China: Domestic Taxation
In May, 2005, the tax authorities of China and Japan negotiated the first-ever advance pricing agreement (APA) for a major Japanese electronics company, paving the way for multinational companies from other countries to invest in China, while reducing the risk of double taxation.
"The decision has wide ranging implications for other multinationals doing business in China, related to the level of risk, time, and expense they incur when calculating certain taxes," explained Bill Dodge, a partner with Deloitte Tax LLP and leader of the Global Transfer Pricing practice, which helped negotiate the agreement. "For the first time, multinationals have the option to negotiate certain tax burdens up to five years in advance, rather than separately determining and defending each year," he added.
Transfer pricing refers to the allocation of profits, for tax purposes, across parts of a multinational company. The tax laws of many countries require that companies establish an 'arm's length' price for a product or service. For example, if a US-based company purchases a component from one of its divisions in China, the price must be similar to a 'comparable' price that another company in the United States would have paid for the same component.
An advance pricing agreement (APA) allows a company to negotiate the price of a product or service associated with transfer pricing over a period up to five years, rather than renegotiating at the end of each year. This helps companies plan their future tax liabilities, reduce the risk of noncompliance, and minimize the time and cost of determining and defending on a yearly basis.
"The decision demonstrates that the Chinese taxation authorities continue to become more transparent in taxation matters, and are willing to follow generally accepted principles from other countries," added Dodge.
"Multinational companies now have the ability to operate more efficiently in China, with easier tax planning, reduced preparation or negotiation costs and less risk," he observed.
In May, 2010, the Chinese State Administration of Taxation (SAT) and the Hong Kong Inland Revenue Department (IRD) held a joint public seminar in Hong Kong, under the auspices of the Hong Kong Taxation Institute, to discuss the latest transfer pricing developments.
After the new China Corporate Income Tax (CIT) law was enacted, several new transfer pricing regulations were introduced in China; in particular two recently released tax circulars had introduced the principle of "returns commensurate with the functions and risks", which has been widely applied in transfer pricing practice, to determine the attributable profits of the permanent establishment of non-residents.
Meanwhile, the IRD also built up its transfer pricing practice framework by issuing the much-awaited Departmental Interpretation and Practice Notes ("DIPN") No. 45 and 46.
The speakers included representatives from Hong Kong's IRD, China's SAT and PricewaterhouseCoopers. They considered the following developments to the transfer pricing environment in China:
- SAT has actively promoted UN development initiatives, such as the UN Practical Manual on Transfer Pricing;
- SAT could envisage a China-Hong Kong bilateral advance pricing agreement, but the IRD said it was not yet ready, preferring to receive advance ruling applications on transfer pricing for the time being;
- SAT intended to implement more specific protocols regarding domestic related party transaction adjustments;
- SAT described its "substance over form" policy when considering anti-avoidance cases;
With regard to tax audits, the SAT acknowledged its focus on four key areas in identifying targets: domestic companies operating abroad (particularly those going into low tax jurisdictions); conversions from manufacturing to service-based companies; intellectual property transactions; and issues surrounding the interplay of transfer pricing, thin capitalisation, controlled foreign corporations, and cost sharing.
The seminar also considered the following transfer pricing developments in Hong Kong:
- The IRD worked on the basis of OECD Transfer Pricing Guidelines, but would accept other non-OECD methods if they "satisfy the arm's length standard";
- The IRD also did not insist on using the interquartile range for companies' transfer pricing arrangements - it would usually accept as deductible year-end adjustments before close of books when adequately supported with documentation;
- The IRD pointed out the different statutes of limitation in China (10 years) and Hong Kong (6 years) and emphasized that activation of mutual agreement procedures should pay due regard to the earlier Hong Kong limits;
- The IRD said it would apply transfer pricing principles to domestic related party transactions;
- The IRD described Hong Kong's territorial source concept governing the taxability of income/profit and emphasized its ascendancy over transfer pricing principles.
SAT and the IRD said they had already co-operated with exchange of information in at least 20 instances in the last 12 months. The two tax authorities also confirmed the OSIRIS database and Standard & Poor's databases as suitable for transfer pricing analyses.
In August, 2010, China's State Administration for Taxation (SAT) directed local tax authorities to prepare statistics relating to the transfer pricing practices of companies in their tax jurisdictions as part of a wider review of transfer pricing by the central government.
'Circular 323,' issued by the SAT in July, calls on local tax authorities to evaluate contemporaneous transfer pricing documentation for the tax years 2008 and 2009. At least 10% of all annual pricing reports must be selected for review, based on one or more of the following criteria: companies with tangible related party transactions of more than CNY200m per year; companies non-tangible related party transactions exceeding RMB40m per year; loss-making companies with limited functions and risks; companies which are undergoing follow-up transfer pricing reviews; companies with issues relating to thin capitalization; and companies with cost-sharing arrangements.
The circular stipulates that the reviews must determine whether the transfer pricing documentation adequately describes five key areas of focus, including the company's organizational structure, the nature of its business, its related party transactions, comparability analysis and transfer pricing methodology.
The local tax authorities were required to furnish the SAT with their analytical reports by October 31, 2010.