China's transfer pricing regulations have been in place for approximately five years. During that period, both the tax authorities and taxpayers have seen major changes in the transfer pricing documentation, audit, and advance pricing agreement (APA) environments, as both groups developed their understanding of the regulations.
Transfer pricing remains a high priority for the State Administration of Taxation (SAT). The SAT has seen success with audits, bringing in significant adjustments across a wide range of taxpayers, and will likely continue to pursue multinational companies that don't get their transfer pricing right.
Transfer pricing documentation
The preparation of contemporaneous transfer pricing documentation is now accepted as part of taxpayers' annual compliance obligations. Despite taxpayer's acceptance of the need to prepare it, the tax authorities have commented on the low quality of some documentation, and the absence of specific information. To counter this, some local tax authorities have organized seminars with companies and advisors to discuss specific expectations and requirements for documentation. These authorities have told taxpayers that they will score the documentation, and let companies know if their reports do not meet expectations.
In addition to requiring higher standards for documentation, China's tax authorities are consistently requesting the submission of documentation after the May 31 deadline passes. The acceptance of the need to prepare documentation, and predictable deadlines for submission have resulted in an increasingly efficient process that should continue to be refined in the future. However, challenges will remain for companies with highly variable or loss-making operations, especially if they treat transfer pricing as an afterthought.
Tax authorities are following up on documentation that is submitted, with a focus on typical transfer pricing issues such as the overall profitability of companies and high-risk transactions. With appropriate support, taxpayers are increasingly able to deal with straightforward follow-up questions, and the two sides can agree on mutually acceptable outcomes. However, when there are fundamental or particularly significant issues, these can become major disputes.
In-charge tax authorities have consistently been prepared to follow up when they are dissatisfied with a taxpayer's transactions or overall results. When the authorities seek an adjustment, it is fairly typical that some additional tax will end up being paid, although the amount will depend on the arguments the taxpayer can make to support its original position. These adjustments can be made formally through the tax returns, although sometimes the tax authorities have preferred voluntary payments of tax or so-called "self-adjustments" instead.
The SAT has introduced policies and procedures for large adjustments to be reviewed by an experienced panel of tax officials from across China, to ensure that adjustments are reasonable and follow Chinese regulations. Ultimately, the best way to deal with audits is still to avoid them entirely – by ensuring consistency with group pricing policy, maintaining stable and reliable profits for simple-function companies in China, and preparing high-quality documentation.
The SAT has made progress in advancing China's APA program in recent years. Although there are only a handful of officials responsible for dealing with APAs, some significant and novel APAs have been concluded.
Taxpayers have also gained some transparency regarding the APA process following the publication of the annual APA statistics for the last three years. These reports contain a full range of statistics on the number of and type of APA applications received and concluded. The statistics have shown that there is a large backlog of APA cases, which is consistent with recent evidence that more straightforward APA requests are not likely to be accepted, especially when the application is for a unilateral APA.
Companies are still being encouraged to consider APAs, and those with large transactions and complicated or novel fact patterns can be confident that their applications will have a better chance of proceeding.
China's position on specific transactions
Like many other emerging markets, China sometimes takes a different technical position than the OECD transfer pricing guidelines. The release of the China country section of the UN Transfer Pricing Practice Manual put forward many of China's positions on technical issues, and has provided some insight into how taxpayers should approach these matters.
The biggest issue raised by China relates to location-specific advantages; questions regarding this issue are being raised during audits and APAs negotiations. Specifically, the tax authorities focus on location savings that firms can obtain by operating in China. The SAT's comments on this topic outline several examples and prescribe a four-step process that taxpayers should use to calculate the extra margin that should be earned in China because of location-specific advantages. This is still a technically controversial issue, with differences of opinion about the countries to use for cost comparison, and how to treat cost savings that are passed on to the ultimate customers. It will still take some time until a consistent approach for dealing with these issues can be agreed upon, and even then there will be some subjectivity involved.
Where to next?
Transfer pricing in China has come a long way in a few years, and there is still a lot of development to come. While the tax authorities previously focused on manufacturing and distribution companies, they have started paying more attention to service providers, and to more complicated transactions. As the rest of the world starts to reconsider international tax and transfer pricing policy, China will continue to pay attention to the OECD, but will most likely continue to adopt positions it considers appropriate for China.