PRC tax

Managing transfer pricing risks in China

Chi Cheng and Leung Ho-yin weigh the pros and cons of advanced pricing arrangements for multinational companies in China
ransfer pricing has emerged as one of the most important issues faced by chief nancial ofcers and tax directors of multinational corporations today. With good transfer pricing management, they can control their groups effective tax rate, which can cost up to a quarter of total operating prots in China, and prevent hefty tax adjustments. Chinese tax authorities have recongured their transfer pricing regime over the past few years and introduced a multitude of related circulars, among them the revamped advanced pricing arrangement guidelines offered in Circular 2 (Guoshuifa [2009] No. 2). In addition, the authorities are focusing on increasing the quality and efciency of their three areas of responsibilities, namely transfer pricing audits, compliance administration and taxpayer services in relation to handling APA and mutual agreement procedure applications and negotiations. They are also planning to boost staff numbers and competencies signicantly in the coming years through national training seminars organized by the State Administration of Taxation. An advanced pricing arrangement is a prior agreement between a taxpayer and its tax authority to determine the transfer price (or in practice, the methodology used to set the transfer price) for future intercompany transactions. This agreed price or pricing methodology will be recognized at arms length for a designated period. These proactive negotiations will help management mitigate the potential transfer pricing risk and give assurance on the companys related-party dealings, thus eliminating uncertainties and minimizing provisions for taxation in the nancial statements and strengthening the groups
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nancial position. Also, room for negotiation with the tax authorities is more exible under an APA than during a transfer pricing audit, where authorities can adjust the taxpayers protability (or transfer price) upwards to at least the median level of comparable transactions (or prices). For companies wishing to mitigate risk in more than one country, a bilateral or multilateral APA can be possible solutions. These are agreements between two or more tax authorities and are based on the authority of the mutual agreement procedure specied in the relevant double taxation agreements. For example, China now has bilateral APAs with Japan, the United States, the Republic of Korea and Denmark. The benet to multinational corporations from such agreements is the assurance that income associated with covered transactions is not subject to double taxation, something a unilateral APA with one tax authority cannot provide. APAs in China The SATs inaugural China APA Annual Report released in December shows that from 2005 to 2009, 53 APAs were concluded. During 2010, more than 30 APA proposals were estimated to have been added to the pipeline. The report showed an increasing trend towards bilateral APAs, with seven such agreements signed in 2009, exceeding the number of unilateral agreements (ve) signed in the same year for the rst time. Currently, most of the signed bilateral APAs are with Japan and Korea, but European companies are expected to play a more prominent role in the coming years as the Chinese tax authorities consider they are still underrepresented in the Chinese APA programme. Despite the existence of a bilateral tax agreement between Hong Kong and

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The benet to multinational corporations from bilateral APAs agreements is the assurance that income associated with covered transactions is not subject to double taxation, something a unilateral APA with one tax authority cannot provide.
China, the Inland Revenue Department is reluctant to engage in any bilateral APA negotiations. During the Institutes 2010 meeting with the IRD, the Inland Revenue commissioner said the current advance ruling procedures were sufcient for unilateral APA purposes. He also said the mutual agreement procedure provided in Hong Kongs double taxation agreements could be used to facilitate discussions on transfer pricing issues between Hong Kong and its treaty partners (see www. hkicpa.org.hk under Membership and benets/Professional representation/ Tax/Annual meeting between the Institute and IRD/Tax bulletins/TaxB 20). But as the IRD gains more transfer pricing experience, we expect to see bilateral APAs between China and Hong Kong. The SAT report also expects the types of transactions will expand to cover not only the purchase and sale of tangible assets, but also services, intangible assets and nancing transactions. Chinese tax authorities are aware that in the near future, the transactional net margin method, where the resulting protlevel indicator (very often the operating margin or mark-up on total costs) is
March 2011

PABLO BLASBERG/IKON IMAGES

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PRC tax

Figure 1 Cost comparison

Time and resource investment

When an APA is agreed and signed

with APA without APA

3 Years

The above graph illustrates the potential time and resource cost for a company successfully applying for and implementing an APA, and for a company without an APA but subject to investigation, audit and subsequent monitoring.

simply compared to that of comparable companies, will not often be used in their analyses of the acceptability of transfer pricing. The SAT is also mindful that many companies in China are not single-function entities acting only according to the instructions of the headquarters. Instead, many of them now contribute to the value chain in terms of brand value creation, developing local customer relationships and China-specic technology. As a result, the SAT expects to encounter more sophisticated transactions and transfer pricing methodologies during APA discussions, as well as more advanced transfer pricing analyses in general compliance matters. One example could be the application of the more complex prot split method, which calculates the portion of prot that should be earned by each associated enterprise in related-party transactions, to determine the appropriate level of return for a non-routine distributor.
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Pros and cons Apart from mitigating tax risks in the future, a multinational corporation may be able to roll back the outcome of an APA and attain certainty for previous years, thus dissolving previous tax provisions and avoiding contentious tax audits that are often conducted in a more confrontational manner. Moreover, the ease of renewing an APA gives multinationals the necessary planning assurance, which frees up management to focus on sustaining the companys growth and competitiveness. Multinational companies can also eliminate costs on documentation preparation and audit defence since covered transactions will not be required to provide contemporaneous documentation during the APA period covered. Informal discussions with the tax authorities during anonymous preapplication meetings are encouraged

and there is no fee for applying or implementing an APA. Chinese tax authorities are showing greater willingness and exibility in negotiating a multinationals transfer pricing methodology in advance. It is better for multinationals to review their transfer pricing position periodically so as to decide whether an APA is necessary. Concluded APAs will mitigate the transfer pricing risks during the covered period, while multinationals without APAs may face transfer pricing audits in later years where its protability (or transfer price) will at least be adjusted to the median level of the benchmarking study. Apart from the transfer pricing risks, multinationals should also consider the time and effort to be spent in an APA application and in a future potential transfer pricing audit (see gure 1 ). On the other hand, tax authorities have said they would like to increase the quality of their administration, which can be seen in the sharp increase in required information to be submitted, and therefore the time and effort taxpayers need to devote in the APA negotiation process. Taxpayers should consider carefully the level of resources required before entering into such negotiations, although the process may still be easier than dealing with a contentious audit. Chinas APA programme helps multinationals mitigate potential transfer pricing and tax risk, minimizes provisions for tax liabilities and improves cash ow. An APA also enables companies to manage their transfer pricing in the long run since renewals are relatively straightforward and exibility can be retained.

Chi Cheng is partner-in-charge of China and Hong Kong of global transfer pricing services at KPMG China. Leung Ho-yin is senior manager of the same department at the rm.