

Guarantee fee percentage

Guarantee fee

Guarantee fee

Name of guarantor

Name of guarantor

Interest receivable

Interest receivable

Interest payable

Currency Unit: RMB Yuan (accurate to 0.01) Form 7: Financing Instructions 1. The ratio of debt financing acquired from related parties to equity investments = the sum of monthly average debt financing acquired from related parties in a year/the sum of monthly average equity financing, whereas: Monthly average debt financing acquired from related parties = (monthly opening balance of debt financing acquired from related parties + monthly closing balance)/2; Monthly average equity investment = (monthly opening balance of equity investment ? monthly closing balance) 2. For fixed-term financing, fill in on a transaction by transaction basis and financing in and financing out shall be filled in different rows. 3. ‘‘Country/Region’’: Fill in the name of the country or region where overseas related party is located. 4. ‘‘Interest rate’’: Fill in the annual interest rate; 5. ‘‘Interest payable’’ and ‘‘Interest receivable’’: Fill in the interest payable and interest receivable on an accrual basis and interest payable shall include capitalized interest. 6. In case of foreign currency, convert it into RMB according to the middle exchange rate as of the last day of the taxable year.

Fixed-term financing Others Subtotal Total

Fixed-term financing Others Subtotal

Name of overseas related party

Form 7: Financing; the ratio of debt financing acquired from related parties to equity investments

Appendices 75

76

Form 8: Outbound Investments

Appendices

Appendices

77

Form 8: Outbound investment instructions 1. This form applies to PRC Resident Enterprises which make outbound investments in foreign countries/regions. 2. ‘‘Basic information:’’ Fill in the basic information of invested foreign enterprise. In case of more than one invested foreign enterprise, complete a separate form for each entity; and fill in the ‘‘exchange rate to RMB’’ the middle rate of recording currency to RMB as of December 31 of each year. 3. ‘‘The total share information of the invested foreign enterprise’’ and ‘‘Share information of invested foreign enterprise:’’ Fill in the total amount of shares of the invested foreign enterprise and the amount of shares owned by the tax payer which shall be categorized as common shares with voting right, common shares without voting right, preferred shares and other similar equity-type shares. Such information shall be filled separately in accordance with holding time period. 4. ‘‘Foreign enterprise’’ also applies to entities established in Hong Kong, Macau and Taiwan.

Form 9: Outbound Payments

Item

1. 2. 3. 4.

Dividends Interest Rental Royalties Trademark Technology licensing 5. Payment for asset transfer 6. Commission 7. Design fee 8. Consulting fee 9. Training fee 10. Management service fee 11. Contractor fee 12. Construction and installation fee 13. Performance fee 14. Certification and testing fee

Current year off shore remittances

Including: Remittances to overseas related parties

Amount of withholding tax

Whether entitled to preferential tax treaty arrangement Yes Yes Yes Yes Yes Yes

h No h h No h h No h hNo h h No h h No h

Yes h No h Yes Yes Yes Yes Yes

h h h h h

No No No No No

h h h h h

Yes h No h Yes h No h Yes h No h Yes h No h (continued)

78

Appendices

(continued)

Item

Current year off shore remittances

15. Marketing fee 16. After-sales service charges 17. Others Including: Total

Including: Remittances to overseas related parties

Amount of withholding tax

Whether entitled to preferential tax treaty arrangement Yes h No h Yes h No h Yes h No h

Currency Unit: RMB Yuan (accurate to 0.01) Form 9: Outbound Payment Instructions 1. Current year offshore remittances’’: Fill in the actual amount of remittances for the current year, including the accrued but not yet paid expenses 2. ‘‘Whether entitled to preferential tax treaty arrangement’’: Fill in ‘‘yes’’ or ‘‘no.’’ 3. ‘‘Amount of withholding tax’’ refers to the income tax withheld on the remittance to a non-tax resident enterprise. Otherwise, fill in ‘‘not applicable.’’ 4. ‘‘Dividends’’: refers to the investment return paid to equity-type investors. 5. ‘‘Interest’’ refers to the investment return paid to debt-type investors. 6. ‘‘Rental’’ refers to the payment to the lessor for the use right of tangible assets such as fixed assets. 7. ‘‘Royalties’’ refer to the payment for the use of patent, know-how, trademark, copyright. 8. ‘‘5. Payment for asset transfer’’ refers to the payment incurred for the ownership of property. 9. ‘‘Commission’’ refers to payments to third parties for intermediary agency services including commission fee, related charges, rebates. 10. ‘‘Design fee’’ refers to payments to consignees for the design of construction, project, system, software and other programs. 11. ‘‘Consulting fee’’ refers to the payment made for the receipt of consulting services. 12. ‘‘Training fee’’ refers to payments related to receiving such training as technical skills, professional knowledge, system application and equipment operation. 13. ‘‘Management service fee’’ refers to the payment made for the receipt of various kinds of management services. 14. ‘‘Contractor fee’’ refers to payments for services in relation to outsourced assembly, exploration projects or other related charges. 15. ‘‘Construction and installation fee’’ refers to payments for the receipt of construction and installation services. 16. ‘‘Performance fee’’ refers to payments made to overseas performing groups or individuals for their art or sporting performance made inside China. 17. ‘‘Certification and testing fee’’ refers to the expenses related to the inspection service of qualification, certification and products. 18. ‘‘Marketing fee’’ refers to expenditure in relation to services as market development, expansion and penetration. 19. ‘‘After sale service charges’’ refers to payments for the after sale services such as product inspection, repairing and maintenance. 20. ‘‘Others’’: Fill in the service expenditure items which cannot be classified in above categories and specify the content of the main items in the table.

Appendices

79

3 Enterprise Function and Risk Analysis Form Enterprise A’s Name (Official Stamp): Taxpayer Identification Code: Enterprise B1’s Name: Enterprise B2’s Name: Category

Investigation items

R&D

R&D for Core Technology Is an associate enterprise commissioned to deal with R&D? Is a third party enterprise commissioned to deal with R&D? Who has the ownership of R&D results? Who owns the shared rights in R&D results? Who bears the R&D cost? Are there any substantive results from R&D? Who receives a distribution of the prospective benefits? Are there any licensing agreements with associate enterprises? Are there any licensing agreements with third parties? Is there any cost sharing agreement? Do you have any patents? Who bears the R&D risk? Who is at the higher control level in R&D? Is the R&D output a unique intangible asset? Can competitive advantage be derived from this R&D? Manufacturing and Technical Know-how Do you have autonomy in product design? Who designs the product? Who owns the technology for production? Who developed the original technology? Who bears the design costs?

Enterprise A

Enterprise B

Enterprise C

(continued)

80

Appendices

(continued)

Category

Investigation items

Enterprise A

Enterprise B

Enterprise C

Is there a substantive outcome from the design activities? Who receives the expected benefits? Is there any licensing agreement with an associate enterprise? Is there any licensing agreement with a third party? Is there any design cost sharing agreement? Are there any patents in place for design? Who bears the risk for design work? Do you provide input into product design and revision? Is the intangible asset unique in nature? Packaging and Labeling Is an associate enterprise commissioned to deal with packaging? Is a third party commissioned to deal with packaging? Who bears the packaging costs? Is there any cost sharing agreement for packaging? Are any patents in place? Do you have autonomy in packaging and labeling decisions? Who bears the risks of packaging? Is there any licensing agreement with an associate enterprise over packaging? Is there any licensing agreement with a third party over packaging? Quality Control Who is responsible for quality control? (continued)

Appendices

81

(continued)

Category

Production

Investigation items

Enterprise A

Enterprise B

Enterprise C

Who determines the quality standards and processes up to the finished product? Who is in charge of quality control? Who provides the technology and equipment for quality control? Does quality control qualify as an intellectual property right? Is there any licensing agreement with an associate enterprise over quality control? Is there any licensing agreement with a third party over quality control? Who bears the risks of quality control? Procurement Who sets the procurement plan? Who performs procurement? Who bears the procurement expenses? Does procurement have to be approved by an associate enterprise? Are goods purchased from an associate enterprise? Are goods purchased from a third party enterprise? Who bears the market risks for sourcing materials? Equipment and Planning Who purchases equipment for production? Who repairs/maintains production equipment? Who bears equipment procurement expenses? Who plans production schedules? Is equipment purchased from an associate enterprise? (continued)

82

Appendices

(continued)

Category

Investigation items

Enterprise A

Enterprise B

Enterprise C

Is equipment purchased from a third party enterprise? Does production only involve processing and assembly? Who bears production risks? Who bears the risks of investment and equipment losses? Quality Control Who determines the form of production quality control? Who determines the quality standards and processes for the end products? Who is in charge of quality control for production? Who provides the technology and equipment for quality control? Who bears the expenses of quality control in production? Is there any cost sharing agreement over production quality control? Are any patents in place? Who bears the risks of production quality control? Inventory Which party stores the inventory? Who controls the inventory level? Who determines what the effective level of inventory needs to be? Who bears the inventory expenses? Who bears the risks of the inventory? Transportation Who is in charge of product transportation? Who pays transportation costs? Who bears the risks of transportation? (continued)

Appendices

83

(continued)

Category

Investigation items

Marketing

Marketing Strategy Who undertakes the market research? Who decides the marketing strategy? Who performs marketing activities? Who bears the risks of marketing? Marketing Approach Who determines the marketing approach? Who pays the marketing costs? Brand and Goodwill Who owns the trademarks and goodwill? Who has the use of the trademarks and goodwill? Is there a legal agreement over the use of the trademarks and goodwill? Do you receive a royalty for trademarks and goodwill? Brand and Goodwill Who determines the contents of the licensing fees and the rate? Who bears the relevant risks? Who does the sales planning? Who bears the selling costs? Which related enterprises are the customers? Who receives the orders? Who issues the invoices? Who bears the market risks? Inventory Which enterprise stores the inventory? Who controls the inventory level? Who bears the inventory costs? Who bears the inventory risks? Transportation Who arranges the transportation of products?

Distribution

Enterprise A

Enterprise B

Enterprise C

(continued)

84

Appendices

(continued)

Category

Administrative and Other Services

Investigation items

Enterprise A

Enterprise B

Enterprise C

Who pays the transportation costs? Who bears the transportation risks? Installation and Customer Service Who provides customer services? Who pays the service costs? Who bears the after sales risks? General Management

Is there an integrated central management structure and function? Do you bear management costs? Do you bear management risks? Pricing Strategy Who decides the product price? Who decides the pricing strategy? Who bears the pricing risks? Financing From which party do you borrow funds? Is interest paid on such loans? To which party do you provide loans? Do you charge interest? Who bears financing costs? Are there financing agreements? Who bears financing risks? Who bears credit risks? Human Resources Are any staff members transferred to an associate enterprise? Who pays the salaries of transferred staff? (continued)

Appendices

85

(continued)

Category

Investigation items

Enterprise A

Enterprise B

Enterprise C

Leasehold Are there any leasehold assets? Who pays the leasehold fees? Who bears the leasehold risks? Signature of responsible person: Date of form completion: Instructions 1. Enterprises required by the Measures to prepare contemporaneous transfer pricing documentation shall fill out this form. 2. This table is a sample of Enterprise’s Function and Risk Analysis. The specific contents should be adjusted based on the actual circumstances of the enterprise. 3. Enterprise A in this form represents the tested party, while Enterprises B1 and B2 represent the related parties of Enterprise A. The number of related parties should be adjusted based on the actual circumstances of the enterprise. 4. Symbols used in this form: ‘‘H’’ means that the enterprise has the function or risk, while ‘‘X’’ means that the enterprise does not have the function or risk.

Transfer Pricing in China, Second Edition

Radiative Heat Transfer, Second Edition

Transfer Pricing for Financial Institutions

Intellectual Property Rights in China, Second Edition

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