Chinese Transfer Pricing Adjustments Call for Sticking to Basics

Multinational enterprises operating in China need to be aware of the significant practical challenges embedded in Chinese transfer pricing adjustment scenarios. These arise first in successfully passing the actual remittance of funds through China’s robust foreign exchange controls, and then in the potential resulting implications across the spectrum of different taxes.

There is no magic solution to ensure a smooth process. The best advice is sticking to the fundamentals of good transfer pricing practice.

Documentation is key in managing the transfer pricing risk profile and in forming the backbone of negotiations with the State Administration of Foreign Exchange.

Maintain proactive management of year-end adjustments. A strong operational transfer pricing framework and regular contact with the local regulators can facilitate a smoother adjustment process.

Ensure the adjustment is being comprehensively treated across its multiple aspects. Transfer pricing adjustments require careful handling from direct tax, indirect tax, accounting, and regulatory perspectives.

Complex Regulations

Transfer pricing adjustments in China are a complex web of regulations. Managing negotiations and interacting regulations among the following key government bodies is of paramount importance:

• the State Taxation Administration, STA, overseeing the collection of direct and indirect taxes and revenue
• the General Administration of Customs, GAC, overseeing the collection of import value-added tax and customs duties (collectively referred to as “import duties”)
• the State Administration of Foreign Exchange, SAFE, overseeing the regulation of foreign exchange market activities

Limited risk entities are a common feature of Chinese transfer pricing supply chains, with multinational enterprises historically favoring single-function entities to simplify their operations. In keeping with these arrangements, both transfer prices and year-end net profits must be monitored to satisfy the tax authorities.

Any transfer pricing adjustment must be supported by a watertight transfer pricing policy with proper documentation. This is particularly important if a downward adjustment is to be made, to withstand any potential challenge from the STA of erosion of the Chinese tax base.

Implementing upward transfer pricing adjustments is also a challenge. While these are more acceptable to the STA, the added complexity involves dealing with China’s foreign exchange controls, which are regulated by the local foreign exchange remittance banks and overseen by the SAFE.

Foreign Exchange Controls

Any significant remittance in or out of China must be approved by the banks and the SAFE. The process generally involves lengthy and exhaustive negotiation, with presentation of a significant amount of supporting documents.

The SAFE’s primary objective is to ensure that funds crossing the Chinese border have a legitimate commercial purpose. Its investigation will be aimed to ensure there is sufficient commercial rationale and documentation underlying the fund transfer.

Documents that should be expected for request include:

• an explanation letter to describe the circumstances surrounding the remittance, including the underlying commercial reasons, transfer pricing policy and economic analysis supporting the adjustment amount
• a special audit file to confirm the accuracy of the accounting treatment of the transfer pricing adjustment under local accounting standards, as well as to explain why the adjustment is necessary from an accounting perspective
• underlying calculations, contracts, and invoices related to the adjustment

The information included in these documents significantly overlaps with what would typically be included in a transfer pricing local file. Having robust local file documentation is therefore highly advisable from both a tax and foreign exchange remittance perspective.

Categories of Adjustments

A practical difficulty arising out of the remittance is that the adjustment must be disclosed and characterized according to pre-determined categories which—depending on the nature of the business and the adjustment—would be trading price adjustment on physical goods, service fee. or royalty.

Each of these categories leads to unique considerations and consequences.

Trading price adjustments. These would generally be implemented through a reduction in import price, which in an ideal world would be balanced out by a corresponding refund of overpaid import duties. However, in practice, such refunds are highly unlikely, as Chinese tax authorities are generally hesitant to refund retrospective amounts on taxes imposed.

Conversely, trading price adjustments that are implemented through an increase in retrospective import price (downward adjustments) will lead to additional import duties and potentially penalties and interest applied by the GAC. Early engagement with the authorities is recommended to navigate this process.

As tax supply chain planning gains prominence, Chinese regulators have reacted to increase cooperation and effectiveness. Most notably, a pilot scheme was launched in June 2022 in the commercial and trading hub of Shenzhen. This initiative created a framework for the Shenzhen Customs and Shenzhen STA to jointly evaluate the pricing of related party imports, ensuring holistic visibility and review powers over the naturally competing fields of transfer pricing and customs duties.

Service fee classification. This may create issues whereby the China entity is disclosing a service income where no actual service has been performed. From the overseas party’s perspective, this results in a service fee expense whose deductibility would be questionable given no actual benefit is being provided to the overseas related party.

Further, as Chinese VAT may need to be charged on the service fee and such VAT isn’t creditable in the overseas jurisdiction, this would result in a VAT leakage unless exemption is available.

Royalty payment. This is an inherently high-risk transfer pricing item susceptible to attention from tax authorities. The Chinese tax authorities focus on ensuring they are collecting a fair share of revenue derived from Chinese-owned or -developed intellectual property. As with service fees above, associated VAT and leakage consideration should also be given to royalties.

Given that disclosure options are limited to these three characterizations, a further challenge is apparent when disclosing these items on traditional transfer pricing documents, such as related party transaction disclosure forms and local files.

Disclosing the adjustment as a service fee and royalty in particular could give an initial impression that there are value-adding activities and IP in China. As these transactions are considered to be key profit-shifting tools, multinational enterprises should avoid giving such an impression.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Yvette Chan is a managing director with Alvarez & Marsal Tax in Hong Kong. With over 15 years’ experience advising on tax and regulatory issues, she has managed all aspects of domestic and cross-border transactions in the Chinese mainland and Southeast Asia.

Eu-Kim Chan is a senior director with Alvarez & Marsal Tax in Hong Kong. He has over 11 years’ experience in transfer pricing, corporate tax and private wealth planning, and has led numerous cross-border projects for multinational enterprises and high-net wealth individuals.

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