Transfer Pricing in China: 5 Things All Foreign Companies Doing Business in China Should Know

Transfer pricing, the prices of transactions between related or affiliated enterprises, especially where they are based in different countries, is strongly regulated in China. 

Here, we explain the key things you need to know, as regulated by the China Corporate Income Tax (CIT) law and its Implementation Regulations (DIR). 

Overview of China Transfer Pricing

Fueled by international initiatives such as the BEPS (‘Base Erosion and Profit Shifting’) Action Plan by the OECD, transfer pricing has become a topic of increasing importance for companies all over the world. Though China is not a member of the OECD, they have also followed OECD recommendations, and in 2016, via ‘Bulletin 42’, introduced a range of rules and regulations for transfer pricing. This includes the key requirements for transfer pricing documentation, when certain thresholds are set,  as specified in the BEPS Action Plan 13.

Though in the past transfer pricing was mostly a topic of concern for larger multinationals, as a result of these global developments transfer pricing has also become a topic of increasing importance for small and medium-sized enterprises.

In our experience, however, many SMEs still lack the knowledge and understanding of transfer pricing, particularly in a China setting.

To help increase the understanding of transfer pricing in China, we have compiled a list of 5 things all foreign companies at least should know about transfer pricing:

1. Basic Transfer Pricing Terminology

When two associated enterprises (such as subsidiaries in an international group) do business with each other, the prices used in between are referred to as the ‘transfer price’. There is a risk that to increase profitability, companies could choose to assign high profits in countries with low tax rates, and lower profits in countries with higher tax rates. As this can be seen as a form of tax avoidance, many countries have implemented various rules and regulations to make sure companies pay the appropriate amount of corporate income taxes on their corporate income in each location. 

The fundamental principle in transfer pricing is the “arm’s length principle”. In Article 9, paragraph 1 of the OECD Model Tax Convention, this term is described as follows:

[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.

This means that, the fact that a transaction is between associated companies, should not have any impact on the (transfer) price of the goods or services: Transactions should be priced according to similar or identical market conditions. This is generally known as the ‘arm’s length’ principle. To determine the amount of profits to be allocated in transactions between associated enterprises, a calculation is made, based on the functions, risks and assets of the companies concerned. This ensures that high (profit) margins on commercial transactions between associated cannot be shifted to ‘shell holdings’ (no activities or employees) registered in countries where either no or low Corporate Income Tax is levied.

2. Master File and Local File

Following Bulletin 42, companies that meet the thresholds are required to prepare mandatory Transfer Pricing documentation in China. The main mandatory reports are what is called the ‘Master File’, which serves as an overview of a multinational group’s Transfer Pricing policies and activities, and the ‘Local File’ which focuses on the local company (i.e. in China) and intercompany transactions between the local company and associated companies in other jurisdictions.

The specific thresholds for these reports are as follows:

1. Master File: Companies that either have annual intercompany transactions with a total amount exceeding RMB 1 billion, or where the ultimate holding company has prepared the Master File, need to prepare this document. This document should be completed within 12 months of the end of the fiscal year of the ultimate holding company and should be submitted to relevant tax authorities within 30 days upon their request. This document needs to be delivered in Chinese. When the Master File of a foreign company is requested by the Chinese tax authorities, this document needs to be professionally translated and drafted according to Chinese standards.
2. Local File: This document needs to be prepared when transactions exceed for  200 million RMB for tangible goods, 100 million RMB for financial assets transactions, 100 million RMB for intangible assets and 40 million RMB for any other type of related party transaction. This document needs to be prepared by 30 June after the fiscal year that the related party transactions take place.  In addition, this document would need to be submitted within 30 days upon request from the tax authority in China and delivered in Chinese. This document investigates in detail whether the intercompany transactions have been carried out according to the arm’s length principle. This document also requires that a value chain analysis is submitted. 

3. Additional Transfer Pricing Files: Country-by-Country Report, Special File, Advanced Pricing Arrangements

Tax authorities might also request other Transfer Pricing files, which are the Special Files, Country-by-Country Report and Advanced Pricing Arrangements (APAs). These documents are, however, mostly of concern for large Chinese enterprises or very large foreign multinationals active in China. Foreign SMEs should normally not be required to prepare any of these files. To provide a better understanding, we have explained these reports briefly below:

1. Country-by-Country Report (CbCR): Companies that need to prepare this report are the ultimate holding company of multinational groups with consolidated financial statements of the last accounting year exceeding RMB 5.5 billion or when the Chinese enterprise has been named the Reporting entity. If a company is not required to file the CbCR, the multi-national group it belongs to is required to prepare the CbCR, which the tax authorities have the right to request during special tax investigations under various circumstances. Though this document is not of primary concern for small enterprises, it remains important for enterprises of different sizes to have a good understanding of the CbCR. This report provides an overview of all the financial results, tax planning, and relevant information regarding all operating subsidiaries in different countries. Small enterprises that belong to large groups, even if their activities in China are very limited, should bear in mind that this financial information can be requested by the tax authorities.
2. Special File: Companies that have cost-sharing arrangements and record a debt-equity exceeding the prescribed limit, are required to prepare a Special File by 30 June following the year when these related party transactions have taken place or within 30 days after request of the relevant tax authorities. Since for foreign companies in China their overseas borrowings cannot exceed the prescribed debt-equity ratio, these files are expected not to become a burden for foreign companies in China.
3. Advanced Pricing Arrangements (APAs): As the name mentions, these are advanced arrangements with the Chinese government to confirm that pricing adheres to the arm’s length principle. Companies which have entered into these arrangements do not need to prepare Local or Special Files. This is mostly a concern for large enterprises which have the resources to establish these agreements with the local government. For most foreign SMEs in China, this will not be applicable. 

4. Transfer Pricing with ‘Chinese Characteristics’

Though most recommendations from the OECD BEPS Action Plan have been followed, Chinese tax authorities have, in several areas, applied their own interpretation and requirements on Transfer Pricing.

For instance, within the Local File, a value chain analysis is specifically requested. To deal with this particular request, you need to decide strategically which information or details to provide. An experienced Transfer Price consultant will be able to draft the value chain according to the requirements set by the local tax authorities.

Specific emphasis is also placed on the location-specific advantages of China: It seems common for the Chinese tax authorities to assume that the opportunities to sell products locally, i.e., market premium, and the vast array of workers and production opportunities would provide more functions to the Chinese entity and therefore more profit need to be allocated to the local enterprise. Companies active within the automotive industry in China, especially, have experienced these interpretations in their dealing with the tax authorities.

5. Future Trends for Transfer Pricing in China

Though preparing Transfer Pricing documentation is not of concern to all foreign enterprises active in China, it remains important – by Chinese law – that all commercial transactions are priced according arm’s length principle. If not, the tax authorities can request the companies to make an adjustment accordingly.

The global tax landscape is increasingly moving to one where companies need to have a genuine commercial substance, rather than existing simply for tax benefits. For example, having your intellectual property rights and patents owned by a British Virgin Islands (BVI) or Hong Kong holding company, which does not have any significant activities, purely for the tax benefits, is increasingly infeasible. 

We can expect that given the size of the market and the increasing powers of the China tax authority will become with the support of technologies and better processes more equipped to investigate transfer pricing issues and is expecting to gain a more tightening grip on these practices.

At this moment, companies which can provide a wide range of Transfer Pricing services remains limited to few boutique firms and the Big Four companies. These companies can have the resources and projects to take on these assignments with their staff. Many companies can provide consulting support on Transfer Pricing, but rather have the ability to provide full TP documentation support according to Chinese standards.

Our thoughts

Though Transfer Pricing documentation is not of concern to all companies active in China, all companies should be aware of the basic principles and requirements as promulgated by the Chinese tax authorities. Enforcement of transfer pricing is not only increasing within China, but within jurisdictions all over the world. Particularly when looking at this development is that maintaining substance and reasonable profitability of the companies within the group becomes very important. It is therefore vital that companies have formulated their right transfer pricing strategies and policies to be in line with these global developments.

Within MSA we have qualified professionals to provide you strategic advice and consultation on transfer pricing. If you are not sure if your company is well in line with the transfer pricing policies or want to understand if your company is meeting the transfer pricing documentation thresholds, please do not hesitate to contact us at [email protected].