Part 1 of this two-part series summarized the latest 2018 version of Guide to Customs Valuation and Transfer Pricing released by the World Customs Organization ("WCO"). Part 2 comments on the trends and observations in the interaction between customs valuation and transfer pricing from a China perspective.
Customs Valuation and Transfer Pricing: China Regulations and Practice
In recent years, both Chinese tax and customs administrations have placed their focus on transfer pricing, particularly of multinational enterprises (“MNEs”), and have published a number of regulations.
Revisions to Transfer Pricing Regulations
As part of the localization of the Organization for Economic Co-operation and Development base erosion and profit shifting (“BEPS”) initiatives, China State Administration of Taxation (“SAT”) released a series of revisions to transfer pricing regulations, some of which may be relevant to customs valuation:
- On June 29, 2016, the SAT issued new regulations (SAT Bulletin  No. 42) to improve the filing of related party transactions and the management of contemporaneous documentation, to update provisions for disclosure of related party transactions, country-by-country ("CbC") reports and contemporaneous transfer pricing documentation, from an enterprise income tax ("EIT") perspective.
- On October 11, 2016, the SAT issued new regulations (SAT Bulletin  No. 64) to improve the administration of advance pricing arrangements ("APAs"), to clarify relevant requirements on APA matters such as the threshold of application, procedures of concluding APAs, roll-back period and application materials.
- On March 17, 2017, the SAT issued new regulations on Special Tax Investigation and Adjustment and Mutual Agreement Procedures (SAT Bulletin  No. 6) to clarify transfer pricing methodologies and procedures for special tax audit and adjustment, and mutual agreement procedures ("MAP"), and set out the regulations on intangibles and intragroup services, including outbound payments (e.g., royalties and services fee) and inbound receipts.
Some of the above new requirements and regulations could provide customs authorities with more information and an approach to evaluate import prices.
For example, SAT Bulletin No. 42 requires taxpayers to disclose in their local file “different types of business and product revenues, costs, expenses and profits,” to explain the rationale for profit allocation between the members of the group and the results in the global value chain. The local file also should reflect specific factors, such as local cost savings and market premium.
This information enables the customs authorities to have greater access to the data relating to imported goods, as well as the costs and profit associated with the supply chain outside China, and companies need to understand the potential customs impact of the disclosure of such information.
Another example is that the provisions on royalties under SAT Bulletin No. 6 could also influence the import price evaluation from a customs perspective.
Revisions to Customs Declaration Form
Meanwhile, since March 2016 the General Administration of Customs (“GAC”) has announced several adjustments to the customs declaration form reporting requirements, requiring importers to disclose related party transactions and to confirm whether import prices have been influenced by the relationship between the buyer and seller.
In the worst case, untruthful disclosure on transfer pricing or a declaration without robust evidence substantiation or ground documentation to support the declaration may be deemed an untruthful declaration, and customs is entitled to impose penalties.
Increase in Investigation of Potential Tax Avoidance
Both the tax and customs administrations are increasingly investigating potential tax avoidance by MNEs with respect to related party transactions. The Chinese tax authorities’ scrutiny of related party transactions has been enhanced by the “Golden Tax Project Phase III” and they have also launched several special investigations.
Chinese customs authorities, by leveraging the newly established Customs National Supervision Center for Duty Collection for customs’ national all-in-one clearance reform, have increased their supervision and monitoring of import transactions between related parties, and have instructed the audit division and port clearance division to carry out focused inspections.
Different Areas of Focus
Although both administrations are examining related party transactions more closely, China tax and customs authorities have different areas of focus and requirements concerning imported goods. Their objectives, perspectives and approaches are different as illustrated in the table.
As China’s tax and customs administrations are legally empowered to perform adjustments retroactively, subject to the assessment of the transfer price, significant amounts of additional duty/taxes may be imposed on companies. There also may be surcharges, administrative penalties or potentially even a downgrade in an enterprise’s credit rating, with associated negative consequences.
Common Cases in Transfer Pricing and Customs Valuation
Based on our observation, there are a number of common situations in China in which taxpayers frequently encounter different views and approaches on transfer pricing and customs valuation from the two respective authorities. These common cases are illustrated below.
Distribution Entities with High Profits
Usually, Chinese customs and tax authorities hold different views on the high profitable distribution entities. Those distribution entities with import business with a higher profit margin compared to similar companies in the same industry may not invite challenge from the tax authorities, as more profits are retained in China to become the tax base of direct taxation for China.
However, from China customs’ standpoint, if the company’s profit margin is higher than the upper quantile established by the benchmark comparable companies, the customs authorities would tend to consider whether the high profit rate is caused by the low import price.
As indicated by case study 14.2, released by the World Customs Organization (see also Part 1 of this article), China customs has been placing more scrutiny on entities with high profits earned in China that conduct significant import transactions with overseas related parties, especially those operating in industries such as luxury goods, pharmaceutical, among others.
More frequently than ever, China customs relies more and more on contemporaneous transfer pricing documentation as the first desktop review documents to identify their potential audit target.
In view of high profits, the GAC would assert that the company has earned excessive profits mainly due to the lower import prices from the overseas related parties.
Similar to Case 14.2 (above), such a situation can become even harder when a transfer pricing bench-marking analysis also shows that the profit level earned by the China entity is much higher than that of comparable companies, especially at the gross margin level: the GAC can use that as evidence to conclude the import price is adversely impacted by a related party relationship.
On the other hand, from the SAT’s viewpoint, unique local specific advantages, (i.e., “market premium” or “location savings” factors) are advocated to request more profit be retained by Chinese entities, especially in industries such as luxury goods and automotive.
Different Prices of Same Products
Under different business circumstances, the same products could be imported into China under a different business arrangement: for instance, MNEs could arrange for the imported goods to be distributed in China via a third-party distribution entity or their own local subsidiary. Usually, the function and the risk profile of the third-party agent is different from the subsidiary company, so the same products could be imported at different prices when declared.
From the SAT’s view, normally the tax authorities would not particularly look into the transaction prices, but assess the profit level, usually at the entity level, based on the function and risk profile of the subject entity.
In contrast, customs normally review and assess prices on an individual products or shipments basis; thus the GAC could question the difference of import prices by the third party agent and local subsidiary company.
As part of group transfer pricing policies, many MNEs set up licensing arrangement for local Chinese subsidiaries to pay royalties relating to the right to use certain intangibles (i.e. trademark fees, technology fees) to relevant intangibles owners. Currently, procedure-wise the MNEs could remit the outbound royalties without preapproval from the Chinese tax or customs authorities. However, both authorities could still look into royalty payments closely even after the outbound royalty payments are made.
SAT Bulletin No. 6 clearly states where royalty payment is disproportionate to economic benefits to the Chinese entity and/or not at arm’s length, the royalty payment is not tax deductible even in the full amount. That is, the Chinese tax authorities place more emphasis on the economic substance and benefits underneath the royalty arrangement.
Customs valuation rules focus on whether the royalties are connected to the imported goods, such that the royalty payment constitutes the condition to sales to China, to assess whether the royalty payment should be dutiable and additional duties and import VAT should be levied.
Given the increasing scrutiny of related party transactions, MNEs with significant imports from related parties may wish to consider taking the following measures:
- Closely monitor changes of regulations and business trends. The arm’s length principle is the basic foundation for customs valuation and transfer pricing, as well as a focus of both authorities when examining the rationale underlying related party transactions. Since the concept is relatively broad, its technical aspects have been evolving. Authorities around the world, including those in China, have been adjusting relevant regulatory methods, and MNEs should closely monitor regulation changes to ensure they are compliant with the regulatory requirements. MNEs also should be aware of common industry practice and determine their transfer pricing policies on a reasonable basis.
- When preparing transfer pricing documentation, consider the perspectives both of the tax and customs authorities, and examine not only the group pricing policy but also the status of policy implementation. Transfer pricing documentation is one of the key records for tax and customs authorities to assess the reasonableness of the pricing of related party transactions. As the documentation is generally prepared pursuant to local transfer pricing regulations, the potential impact from the customs valuation perspective may be overlooked, particularly with respect to function/risk profile and the comparable search from a customs perspective. Hence, MNEs may also wish to involve the trade compliance team and consider including analysis from the customs valuation perspective—in particular, the analysis of tangible goods transactions and bench-marking on gross margin.
- The actual transfer price may be influenced by a number of factors, such as the tax rate, foreign exchange fluctuations, capital and market conditions, which could result in deviations from the target margin following the transfer pricing policies. MNEs may wish to explore the feasibility of self-adjustment, for example, retroactive adjustment of the imported prices, or year-end transfer pricing adjustment to satisfy the target margin. In the context of China’s complicated regulatory environment, aspects such as foreign exchange, the corporate income tax impact and customs valuation should be thoroughly evaluated before properly implementing the transfer pricing self-adjustment.
MNEs may also wish to consider available mechanisms such as APAs and customs advance rulings (China introduced the Customs Advance Ruling mechanism from February 1, 2018 which enables importers to seek confirmation with customs as to whether the special relationship has influenced the declared price) for valuation that can reduce potential risks that may arise from the conflict between transfer pricing and customs valuation.
The binding nature of APAs and the customs advance ruling mechanism can mitigate uncertainty and help manage the potential risks of post-transaction adjustments by the tax or customs administrations.
Dolly Zhang is a Partner of Deloitte China specializing in global trade advisory; Mandy Yu is a Director of Deloitte China transfer pricing services; and Roger Chen is a Senior Manager of Deloitte China global trade advisory. They are all based in the Shanghai office.
Any errors or omissions are the authors’, and this article is written in the personal capacity of the authors. Neither the authors nor the global Deloitte organization—nor any of its member firms—can accept the responsibility for any loss related to any person acting on the information in this article.