December 2004

Transfer pricing has always been a hot topic in China. It involves one branch of a company to set a price for physical goods or services when selling to another branch (usually a foreign one) of the same company. When one branch is based in a high tax-paying country, for example China, and sells to a related branch in a low-tax area, the company can make a low profit in the first country and a high profit in the second.

As a result, China has been experiencing high growths of tax evasion. According to the Ministry of Commerce, in August 2004, transfer pricing was the method used in approximately 60% of all foreign company tax evasion cases. This has caused an estimated annual tax revenue loss of RMB 30 billion, causing the Chinese government to take notice and instigate a national campaign to prevent transfer pricing.

One method to avoid being investigated is by applying for Advance Pricing Agreements (APA) with the Chinese Tax Authorities. China's State Administration of Taxation (SAT) issued on the 20th September 2004 the Guo Shui Fa [2004] 118, "The Implementation Rules on Advanced Pricing Agreement for Transactions between Related Parties," which provides formal guidance to foreign enterprises in China.

History of APA's

When the SAT issued "The Taxation Management Regulations for Business Transactions between Associated Enterprises" in 1998, widely known as Circular 59, it was China's first approach towards APAs. The document covered the subject, which taxpayers may propose pricing principles and calculation methods to the tax authorities to determine transfer prices with associated Enterprises.

Then, in September 2002, "The Implementation Rules of Tax Collection and Administration Law", Article 53 was issued, which allowed taxpayers to apply to the tax authorities for APAs.

Since then, more than 130 unilateral APAs have been concluded, but the lack of uniformed formal rules was still a stumbling block for multinational corporations (MNC's) with subsidiaries in different regions of China. A draft of the APA rules was issued in May 2003 for comments, and the revised Implementation Rules were issued in September 2004.

Overview

The Implementation Rules apply to unilateral, bilateral and multilateral APAs. An unilateral APA is an agreement between a taxpayer and the respective Chinese tax authority, where as one or more respective authorities of China's tax treaty countries are involved in a bilateral or multilateral APA.

The APA Term may range from 2 to 4 years, starting from the year after the formal application. The application year can be included, which means the term effectively can be between 3 to 5 years. Until the Implementation Rules were issued in September, MNCs with multiple subsidiaries in China experienced problems with the lack of coordination and communication between the local Chinese tax bureaus in different regions. Under Chinese law, legally separate entities in different regions cannot file consolidated tax returns, which meant that each entity has to file an APA with its respective local authority. The Implementation Rules ensure the coordination by issuing procedures for the tax bureaus in the different regions or provinces to communicate between themselves. Local tax bureaus have the responsibility to ensure coordination between the tax authorities in the different regions, where as the SAT has the responsibility to monitor coordination amongst tax authorities in different provinces. The SAT will also be responsible for the coordination, guidance or even direct handling if an APA involves more than two provinces, is a bilateral or multilateral APA or covers inter-company transactions of more than RMB 10 million.

The Process of applying for an APA

The process of applying for an APA has been separated into six steps:

1. Pre Filing
   Before a taxpayer submits the formal application, one or more pre-filing meetings may be requested with the respective authorities. The meeting serves the purpose of exploring the feasibility and the success of a formally filed APA. The taxpayer has to submit its preliminary proposal in writing, including a functional and comparability analysis, economic analysis and other information. Meetings can only be conducted on a named basis. The relevant authorities will also discuss at this stage the anticipated timing and the evaluation.
   
   
2. Formal application
   After an agreement has been reached and the authority has issued a written notice confirming the feasibility of the proposed APA, the taxpayer has to generally file a written application within three months. The application has to include:
   • Details of all relevant parties, relationships, organizational structure and inter-company transactions
   • Financial reports of the previous three years, product information, functional and comparable information
   • Related party transactions and a timeframe for the APA
   • Functions and risks of the related parties
   • The nature of the APA, e.g. bilateral, multilateral etc, including the involved treaty country / countries
   • Presentation of proposed transfer pricing models
   • Market overview
   • Annual forecasts and business plans
   • Double taxation issues
   • Any issues related to domestic and / or international laws and tax treaties
3. Examination & Evaluation Process
   Once the tax authority has received the formal application, an evaluation and analysis of the information received will occur. The tax authority will focus on the taxpayers historical operations, functions and risks, comparable information, critical assumptions, transfer pricing methods and a reasonable range of prices or profit margins.
4. Negotiations
   Once the evaluation has been completed, generally in a time period of 5 months, the authorities and the tax payer will enter negotiations on six major areas covered by the APA. Both parties will draft the APA once an agreement has been reached. If no agreement on an APA can be reached between both parties, any non-factual information obtained during the negotiation process cannot be used by the tax authority to audit the company.
5. Signing the APA
   Usually within 15 days after the completion of the draft of the APA, the APA will be signed.
6. Execution and Monitoring
   Every year, the taxpayer will have to file an annual report that demonstrates its good faith in compliance with the terms and conditions of the APA. On average every half year, the local authorities will also examine the taxpayer's execution. A minimum 90 days before the APA expires, the taxpayer will have to apply for renewal.

Transfer Pricing Enforcement

Additionally, on the 22nd October 2004, Circular [2004] 143 was issued by the SAT, which is an amendment to Circular [1998] 59 of the Guo Shui Fa. The amendments cover three areas of the enforcement of the transfer pricing:

1. Moving towards centralization and
   
2. Empowering tax bureaus in transfer pricing audits
   Under Circular [1998] 59, transfer pricing investigations or audits could be carried out by tax bureaus at or above county level. This made it difficult for tax bureaus in different regions or provinces to communicate and coordinate with each other. To improve the efficiency, the responsibilities for conducting the investigations or audits for transfer pricing has now been given in Circular [2004] 143 to the tax bureaus at higher level. The SAT also becomes the higher authority in cases in which tax bureaus at the provincial level require additional information outside their own jurisdiction or outside China.
3. Increasing penalties for non-compliance
   Penalties for Non-compliance have been increased in Circular [2004] 143 from a minimum of RMB 2,000 to penalties between RMB 2,000 to RMB10,000 for serious non-compliance cases if an FIE fails to file declaration forms to report its related party transactions within the given time frame. Additionally, penalties from RMB 10,000 to RMB 50,000 can be enforced if a company under audit or investigation provides false information.

When audited, the new Circular also gives the taxpayer the opportunity to request a 30 day extension to submit all requested information from the original 60 days.The SAT also addresses the double taxation issue in the transfer pricing rules in the Circular [2004] 143. The audited taxpayer can request in writing a corresponding adjustment if an income adjustment results in possible domestic double taxation.

Due to the losses incurred by the Chinese tax authorities, the government has become more stringent and developed training programs for its tax evasion investigators to take notice of serious transfer pricing of MNCs. It also shows the reforms taking place by the tax authorities gearing towards a more simplified taxation system, a broader tax collection basis, lower tax rates and stricter tax collection.

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All information in this report is verified to the best of our ability and is assumed to be correct at time of release; however, Klako Group does not accept responsibility for any losses arising from reliance on the information provided within.