CHINA

Transfer Pricing News Issue 34 - October 2020

Latest transfer pricing updates

In the context of the COVID-19 pandemic in the first half of 2020, there are several updates in the Transfer Pricing (TP) field in China, which we highlight in this article for the attention of multinational companies with investments in China.

Key updates

1. Documentation procedures are still tight in the context of the COVID-19 pandemic

Under the prevailing transfer pricing regulations in China, enterprises that meet the threshold for preparing Documentation local files are required to prepare local files by 30 June of the year following the year in which the related party transaction occurs. Due to the COVID-19 pandemic outbreak in 2020, the majority of enterprises in China closed their offices and implemented work-from-home arrangements from February until March or April. In this context, the audit and annual tax filing work have been postponed in most cities. Some taxpayers wonder whether the deadline for local files could also be extended. However, the Chinese tax authorities have not published any notification of a deadline postponement. In July, we noticed that the tax authorities in various locations started to ask taxpayers to submit the local files.

In addition, the tax officers who review the local file reports will, as in past years, continuously evaluate the quality of reports and give ratings to reports. If reports are not prepared in accordance with the regulations - for example, some of the required contents are missing - the reports may be given a low rating. When low ratings are given, the tax officers may return the reports to the taxpayers for resubmission, and in the meantime keep a low credit rating for the taxpayers.

2. Specific database preferred by tax authorities for benchmarking studies

In the local files, benchmarking studies are one of the key contents required by the prevailing PRC transfer pricing regulations. Some multinational companies adopt a centralised approach for their group documentations worldwide, i.e they conduct benchmarking analysis on a group level by applying a database commonly applied in the US or Europe and then roll out the benchmarking set to various countries including China. However, the Chinese tax authorities normally use an OSIRIS database and also prefer to review benchmarking studies performed with that database.

3. TP investigations have not slowed down in the context of COVID-19

Although the economy has been hit by the COVID-19 pandemic since February 2020, we have not yet noticed any obvious slow-down in TP auditing and self-adjustment in China. In practice, some of our clients still receive tax authorities’ enquiries regarding TP issues; other clients in the process of a TP audit are still facing questions and challenges from the tax authorities. We await any actions to be taken by the Chinese tax authorities in the context of COVID-19, but up to now there is no sign of a relaxation of TP investigations.  

4. Potential TP planning considerations for lowering profit in China

Many multinational companies have set up subsidiaries in China as limited risk distributors, contract manufacturers, toll manufacturers, and limited risk service providers. These types of Chinese subsidiaries were viewed by tax authorities as single-function entities, and were required to maintain fixed stable profit margins, and not allowed to bear any risk or loss associated with investment failure, market entry failure or decision-making failure. In past years, multinational companies set up stable routine profit margins for such Chinese subsidiaries, and residual profits went to overseas entities. Such TP arrangements were in line with the prevailing PRC TP rules as well as practical requirements.

In the context of COVID-19, due to a profit decline or even loss of group companies of multinational companies, some multinational companies view it unsustainable to continuously compensate Chinese subsidiaries with a fixed stable return whilst other group companies outside China bear the profit decline or even loss. As such, they are considering lowering the profit margin left to China, or even changing the TP policy so as not to leave a fixed margin to China. 

Impacts

1. Documentation procedures are still tight in the context of COVID-19 pandemic

As the tax authorities in various locations have started, since the beginning of July, to request taxpayers to submit local files, the tax officer may request local file reports at any time. For those who met the threshold of preparing reports, but have not yet done so, the time left for completing the report is limited.

2. Specific database preferred by tax authorities for benchmarking studies

Some taxpayers submitted the Chinese local files with the central benchmarking analysis conducted at the group level, but are required by the Chinese tax authorities to apply an OSIRIS database for the benchmarking analysis for China local file purpose.  Multinational companies with a presence in China therefore need to conduct a localised benchmarking analysis to minimise potential TP risks in China. 

3. TP investigations have not slowed down in the context of COVID-19

Taxpayers with cross-border related party transactions may still face pressure from the tax authorities regarding TP enquiries and investigations, though the economy has been negatively impacted by the COVID-19 pandemic. Profit declines and losses of enterprises in China may trigger stronger attention from the tax authorities, and the TP arrangements of such enterprises will face bigger challenges.

4. Potential TP planning considerations for lowering profit in China

As the prevailing TP rule requiring fixed stable profits for single-function entities is still valid, and there is no new regulation published to relax the profit requirement for single-function entities, any change in a TP arrangement would likely trigger attentions and even challenges from the tax authorities.

Our recommendations

1. Documentation procedures are still tight in the context of COVID-19 pandemic

As the tax authorities in various locations have started to ask taxpayers to submit local files, we suggest that multinational companies that meet the threshold of preparing local files but have not yet done so should speed up the local file preparation, as the tax officer may request the local file reports at any time.

In addition, the reports should be prepared to a high standard, in accordance with the requirements of the prevailing PRC transfer pricing regulations. The preparer should refer to the specific requirements set out in the regulations and write up all the required contents to avoid a low rating being given by the review tax officer.

2. Specific database preferred by tax authorities for benchmarking studies

Considering the preference of the tax authorities, we suggest the taxpayers adopt local benchmarking approach by using an OSIRIS database rather than a centralised approach by using a database not applied by Chinese tax authorities. A localised benchmarking analysis is more likely to pass the review of the tax officer. In addition, as localised benchmarking studies are performed with the same database as applied by Chinese tax authorities, it will be easier for the taxpayer and tax officer to communicate on the comparable selection process in a real TP audit case. Hence, a localised benchmarking analysis would better serve as a first-line defence file in the event of a real TP audit.    

3. TP investigations have not slowed down in the context of COVID-19

As we have not noticed any obvious slow-down in TP auditing and self-adjustment in China, in order to reduce the potential TP audit risk, it is advised that companies carefully review their TP arrangements, revisit their TP policy if applicable, and prepare solid supporting documents.

In addition, as the practical views and technical treatment of the same TP issue by tax bureaus in different jurisdictions of China may differ, communications with the tax authorities will play an essential role throughout the TP investigation process. As such, companies are advised to work with a reliable local tax advisor who can help with all risk management and communication with the tax authorities in China.

4. Potential TP planning considerations for lowering profit in China

Any revisiting and change to TP arrangements involving single-function enterprises in China should be carefully planned in view of the possible enquiry and challenge from the Chinese tax authorities. We suggest reviewing TP arrangements from the whole supply chain of group companies, and assessing the function and risk characteristics of each entity on the supply chain so as to support the change in the TP policy. Taxpayers should also be prepared to disclose more transparent information (such as financial data of overseas entities) to the Chinese tax authorities, when questioned by the tax authorities. It is also worth considering initiating proper communications with tax authorities in advance, to check their attitude, to help assess the feasibility of the TP policy change.

BDO China is experienced in all kinds of TP analysis as well as TP audit defence. We will be happy to support companies in preparing TP documentation, performing benchmarking analysis, establishing a proper TP policy, preparing solid TP analysis supporting documents, and assisting with communications with tax authorities in China.

Please do not hesitate to contact us for any such assistance.

Gordon Gao
gordon.g@bdo.com.cn

Emily Li
emily.li@bdo.com.cn