Transfer Pricing in China
Transfer pricing is one of the more important international tax issues for many businesses. In an effort to combat tax base erosion and shifting of profit, there has been enhanced focus on developing stricter enforcement measures, by the Chinese authorities. Transfer pricing, which is often a problem with multinationals and larger corporations, is becoming more prevalent for SMEs operating in China.
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Framework of Transfer Pricing in China
Transfer pricing has to do with the prices which are applied when a company is making a transaction between related enterprises within itself, where the enterprises are operating in different tax jurisdictions.
In order to determine if an enterprise is related to another, the following definitions have been provided for “associated relationships”, according to Chinese law:
- Party A has direct or indirect ownership of more than 25% of equity interests of party B;
- Direct or indirect ownership by a third party of more than 25% of equity interests in party A and party B;
- The existence of loans provided by party A which represents more than 50% of the total paid-up capital of party B;
- Party B is dependent on the proprietary technologies of party A for its business activities;
- Party A has control of purchase and sales activities or services of party B;
- Over half of the directors or senior management personnel party A have been appointed or concurrently hold dual positions with both party A and party B;
- Control of activities of party B through other means, such as family members or relatives;
- Two parties who are not directly connected but may have other substantial common interests.
What is the Purpose of Transfer Pricing?
The main objective of transfer pricing regulations being implemented, is to avoid profit shifting between entities based in higher-tax jurisdictions to lower-tax jurisdictions, where there is limited economic activity, which allows entities to avoid the tax liable in the higher-tax jurisdictions.
The fundamental principle in transfer pricing is the “arm’s length principle”. According to this principle, taxpayers should be able to effectively demonstrate that transactions between the parties related are treated and priced similarly to transactions with unrelated third parties.
Is Transfer Pricing Allowed in China
Although China is not a member of the OECD, a transfer pricing framework has been developed by Chinese authorities which has been adapted from the OECD Base Erosion and Profit Shifting (BEPS) Action Plan 13, incorporated with various local transfer pricing regulations. The Chinese transfer pricing framework is primarily made up of two distinct aspects:
- Related party transactions, which must be disclosed during annual CIT filing and annual reporting; and
- Transfer pricing documentation, which is to be prepared by those enterprises exceeding the established thresholds.
Transfer Pricing Documentation in China
In 2016, the Chinese State Administration of Taxation (STA) introduced a 3-tier transfer pricing documentation framework, which was set out in ‘Bulletin 42’, which consisted of the
- The Master File
- The Local File
- Country-by-Country Reporting
Additionally, any further documentation that is requested in line with Chinese requirements.
Following Bulletin 42, enterprises are required to prepare mandatory transfer pricing documentation once specified thresholds have been exceeded. Below we provide an overview of the specific transfer pricing documentation and their respective thresholds.
The Master File is the main transfer pricing documentation that serves to detail the transfer pricing policies and activities of larger multinational corporations. A Master File must be prepared by Chinese enterprises and must meet specific requirements.
A Master File must be prepared in Chinese and in accordance with Chinese legislation, and should include details on:
(1) the investment structure;
(2) description of the group business activities;
(3) the group’s intangible assets;
(4) the group’s financing activities; and
(5) financial information and tax status of the group.
A Local File has its focus on the Chinese company and the intercompany transactions between the Chinese company and the related company based in another tax jurisdiction. A Local File must be prepared by the Chinese enterprise if any the following thresholds are met:
- If the Chinese enterprise has annual related party transactions of tangible goods exceeding RMB 200 million;
- If the Chinese enterprise has annual related party transactions of intangible assets exceeding RMB 100 million;
- If the Chinese enterprise has annual related party transactions of financial assets exceeding RMB 100 million; or,
- If the Chinese enterprise has annual related party transactions of any other type exceeding RMB 40 million.
The Local File will include details regarding the organizational and shareholding structure, information on business operations, the business strategy of each department/business segment and financial data of each type of business or product, and more.
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Chinese companies may also be required to prepare Country-by-Country Reporting in the following circumstances:
- The Chinese resident company is the ultimate holding company of a group with consolidated revenue which exceeds RMB 5.5 billion in the previous accounting period; or,
- The Chinese company is nominated as the Country-by-Country reporting entity by the holding group.
In addition, the Chinese subsidiary of a group may be required to submit Country-by-Country reporting if the groups ultimate holding company must prepare the Country-by-Country reporting according to the regulations of the jurisdiction it resides in and one of the following conditions is met:
- The group has not provided the Country-by-Country reporting to the taxation authority of any jurisdiction;
- The group has submitted the Country-by-Country reporting, but the jurisdiction in which the reporting is submitted does not have an information exchange mechanism with China; or,
- If despite the group having submitted the Country-by-Country reporting and the jurisdiction in which the reporting is submitted has an information exchange mechanism with China, but the reporting has not been successfully exchanged with China.
The content of the Country-by-Country reporting forms is in line with OECD BEPS Action Plan 13 and must be submitted with the in-charge tax authority by May 31st of the subsequent fiscal year.
If Chinese enterprises meet the following requirements, they would additionally be required to prepare the Special File:
- The Chinese enterprise has a cost sharing arrangement; or,
- The Chinese enterprise has exceeded the related party debt-to-equity ratio (5:1 for financial institutions and 2:1 for other enterprises).
The Special File should be completed by 30 June of the following fiscal year.
Related Party Transactions
In addition to the previously mentioned transfer pricing document requirements, during the annual CIT filing and annual publication reporting, all foreign-invested enterprises in China should submit the “Enterprise Annual Reporting Forms for Related Party Transactions of the People’s Republic of China” and these are referred to as the so-called “Local File”. The Local File consists of 22 forms including Country-by-Country reporting forms and others detailing related party transactions. According to Chinese regulations these forms should be submitted by May 31st of the subsequent fiscal year.
Transfer Pricing Methods
The arm’s length principle is the most fundamental principle of selecting an appropriate transfer pricing method. In accordance with Chinese regulations, the following transfer pricing methods are identified:
- The comparable uncontrolled price method;
- The resale price method;
- The cost-plus method;
- The transactional net margin method;
- The profit split method.
Chinese regulations do not prescribe a hierarchy for the selection of an appropriate transfer pricing method and other methods can also be applied if they are justifiable and appropriate.
Transfer pricing issues are closely connected to an entity and the rules concerning the diversion of profits tax. Therefore, it is important for any business that has a China operation, to consider the above-mentioned aspects and how it may affect them.
How Moore MS Advisory Can Help
As your partner in China, we provide assistance with transfer pricing advisory which includes facilitation of the selected transfer pricing method, preparation and submission of master and local files and more. Get in touch with us right away and our consultants can help with all your transfer pricing needs.
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