Usually, when you hear about transfer pricing, it is in the context of multinational corporations using elaborate constructs to shift profits to tax havens. Apart from the question of the legitimacy of this behavior, the manner in which countries and the international community handle this issue has real implications for a large variety of businesses all over the world. Especially those who are active in China have recently experienced some turbulences with regard to transfer pricing.
What is Transfer Pricing
Transfer pricing is a great tool for inner company coordination, which helps to improve cost efficiency and budgeting within a network of departments or subsidiaries. And, of course, it lies in the nature of enterprises to utilize any opportunity to cut costs, this includes finding the optimal tax structure within the legal boundaries. Now, as economies are becoming globalized, the old mantra according to which the corporate tax is due where the economic value is created loses its significance. Consequently, national tax systems face the challenge of keeping up with this development.
In theory, departments or subsidiaries within a corporation charge each other for services they provide to each other and thus ensure that they run cost efficient and only carry the respective tax burden. But, this is where it becomes tricky. How do companies value the service they provide to each other? And even more so, how can tax authorities from different countries check the adequacy of such valuations?
In praxis, the most prominent examples are Apple and Facebook, who set up their tax-headquarters in low-tax countries, such as Bermuda or Ireland. This entity then charges the subsidiaries in other countries royalties or fees for licenses and thus funnels profits from higher tax countries into tax havens, where they are ultimately taxed. Even though these practices might be in compliance with the law, the international community has recently launched initiatives to return to the basic principle, based on which corporate tax is due where the value is created.
China’s recent reforms on Transfer Pricing
In 2013, the OECD has published a Base Erosion and Profit Shifting (BEPS) Action Plan to better regulate the global flow of capital and harmonize international tax regimes. The action plan was endorsed by G20 finance ministers at their meeting in Lima on 8 October 2015. The plan contains 15 measures to harmonize international corporate tax regulations, one of which is a standardized documentation of transfer prizing.
On 10 October 2015, only 5 days after the OECD had released the last of 15 reports on BEPS, Beijing presented its on measures, including three principles according to which, 1) the implementation of BEPS rules would reflect the specific circumstances of China’s own tax rules; 2) tax interests and economic development should be protected, and 3) tax administration and compliance should be boosted.
Then, on 13 July 2016, shortly before China was to host this year’s G20 summit at Hangzhou, adjustments to the regulations of transfer prices were published by the State Administration of Taxation (SAT) [Guoshuifa [2016] No. 42 ].
What Changes?
The new rules replaced parts of the Guoshuifa [2009] No.2 and the (Guo Shui Fa [2008] No. 114. Guoshuifa [2016] No. 42 changes two main aspects of transfer pricing:
1) The reporting on related-party transactions
2) Management of Contemporaneous Documentation (Actual project invoices, plans, and specifications, used to document the outlay of capital by a particular taxpayer for a particular construction project)
Related Parties
To decide if two companies are considered related parties, 25 percent direct, or indirect control is the threshold. Direct control applies in cases, where one party owns another party or two parties are owned by a common party. Indirect shareholding is determined by a special formula and other factors, such as loans, control of management and other types of management. The new regulations also stipulate that spouses or other connected natural persons, such as siblings, should be considered as related parties.
One of the core issues of transfer pricing is determining the price of a transaction since two related parties would probably agree on a different price than two non-affiliated parties. The general rule is that the price shall be determined according to the arm’s length principle. To calculate the arm’s length price, five major pricing methods exist:
1. Comparable Controlled Price (CUP)
2. Resale Price Method (RPM)
3. Cost Plus (C+, CP)
4. Profit Based Methods
a)Profit comparison methods (TNMM/CPM)
b)Profit-split methods (PSM)
In addition to that, there is the possibility to negotiate advanced pricing agreements (APA) with the tax authorities. Unfortunately, during the implementation period of the transfer pricing regulations, the tax authorities find themselves in a bottleneck situation with more applications than they are able to review.
Practical Implications
The contemporaneous documentation is divided into a three-tier framework, master file, local file and special file. The following criteria determines which file an enterprise has to prepare:
Master File
- Cross-border performance relationship
- Ultimate group holding prepares master file
- Cross-border performances exceed the overall value of RMB 1 bn. (EUR 133 mil)
Local File
- Cross-border commodity transaction exceeds a total value of RMB 200 mil.
- Cross-border transfer of financial assets greater than RMB 100 mil.
- Cross-border transfer of intangible assets exceeds a total value of RMB 100 mil.
- Other cross-border transactions greater than RMB 40 mil.
Special File
- Corporations with a “Cost Sharing Agreement” (CSA)
- Related-party debt-to-equity ratio exceeds the standard ratio (File for thin capitalisation)
Country-by-Country Reporting (CbCR)
- This will mainly apply to multinational enterprise groups whose final holdings are located in China, and whose revenue exceeded RMB 5.5 bn last year
- Multinational enterprises are obligated to create an automatic CbCR
- If query by the authorities is unsuccessful, the authorises will request the information from the Chinese company
- Each file has specific requirements for the information that companies have to provide to the authorities
What is important?
The reform targets primarily large MNCs! A lot a foreign SMEs operating in China do NOT exceed the thresholds as laid out by the new regulation.
However, if your cross-border transactions DO exceed or are close the threshold, it is best to consult a local, trusted partner for precise advice and improve internal communication in preparation for the new filing requirements.
Continue reading about similar topics such as How To Set Up A WFOE In China – The Six Most Important Steps or VAT in China – Part 4.
ECOVIS Beijing is a consultancy focused on accounting, audit, tax and legal advisory. If you have questions regarding transfer pricing and cross-border tax issues, please contact elizabeth.shi@ecovis-beijing.com
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Elizabeth Shi Elizabeth Shi is a Senior Tax Manager at Ecovis Beijing. She has over 10 years of working experience in China´s legal, tax and business field. Prior to joining Ecovis, Elizabeth has worked in the Big Four accounting firms’ tax and business advisory departments. She has advised companies on various China tax and legal related matters, including dealing with tax and other government authorities. Her expertise covers tax compliance, restructuring, M&A, tax due diligence, liquidation and deregistration related tax matters as well as tax planning for companies and individual expatriates. Elizabeth started her professional career as a legal consultant in a prestigious IP firm, working on foreign direct investment (FDI) and intellectual property (IP) projects. With her legal background both in academics and in practice, she has a profound understanding of China’s tax system and its operation. For further information please contact:elizabeth.shi@ecovis-beijing.com
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