Brief introduction of transfer pricing in China

I. Current position of transfer pricing in China

Transfer pricing is an important part of anti tax avoidance in China. Compared to developed countries, the anti tax avoidance legislation in China has started relatively late, until 2008, under Clause VI of Enterprise Income Tax Law of the People’s Republic of China (“PRC”) and Regulations for the implementation of the PRC Enterprise Income Tax Law, it has regulated the terms of special tax adjustment which is the first anti tax legislation including the provisions of Transfer Pricing, Advance Pricing Agreements for cost apportion, Thin Capitalization, Controlled Foreign Corporation, General Anti Avoidance Rules and Interest subject to adjustment of overdue tax on tax avoidance. Within the purpose of supporting the Enterprise Income Tax Law, the Implementation Measures for Special Tax Adjustments (Trial) have also been issued by the State Administration of Taxation, following with more than ten related documents.

In 2011, the results of works of anti tax avoidance, the tax authorities have made an increased tax revenue by RMB 2.39 billion by the ways of management, service and investigation etc. From the magazine of Transfer Pricing Week published by UK, it stated that in the world’s top 10 of the most stringent of transfer pricing systems, China has rose from top 8 in 2007 to top 3 in 2010 which is just behind Japan and India. 

Anti tax avoidance has divided into several parts (included type of organization, business transaction, and industry etc) for reviewing and monitoring. For the anti tax avoidance legislation, the anti avoidance tax range has also included the business tax and personal individual income tax. According to the News released by the State Administration of Taxation, the next step for the works of anti tax avoidance is to expand the range of anti tax avoidance legislation and improving the related supporting regulation, perfecting the basic works of anti tax avoidance by taking practical measures, continuing to develop business areas of anti tax avoidance within the needs of economic development, exploring the rules of tax avoidance in each industry and promoting the application of quantitative analysis techniques etc. 

II. Recognition of related parties and associated transactions 

The Implementation Measures for Special Tax Adjustments (Trial) has clearly indicated the definition of Associated Relationship and its transactions: 

Associated Relationship - mainly refers to any of the following relationships between an enterprise and another enterprise, organization or individual: 

a) Either party directly or indirectly holds 25% or more in aggregate of the shares of the other party; a third party directly or indirectly holds 25% or more in aggregate of the respective shares of both parties; where either party holds the shares of the other party through an intermediary, as long as such party holds 25% or more of the shares of the intermediary, the percentage by which such party holds the shares of the other party is the one by which the intermediary holds the shares of the other party;

b) Borrowings by either part from the other party (with the exception of any independent financial institution) account for 50% or more of the actually paid-in capital of such party or 10% or more of the total amount of loans borrowed by such party is secured by the other party (with the exception of any independent financial institution); 

c) A majority of senior officers (including directors and managers) or no less than one senior director of either party who controls the board of directors is appointed by the other party or a majority of senor officers (including directors and managers) or no less than one senior director of both parties who controls the board of directors is appointed by a third party; 

d) A majority of senior officers (including directors and managers) of either party simultaneously acts as senior officers of the other party (including directors and managers), or no less than one senior director of either party who controls the board of directors simultaneously acts as a senior director of the other party; 

e) The normal production and operation activities of either party is unable to be conducted without the provision of industrial property, proprietary know-how or other franchises by the other party; 

f) The purchase and sales activities of either party are controlled by the other party; 

g) Labor services accepted or provided by either party are controlled by the other party; 

h) Any other relationship in which the production and operation or transactions of either party is materially controlled by the other party or the interests of both parties are associated, including any relationship in which either party, without reaching the shareholding percentage specified in Item (a) hereof, is entitled to basically the same economic interest as the substantial shareholders of the other party, family relationships, kinships and other relationships. 

Associated transactions - mainly include the following types: 

a) The purchase, sale, transfer and employment of tangible assets, including the business of purchasing, selling, transferring or leasing buildings, transport vehicles, machinery and equipment, tools, commodities, products and other tangible assets; 

b) The transfer and employment of intangible assets, including the business of transferring titles in franchises such as land-use rights, copyrights (author’s rights), trademarks, lists of clients, distribution channels, license numbers, business secrets, and proprietary know-how and in industrial property such as industrial designs or utility models and of providing the rights to employ such franchises and industrial property; 

c) Financing funds, including all types of short and long-term loans and guarantees, all types of interest-bearing advance payments and delayed payments, and any other business; and 

d) The provision of labor services, including the provision of services such as market surveys, marketing, management, administrative affairs, technology services, maintenance, designs, consultancy, agency, scientific research, legal services, and accounting affairs. 

III. Introduction of transfer pricing method 

The core work of transfer pricing is the method of transfer pricing, and comparability analysis is the most important basis or standard for selecting the method of transfer pricing. It has divided into two types of transfer pricing methods during the works: 

(a) Traditional Method - Comparable price method mainly emphasizes the similarity of the terms of trade. Details are as follows: 

i) Comparable uncontrolled price method is the pricing method adopted by arm’s length parties in conducting same or similar transactions; this method is suitable for all types of transactions, closed to their fair value. 

ii) Resale price method is a product purchase pricing method that begins with the resale price to arm’s length parties (of a product purchased from an affiliated party), reduced by a gross margin of the same or similar transactions; Generally applicable to the businesses with simple processing or pure buying or selling transactions, and it is not applicable to the products sales which has actual add-value to the products (including changed the surface of products, functions, and structures, or replaced the trademarks). 

iii) Cost-plus method is the pricing method that it is basis on the cost of sales, adding a percentage of the gross margin. One conditions for this method is there is no fail value in the sales market and cost represented fairly. Under the special circumstances, it can used the expenditures (raised during the corresponding period) to convert, such as cost apportion. 

(b) Non-traditional transfer pricing method – 

Refers to a comparable profit method which mainly emphasizes the comparability of functional risk analysis.

i) Transactional net profit method is a method by which profits are determined as per the net profit margins of arm’s length parties in conducting same or similar transactions. It is usually included return on assets, sales profit, full cost-plus pricing, and Berry ratio etc. This method is the most common method of transfer pricing during practical works.

ii) Profit split method is a price method by which the consolidated profits or losses of an enterprise and its affiliated parties are allocated between or among them using a reasonable rate. This method has showed both transaction parties have achieved the profits which matched to each party’s functions, assets and related risks. It has certain rationality and reflects the principle of independent trading in a certain level. 

IV. Introduction of contemporaneous documentation 

In accordance with the provisions of New Regulations for the implementation of Enterprise Income Tax Law, apart from related parties who have implemented the agreement for cost apportion or Advance Pricing, any enterprise which has reached one of the following conditions shall prepare and keep the record of contemporaneous documentation in the tax years. The main content of contemporaneous documentation shall include organizational structure, operating position, related party transactions, comparability analysis, selection and usage of transfer pricing method. Enterprise shall submit the contemporaneous documentation report of associated transactions within 20 days from the date of the tax authorities required. 

The conditions which need to provide the contemporaneous documentation report of associated transactions will be as follows: 

a) The annual purchasing and selling amount between the related parties (processing business shall calculate based on the declaration prices of annual import and export) is no less than RMB 200 million Yuan. 

b) Except for the purchasing and selling business, the annual amount of other associated transactions (if it is financial interest, it shall calculate based on the amount of interest receipts and payments) is no less than RMB 40 million Yuan; 

c) The enterprise has single function and showed a loss of net profit. 

V. Transfer pricing risk management 

Transfer pricing risk management can be divided into three stages according to the timeliness of the transfer pricing risk: 

Before the event: before the associated transactions have occurred, it shall be planed and controlled the related risks, so that it will minimize the transfer pricing risks. 

Over the event: managing the transfer pricing risks in a controllable range. 

After the event: minimizing the loss of transfer pricing investigation 

It shall recommend enterprises to improve awareness of transfer pricing risk management, manage the transfer pricing risk in before, over, and after the three stages.