The Covid-19 pandemic has wreaked havoc on the world economy and disrupted global supply chains. Multinational companies (MNEs) are at the forefront of the impact. For MNEs fortunate enough to have advance pricing arrangements (APAs) with the tax authorities in jurisdictions they operate in, they may find themselves in a different position from where they were at the time their APAs were negotiated and may feel the urge to revisit their APA position.
Governments all over the world are taking actions, and their responses to the pandemic have created challenges for the application of the arm’s-length principle, which is the core of the long-standing international norm in transfer pricing. To address such challenges, OECD released the Guidance on the transfer pricing implications of the Covid-19 pandemic (OECD Covid-19 TP Guidance), providing some guidelines for dealing with transfer pricing issues, including APAs in the time of the pandemic.
China, so far, has not issued its own guidance on transfer pricing (including APAs) in response to the pandemic. However, like many other things, no guidance does not mean no action. What we have observed in China is that the PRC State Taxation Administration (STA) has started reviewing existing APAs, and some taxpayers have already taken steps to amend/revise the APAs. With 2020 behind us, the deadline for filing annual tax returns is fast approaching; it is time for MNEs impacted by the pandemic to look back and decide if they are to follow the terms of the APAs, or depart from them in their annual returns.
The Pandemic’s Impact on the Arm’s-Length Rate of Manufacturing Industries
According to the 2019 China Advance Pricing Arrangement Annual Report published by the STA, the vast majority of APAs signed by the STA in the past 15 years adopt the transaction net margin methods (TNMM), including full cost mark-up (96 of 208 APAs, representing 46.15% of all APAs signed). Such choice of transfer pricing method is consistent with the profile of the industry sectors involved—141 APAs pertain to the manufacturing industry.
The application of TNMM heavily relies on the use of comparable data. Drastic changes in the economic environment brought about by the Covid-19 outbreak could result in significant changes to the business conditions for a covered transaction, compared to those of the selected comparables for prior years. During the pandemic, if the applicable TNMM rate in an APA is a range wholly or partly determined by prior year data of selected comparables, the range may no longer reflect an arm’s-length price in the Covid-19 period. While some of China’s APAs that apply multiple year data and multiple year averages on a rolling basis for benchmarking may imply that the results have already, to some extent, absorbed the Covid-19 shock, the mere adoption of a weighted averaging method may be insufficient to produce a reasonable arm’s-length benchmark in light of the pandemic’s broad implications.
Although the China APA template does not list critical assumptions, the STA typically includes force majeure and economic downturns as a breach of critical assumptions in the APAs. If a taxpayer wishes to rely on the breach of a critical assumption to revise (or even terminate) an APA, the taxpayer is required to report the material change affecting the APA to the STA, technically within 30 days of commencement of the material change. For a taxpayer contemplating a revision, it is advisable to approach the STA as soon as possible to discuss the impact of the material change on the implementation of the APA and explore with the STA the possibility of making appropriate adjustments to the pre-agreed benchmark range under an APA, and where appropriate, of having separate testing periods for the duration of Covid-19 influence.
Considerations Specific to Limited Risk Entities
Some of the manufacturing entities in China that are party to an APA are profiled as single-function, limited risk manufacturers. The STA has consistently taken the position that limited risk entities (LRE) as such should not make any loss at any time. Consequently, an LRE’s reporting of losses is often taken by the STA as an indicator of a potential breach of transfer pricing regulations, where the LRE belongs to an MNE group and partakes in related party transactions. In selecting comparables for the purpose of benchmarking, the STA frequently excludes loss-making companies from forming part of the comparables that the LRE is benchmarked against.
However, the unprecedented business disruption brought about by the pandemic has caused manufacturers, including LRE manufacturers, to be ordered or forced to suspend production for a certain period(s) of time. In that regard, paragraph 40 of the OECD Covid-19 TP Guidance seems to suggest that where the relevant losses pertain to risks assumed by an LRE, a loss-making position of the LRE may still be regarded to be at arm’s-length. As China has not issued any domestic transfer pricing guidance relating to Covid-19, nor have senior STA officials officially endorsed the OECD Covid-19 TP Guidance, it remains to be seen whether the STA may shift its long-held beliefs regarding LREs in APA negotiations for these exceptional times and possibly beyond. Still, taxpayers may consider raising the relevant counter-arguments from the OECD Covid-19 TP Guidance when discussing with the tax authorities the application or revision of an APA.
Possible Covid-19-related Location-specific Advantages in China?
The STA frequently alludes to China’s location-specific advantages (LSA) during APA negotiations, to make a case that the Chinese tested party deserves a return in addition to the benchmark range derived from comparables. According to the China Chapter of the United Nations Practical Manual on Transfer Pricing for Developing Countries, one of the main transfer pricing challenges identified by the STA is the lack of reliable comparables to adequately reflect China’s LSA. According to the China Chapter, LSAs are “advantages for production arising from assets, resource endowments, and the government’s industrial policies and incentives, etc., which exist in specific localities.”
China’s relative success in its resumption of business after nationwide lockdown measures were lifted around the second half of 2020, has made it the only major economy reporting GDP growth in 2020. In the past, the STA has focused on “location savings” and “market premium” in applying the concept of LSA. It is unclear whether the more favorable economic conditions in China during the pandemic could become a Covid-19 specific China LSA, if the STA considers the economic conditions faced by the comparables to be so different from that of the Chinese tested party’s for the covered transaction in an APA that it warrants an LSA adjustment. Under the right facts and circumstances, taxpayers should prepare to address a potential position from the tax authorities related to Covid-induced LSA during an APA negotiation.
STA’s Acceptance of Technological Cross-border Communications Solutions
Without official guidance from the STA, much remains uncertain as to China’s attitude towards the application of substantive transfer pricing principles in the Covid-19 era, including how APAs may be affected. What can be said with a degree of certainty, is the STA’s gradual acceptance of technological solutions (e.g., virtual conferences) to substitute traditional face-to-face meetings for APA (and mutual agreement procedure) discussions, whether for communications with other competent authorities or the taxpayers. The growing complexity in international tax and transfer pricing practice, such as the assertion of new taxing rights associated with the digitalized economy and the possible introduction of global anti-base erosion rules (i.e., the OECD Pillars One and Two proposals), could beckon an age of cross-border tax and transfer pricing disputes. The STA’s adoption of telecommunication means to discuss, negotiate, and try to resolve bi-lateral and multi-lateral disputes is definitely a welcome development.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Shanwu Yuan is an international tax director at Baker McKenzie. Jason Wen is an international tax director at Baker McKenzie FenXun (FTZ) Joint Operation. Abe Zhao is an international tax director at Baker McKenzie FenXun (FTZ) Joint Operation. The authors would like to thank Lydia Peh of Baker McKenzie for contributing to the article.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.