Many multinational enterprises whose supply chain is rooted in China have increasingly become interested in restructuring—to mitigate the impact of trade-related geopolitical tensions and address the rising costs of doing business in China.
Supply chain restructuring for MNEs in China typically entails the migration of manufacturing activities to other parts of Asia, especially Southeast Asian countries. MNEs often choose to perform outbound migration in stages and retain some production operations in China: The Chinese manufacturing activities retained are typically aimed at the Chinese market.
The scaling down of Chinese operations—as opposed to complete termination and exit—is the main scenario discussed here.
Tax Issues
Supply chain restructuring has important transfer pricing implications, as it leads to a reduction of profits in China. This can easily trigger the attention of Chinese tax officials.
In recent years, Chinese tax authorities have been implementing more stringent transfer pricing regulations to preserve their tax base and have been increasing their audit activities. To manage tax audit risks, MNEs considering supply chain restructuring should be prepared to deal with the relevant risk areas, adjust transfer pricing policies to reflect changes in their business operations post-restructuring, and maintain robust tax and transfer pricing documentation.
Key Factors to Consider
If existing intercompany manufacturing agreements with a Chinese subsidiary are canceled or renegotiated due to the restructuring exercise, and the resulting smaller business volume leads to a profit decrease for the Chinese subsidiary, one issue to evaluate is whether the subsidiary deserves compensation for the loss of future profit potential in an arm’s-length situation.
The Chinese transfer pricing regulations lack guidance in this area and therefore this argument hasn’t been frequently raised in audits. However, given the increasing involvement of the Chinese tax authorities in the development of the OECD transfer pricing framework, some local governments may begin to embrace this notion of compensation for future loss of profit, if the restructuring trend continues and creates a material impact on Chinese tax revenue collection.
Supply chain restructuring may change a Chinese subsidiary’s functions, assets, and risk (FAR) profile. Before restructuring, a Chinese manufacturing subsidiary may locally maintain valuable intangible property regardless of whether such IP is legally registered in China or recorded on its financial statements.
Where a restructuring involves the transfer of IP from the Chinese subsidiary to another affiliate contractually (or economically in the absence of an explicit transfer agreement), such transfer could attract Chinese income tax implications, potentially value-added tax and levies and stamp duty. The transfer value of the IP needs to meet the arm’s-length standard and should be supported by transfer pricing analysis.
If the outbound transfer of IP produces an infusion of cash that exceeds operating needs in China, ways to repatriate the excess cash in a tax-efficient manner should also be explored.
A modified FAR profile after the restructuring may require a different transfer pricing policy and revisions to legal documents or government applications that are tied to it.
For instance, if the Chinese subsidiary is a party to an advance pricing agreement with the local Chinese government based on the preexisting FAR profile, the restructuring may necessitate a renegotiation of the agreement. If the Chinese subsidiary enjoys tax or fiscal incentives tied to local IP ownership, the IP transfer may call for an adjustment of the income tax return position.
If the Chinese subsidiary is a contract manufacturer (or toll manufacturer) and experiences a significant sales decline after the restructuring because a chunk of its export sales is relocated overseas, the reduction in production volume may cause manufacturing capacity under-utilization and reduce both the profit amount and the profit margin in China.
Under the Chinese transfer pricing regulations, a contract manufacturer is classified as a “single-functioned” entity and isn’t expected to incur losses. The tax authorities expect any capacity under-utilization risk to be borne by the foreign principal entity within the group.
The Chinese contract manufacturer should monitor its operating margin after the restructuring and may wish to implement a year-end true-up mechanism to ensure the final operating margin falls within the targeted range that is used as a benchmark. The true-up mechanism needs to be carefully considered from not only the transfer pricing standpoint but also the Chinese customs and foreign exchange control perspectives.
Customs Issues
Where the supply chain restructuring results in the transfer of technology to China, the payment of consideration, relevant contractual terms, and operational handling of the transfer of technology should be entirely separated from any equipment, machines, tools, molds and other items imported into China to be used to take advantage of the technology received.
If uncertainty arises as to whether any technology is imported together with or applied to any imported physical item, China Customs may assert that the consideration should be factored into the customs value of the item imported, and that any customs duty and VAT payable on the importation of the item should be adjusted accordingly.
On the other hand, technology may be transferred out of China and a Chinese manufacturer pay for the use of the foreign principal or affiliate’s trademark, technology, and know-how through a royalty or license fee arrangement (based on a percentage of its sales revenue or otherwise).
If as part of this arrangement the principal or affiliate supplies physical goods to the manufacturer, the business should take precautions to ensure that the royalty or license fee payment isn’t linked to the imported goods such that the royalty or license fee payment becomes liable to be added to the customs value.
Implementing transfer pricing adjustments relating to the purchase and import of goods—including raw materials, components, equipment, machinery, finished goods sourced from outside of China, etc.—would have corresponding implications for the customs value of the goods.
Post-importation transfer pricing adjustments relating to imported goods are becoming increasingly challenging and should generally be treated as the last resort to address a company’s transfer pricing compliance requirements.
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
Abe Zhao is a tax and transfer pricing partner and Frank Pan is a partner at FenXun, Baker McKenzie’s joint operation platform partner in China.
Ivy Tan is a tax, trade and customs lawyer at Baker McKenzie Wong & Leow, member firm of Baker McKenzie in Singapore.
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