United States: China´s Transfer Pricing Wall

In May 1998 China’s State Administration of Taxation (SAT) released a comprehensive circular on transfer pricing entitled "Tax Administration Rules and Procedures for Transactions Between Related Parties" (Guoshuifa [1998] 59).¹ The circular was directed at modernising efforts to control alleged tax avoidance by multinational companies (MNCs) and consolidate many previously issued transfer pricing rules. For a detailed analysis of the circular and the June 1998 meeting with SAT officials following the issuance of the Circular see BNA’s Transfer Pricing (July 29, 1998)²

In November 2001 we were invited by SAT (National) in Beijing to discuss China’s experience with Circular 59, as well as other recent developments with regard to China’s rapidly developing transfer pricing enforcement policies.

The meetings were held with the national chief responsible for transfer pricing (from the "Tax Avoidance Inspection Division"), with the Deputy Director-General from the International Tax Department and with various provincial leaders (from Tianjin, Shandong, Inner Mongolia and Hebei). The Tax Avoidance Inspection Division is one of seven divisions of the International Taxation Department. In addition to meetings at SAT (National), we were invited to meet with about 40 transfer pricing tax inspectors at the SAT Bureau in Beijing. After answering numerous questions, we have developed a deeper insight into the level of expertise of those individuals who actually audit Foreign Invested Enterprises (FIEs) and the areas in which they are focusing their attention. It is clear that SAT inspectors view "transfer pricing" as a technique being used by MNCs to "avoid" taxation and that it is the SAT’s role to counter such "tax avoidance".

The comments in this article represent our best under-standing of the current situation; however, it is possible that some of the points could be interpreted in a different way. SAT is fully aware that we are publishing this article. If any misinterpretations should exist in this document, the authors offer their apology to SAT officials.

Currently, there are approximately 300 transfer pricing specialists throughout the country. For the most part, they are not organised into specialty teams or by industry. In 1998 there were approximately 400 specialists and in November 1997 there were between 100 and 200. So, since 1998 there has been a reduction in the number of full time staff devoted to the issue.

This is not because SAT view transfer pricing as having become less important, but rather due to a variety of staff reorganisations. In fact, if anything, transfer pricing is considered to be more important than ever and SAT believes that it is "severely understaffed". The expectations are that this number will increase ("we do not have enough").

Transfer pricing inspectors frequently rotate to other assignments and positions within SAT and this has created a need for on-going training of many new staff (this same situation can be observed in other Asian countries, such as Japan). To some extent this may be part of the reason why some MNCs feel frustrated in dealing with SAT inspectors and often find themselves in situations where they are, in a sense, training inspectors on transfer pricing rules and principles. On the other hand, the national leaders have been the same individuals since we have been following Chinese transfer pricing over the past several years and their direction has been consistent.

In 2000 SAT audited 1,064 FIEs and "finished" 546 transfer pricing cases of which many resulted in

adjustments. On average, approximately 1,000 companies are audited per year. It takes 15-24 months to audit an FIE. All FIEs are audited at least once every two to five years and some more often. SAT feels that they are "making progress" in the sense that they are increasing the rate of success in sustaining positive transfer pricing adjustments; however, there is full acknowledgment that "we have a long way to go".

In 1998 approximately 70 percent of FIEs (which include wholly foreign-owned enterprises (WFOEs), equity joint ventures (EJVs) and co-operative joint ventures (CJVs)), reported tax losses and this included MNCs from around the world. The percentage has decreased - perhaps to about 60 percent. It is SAT’s view-point that Circular 59 has helped to contribute to this change, as well as their increasing level of expertise in transfer pricing throughout the country. Also, it has been previously reported that many FIEs lose money after tax holidays expire (generally, they last up to five years). Apparently, there has been a decrease in the number of these situations and, as discussed below, with the entry into the World Trade Organisation (WTO), it is quite likely that there will be a phasing out of tax incentives.

To a great extent SAT relies on the use of forms for the collection of information. The two primary forms have been A and B which are entitled FIE and Annual Report of Transactions with Associated Enterprises.

Circular 59 requires a taxpayer to attach Form A or B to the corporate tax return. Form A reports on single related-party transactions and Form B reports on multiple related-party transactions (see BNA’s Transfer Pricing, July 29, 1998, for an English translation of the forms). While Forms A and B are required, these forms are not always completed and submitted. Penalties for failure to file forms A and B are small, but it is "quite likely" that SAT will increase penalties in an attempt to encourage compliance. Recently, a revised related party form has been issued which requests somewhat more detail.

In fact, there is an extremely low percentage of MNC compliance with these forms. According to SAT,

"about 20 percent of FIEs" are completing Forms A and B. Strangely, SAT does not put the sole responsibility on the FIE-taxpayer. They feel that the local tax officials should also be held more accountable for not obtaining the requested information from taxpayers - a rather unique attitude. This may be one of the reasons why the 1998 circular was issued "primarily" for use by tax examiners.

Since 1998 SAT has promised to issue a procedure for APAs. Again, it appears imminent. Among the features will be:

• Confidential Conference - As in the U.S., it will be possible to discuss with SAT the contents of a proposed APA on a "no-name" basis. In the U.S. it is easy to create an anonymous scenario. In China this will be more difficult since local provincial authorities are likely to issue APAs. Depending on the province, there may be many or only a handful of FIEs and, therefore, it could prove more difficult to remain anonymous. It remains to be seen whether the initial anonymous meeting can be relocated
• to SAT in Beijing. Even if this is the case, there is no certainty that the provincial government will adhere to the parameters agreed to with SAT National.
• APAs will be issued for one to three years, al-though it is difficult to conceive of a case where a one or two year period would be desirable in light of the length of time it will take to negotiate an agreement.
• There will be an option to obtain a bilateral APA. SAT was reluctant to include a bilateral option; however, this was strongly encouraged by the OECD.

We pointed out that according to IRS Announcement 2001-32, dated April 2, 2001 (the IRS Annual Report on APAs), "the APA application can be a relatively modest document for a small business taxpayer consisting of about 30 to 50 pages" and that "for most taxpayers, the APA application is a substantial development filling several binders".

Although SAT officials would not comment on their expectations in terms of the length and depth of an APA application, it is clear that there procedures will call for "less" (probably a great deal less) information than is submitted in the U.S.

Although there is no formal APA procedure, China has in fact entered into about 50 APAs. Many of these are with parent companies from Japan, Korea, Singapore and Australia. None are with the U.S. companies or European companies, although there are current negotiations with one large U.S. MNC. In 1998, SAT officials had entered into only one APA with a Japanese company; therefore, the increase has been substantial and remarkable, in particular, in the absence of specific guidelines.

Other commentators have suggested that "cost sharing agreements" may be accepted in China. This is probably not the case. The main reason is that China does not have a specific provision similar to Internal Revenue Code Section 6038A, which in the U.S. permits access to "foreign books and records" of foreign related parties. SAT’s viewpoint is that they have no way of confirming the "foreign costs" or "revenues" that would make up part (or all) of a bona cost sharing arrangement and, therefore, would not have an ability to audit the Chinese portion of cost sharing payment.

In any event it is uncertain whether many MNCs would choose to divide the ownership of intangibles with a WFOE (perhaps this will change over time as more protection is available for intellectual property - especially in light of entry into the WTO). On the other hand, by not doing so, royalty payments received from a WFOE would suffer a 20 percent withholding tax in China unless reduced by treaty (e.g., 10 percent under the U.S./China treaty). Also, the amount of such royalty as a tax deduction would undergo scrutiny.

No objections were raised with respect to contract R&D, where the relationship calls for research conducted in China on behalf of a foreign-related principal that becomes the owner of the research and any new tangibles. On the other hand, they did not expressly accept or acknowledge this concept and legal relationship. The main focus of the Beijing tax inspectors was the determination of the arm’s length mark-up on costs.

China’s entry into the WTO will have a major impact - not the least of which will be new enforcement efforts to collect taxes from FIEs (including the likely phase-out of preferential rates of tax for foreign companies). According to Government ministry officials, the move to phase-out the preferential rate of corporate income tax for foreign companies in five SEZs and 49 smaller "development zones" around the country is part of an effort to conform with the terms of the WTO. One WTO principle is "national treatment" or the establishment of a "level playing field" for Chinese-owned and foreign companies. China will abolish preferential rates for FIEs and establish a uniform enterprise in-come tax of 24 percent.³ This may work to the disadvantage of certain FIEs that enjoy a corporate tax rate of 15 percent in SEZs and state-level development zones, as contrasted with a 33 percent rate for Chinese enterprises.⁴

It is not certain how long it will take China to phase out tax incentives enjoyed by FIEs and whether it is absolutely certain that they will do so without any exceptions. Nevertheless, over time a combination of higher rates and an increase in the intensity of transfer pricing enforcement will cause MNCs to spend more time monitoring their current and future Chinese tax positions.

In addition to deriving tax revenue from the elimination of preferential tax, there will be pressure from other areas. For example, since import duties will be reduced to enable foreign-produced goods to enter the Chinese marketplace to compete with Chinese-produced goods, there will be an incentive to derive tax revenue from other sources. Tax collection from transfer pricing enforcement is likely to be one of these sources.

Since 1986 transfer pricing has been an area of focus within China. If there is a dispute, a taxpayer may seek a reassessment, as long as the disputed tax is paid up front. Although there is a procedure to bring "unagreed" cases to a "higher tax authority" (the so-called "Administrative Reconsideration" process) within SAT, only three such matters have ever been initiated and they were in the mid 1990s.

The cases originated at the "provincial" level and were appealed by MNCs. Two of these cases resulted in "no change" (i.e., "no change" to the assessment made by the SAT bureau at the "provincial level") and the third, for technical reasons, appears to have had an adjustment in the taxpayer’s favour. No transfer pricing cases have been litigated in court, although it is theoretically possible to do so. (See BNA’s Transfer Pricing, July 29, 1998 for additional details on "Reassessment and Appeals").

We pointed out that MNCs are accustomed to more remedies and that, in the future, they may feel pressure to introduce more type of appellate procedure. Again, this may very well be the case because of the phase-out of tax concessions, as well as an increase in enforcement capabilities with respect to FIEs.

Applying the Comparable Profits Method (CPM) or Transactional Net Margin Method (TNMM) in China raises the question of which country data should be used (these are among the acceptable methods listed in the circular). There is very little Chinese financial data on comparable companies that can be obtained.

One issue is whether taxpayers should use Asian information or U.S. data. Neither provides ideal information, since China is unique. In practice, using the most reliable data, whatever the source, is the most appropriate approach.

SAT mentioned that they are now using companies listed on the Shanghai Stock Exchange as com-parables. Although they did not say so, one can assume that they are also looking to the Shenzhen Exchange.

The Shanghai Stock Exchange and the Shenzhen Exchange were opened in 1990 and 1991, respectively. They are two classes of shares traded: "A" which shares can only be acquired by Chinese nationals and "B" shares introduced in1992.

For the most part the two exchanges list different companies. The Shanghai Exchange lists approximately 70 companies (which includes state-owned enterprises) in industries such as: automotive, chemicals, consumer products, electronics, energy, food and beverage, healthcare, transportation, agriculture, manufacturing, metals and mining, real estate, telecommunication and real estate. Generally, the Shenzhen Exchange lists smaller export related companies (about 30). A listing of companies on the exchanges can be found at www.ChinaOnline.com

Although these public companies may offer more information than the publication entitled "Statistical Analysis of Industrial Enterprises"(which reflects state-owned companies and, in any event, is not available to the public), there is no certainty that many of them would stand up as comparables to the Chinese related party which might be the "tested party", for example, for purposes of performing a CPM calculation. Moreover, there are very few companies from which one can do an adequate "screening" for the selection of high quality comparables (if any comparables at all). The SAT is keenly aware of this lack of "comparable" data that they try to derive internally based on Chinese companies. They have expressed much interest in how the U.S. gathers comparable data.

Also, in performing a sampling of the companies listed, it appears that many of them are "loss making" companies, most likely due to the fact that many of them were originally state-owned enterprises.

There are virtually no competent authority matters currently pending and none involve a U.S. company. Out of the few cases they have had, two involve Japanese companies and one involves a Korean company. It appears that they are sensitive to the fact that over time they will need to gain experience with Competent Authority, (including the fact that it is provided for in treaties), in particular, as they find more situations where there is a greater amount of taxable income in China.

SAT has just installed a new database in several provincial offices of SAT. In this database they will be putting information on individual taxpayers. It appears that it will be used for a number of purposes including which companies are to be selected for audit. Al-though this type of database is found in the U.S. and other countries, there is some concern that this might be a SAT source of financial information on potential comparables or, at least, what SAT perceives to be potential comparables.

In addition, the SAT has developed their own proprietary tax modelling software that allows for the rapid computation in tax liabilities due to the effect of transferring pricing adjustments. According to the SAT, this software is in the "testing stage". The significance of this is that, consistent with other signals, the SAT views transfer pricing as an important area – now and in the future.

There is no specific list of issues or fact patterns which the SAT audits. Nonetheless, for several years they have analysed cases where loses are incurred after the tax holiday period. This is still the situation. More recently they have spent time investigating transactions with tax haven related parties.

SAT is keenly aware of tax haven jurisdictions and pays additional attention to related party transactions involving such jurisdictions. Again, part of the SAT’s frustration is the difficulty in obtaining foreign-based documentation and books and records of foreign-related parties. Also, SAT spends time examining "representative offices" to see if their activities fall within the scope of the business licenses which they receive from the State Administration for Industry and Commerce (SAIC).

Chinese transfer pricing rules are applicable only to transfer between related parties. While the U.S. concept of "related parties" is governed by the "reality of control" principle under section 482 regulations, the Chinese definition of related parties is different in some respects".⁵

A related party exists if "25 percent or more of the shares of an FIE are owned or controlled directly or in-directly". On the other hand, it is clear that one can be a related party even in cases where there is no actual legal ownership.

In response to a question of whether there could be a transfer pricing adjustment in the case of a 50-50

joint venture, the response was that although the parties are related pursuant to their shareholders by virtue of passing the 25 percent threshold, this would not necessarily be a situation calling for a transfer pricing analysis or adjustment since the issue of whether or not control exists would have to be addressed. So, in a very general sense, it may be comparable to the U.S.

SAT is currently working on a case where there is no actual legal ownership of an FIE by a company with which it transacts business. Apparently, the situation includes a joint venture that sells products to a foreign buyer. For some reason, the buyer "has the right to set the prices" charged by the joint venturer. Evidently, this case is an application of the principle that no legal ownership is required.

BNA’s Transfer Pricing, July 29, 1998, defines related party to include (but not limited to):

• another enterprise controls or supplies raw materials that the enterprise purchased for its manufacturing;
• control by another enterprise of sales of the product (including the price and transaction conditions) that the enterprise produced; and
• other beneficial relationships that relate to the actual content of the enterprise’s manufacturing.

There was a discussion about the possibility that the existing transfer pricing rules might be elevated within the Chinese legislative system to a higher status - possibly just below the status of legislation which is passed by the National People’s Congress. This may be part of an attempt to unify the entire Chinese tax system. In any event, as a practical matter, it is uncertain whether this would have any impact on the way SAT enforces principles and methods of transfer pricing.

In 1998 it was reported that SAT may request a review of foreign books and records, however, this was a matter of practice and not a rule of law. SAT is "considering" introducing a rule that would require that FIEs produce books and records of foreign related parties. Potentially, this could be along the lines of Section 6038A.

SAT feels that it has "a long way to go to get effective legislation and to carry it out". According to SAT, "it is not because we don’t want to have a rule like 6038A".

Unlike the Section 6662 "contemporaneous documentation" found in the U.S. and in several other countries, technically speaking, current Chinese rules do not require contemporaneous documentation to be prepared by the taxpayer at the time the tax return is filed. Instead, according to Circular 59, the SAT will prepare documentation for an FIE based on the data it gathers from the information forms submitted pursuant to the circular. FIEs are required to submit further information after the tax authorities have completed the basic audit. The request for information may in fact rise to the level of "contemporaneous documentation" for U.S. tax purposes. However, in practice, SAT has been receiving from MNCs a number of documents and reports which bear a great deal of resemblance to Section 6662-type documentation. In other words, SAT has seen and reviewed (from FIEs under audit) detailed transfer pricing studies in which various methods have been asserted by MNCs.

SAT is also considering imposing a requirement for contemporaneous documentation "to be attached to tax returns of FIEs". Such a rule would be a significant departure from Section 6662 which requires that the documentation be in existence at the time the return is filed but there is no requirement to produce it, unless the IRS makes a request. Nevertheless, even though there is no technical requirement at present, there is no question that it is prudent for MNCs to prepare documentation, which supports its position and preferred method of transfer pricing.

Whether either or both of the above rules will be introduced remains to be seen, but it will be a subject which these authorities will continue to monitor with SAT. Also, the timing of such rules and the nature and extent of penalties is also uncertain at this time; however, SAT is fully aware of how the 20 percent and 40 percent section 6662 penalties apply.

SAT is rapidly increasing its knowledge and skills in the transfer pricing area. If one looks at the situation in 1997 and compares it to November 2001, the growth has been tremendous. On the other hand, we are concerned about the on-going inconsistency throughout the country in the way transfer pricing issues are handled and the minimal resources that exist to identify potential comparables.

Entry into the WTO will create many new challenges for China. Tax reform will play an important role and, as tax incentives are phased out, the cost of doing business may rise. This cost will rise even higher in the absence of a well- documented transfer pricing policy that will be acceptable to the SAT.

1 In general, the SAT is the People’s Republic of China’s equivalent of the Internal Revenue Service in the United States. The SAT, together with the Ministry of Finance, is entrusted with the authority to interpret tax legislation and implement tax policies in China. The SAT frequently issues interpretive notices, rules and regulations. Although the SATs rules and regula-tions do not have the force of law, they are in practice respected as such.

2 Additional background can be found in BNA’s Transfer Pricing (December 10, 1997).

3 BNA, Daily Tax Report, November 14, 2001, P. G-2.

4 Financial Times, November 13, 2001, p.9 "China Ready to Scrap Tax Breaks for Foreign Companies."

5 Regs. 1.482-1(a)12