Insights into the forthcoming China transfer pricing ruling

China's new Corporate Income Tax (CIT) Law and its Detailed Implementation Rules (DIR) both came into effect on 1 January 2008. These have allocated an entire chapter - chapter six: Special Taxation Adjustments - to the subject of transfer pricing. The 23 clauses under this heading (eight in the CIT Law and 15 in the DIR) introduce and formalise a transfer pricing framework in China for the first time.

On 21 March 2008, the State Administration of Taxation released the Draft Administrative Rules for Special Taxation Adjustments for public discussion and comment. Designed to provide guidance on some practical issues not covered by the CIT Law or DIR, they also sent out a clear signal that China will continue to improve its transfer pricing regime and enforce it more vigorously.

This article offers some insights into the Draft Rules. Although these might be revised in the final version, their material aspects are likely to remain intact. So taxpayers should use them as the basis to start planning for compliance.

Key provisions of the Draft Rules
The Draft Rules consist of 13 chapters. Besides being directly linked to the Special Taxation Adjustment Chapter in the CIT Law, they summarise the previous transfer pricing regulations of China. Their key stipulations - and the immediate implications for taxpayers in China - are as follows.

A.	Contemporaneous documentation and disclosure
	The main emphasis of the Draft Rules is on contemporaneous documentation. Under the CIT Law, this has now become a legal obligation not a "voluntary action". However, the Draft Rules stipulate a di minimis (a minimum level below which documentation is legally exempted) as well as two documentation thresholds. These are based on the following criteria:
		exempted - related-party transactions with a total annual value of RMB20 million and related-party transactions within mainland China;
		simplified documentation - related-party transactions with a total value of between RMB20 million and 100 million a year; and
		standard documentation - related-party transactions with a total value exceeding RMB100 million a year.
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	Simplified documentation means that the parties concerned need to supply standard information about their organisational structure, pricing policies, market conditions and profit-sharing arrangements, as well as functional analysis, related-party transactions analysis, the transfer pricing method that has been adopted, comparable analysis and other factors that affect arm's length prices and profits. Standard documentation requires many more details. Besides the standard items above, a wide range of overseas information is required, such as the global structure of the group concerned, resale prices and the allocation of profits from related transactions throughout the supply chain. Naturally, this type of information is sensitive, and it may not be easily accessible to the local entity. When they are implemented, the Administrative Rules for Special Taxation Adjustments will become retroactively effective from 1 January 2008. This means the legal deadline for completing documentation for the fiscal year 2008 will be 30 May 2009. Companies may keep such documentation - which must be in Chinese - in-house, but they must submit it within 15 days if the tax authorities request it. Besides setting out the documentation required, the Draft Rules contain a set of transfer pricing filing forms that are applicable to all taxpayers. These forms need to be submitted during the annual income tax filing. They include a list of related parties, as well as full details of related-party transaction volumes (listed under different types of transactions), outbound investments, "thin capitalisation" and "controlled foreign corporations" (CFCs). Taxpayers are also required to indicate in the transfer pricing filing package whether or not they have completed the transfer pricing documentation. There is speculation that the abovementioned di minimis and thresholds may be changed. Even so, entities with significant, cross-border related-party transactions are now obliged to document and disclose details of them.
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B.	Transfer pricing audits and tax adjustments
	The Draft Rules introduce a more standardised approach to transfer pricing investigations and audits by the Chinese tax authorities. Taxpayers should pay particular attention to the following points:
		a number of standardised forms will be used for transfer pricing audit purposes, including functional and risk checklists, segmented income statements for related and unrelated businesses, and entity characterisation;
		transactions with domestic affiliates who have the same effective income tax rate may not be chosen for transfer pricing audits;
		taxpayers who fail to prepare contemporaneous documentation may be subject to a transfer pricing audit;
		the tax authorities could determine a "deemed profit adjustment" (i.e. mandate a taxpayer's arm's length profitability) if it fails to provide accurate and complete transfer pricing information on request;
		if an audited entity's profitability falls below the median of a range established by comparables, its profitability should be adjusted to a level no lower than the median (this is very different from the international norm that an arm's length range extends from the lower quartile to the higher quartile, not from the median);
		the post-audit monitoring period has now been extended from three years to five.
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	The threshold for the documentation requirement should not be confused with that of the transfer pricing audit. There is no di minimis level for transfer pricing audits. In fact, a growing number of transfer pricing investigations and audits have been conducted in China in the past few years, and this trend will continue with the new CIT Law and transfer pricing rules. At the same time, the tax authorities are growing more sophisticated about transfer pricing audits. They no longer consider only tangible transactions. Intangibles (such as technology royalties and marketing intangibles), services, and intercompany financing have also become routine targets. Tax adjustments that result from transfer pricing audits are now subject to interest, plus an additional penalty of 5%. However, the penalty may be waived if an audited entity has compiled contemporaneous and sufficient documentation. The implication of this is obvious: even in a worst-case scenario when a taxpayer has undergone a transfer pricing audit and its income tax liability has been adjusted, the existence of well-prepared documentation will still reduce its loss.
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C.	Other important updates
	The Draft Rules also expand the definition of a related party. They stipulate the criteria for applying APA, and introduce such pioneering concepts as CCA, CFC, "thin capitalisation", etc. We can expect more cases concerning these to occur when the final rules are released.

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The immediate implications for taxpayers
The recent and significant updates of tax and transfer pricing legislation mean that China's transfer pricing environment is changing and it is becoming more stringent and regulated. Taxpayers should be aware of these crucial updates for both compliance and planning purposes. Although it is never too late for them to start examining their transfer pricing system, we suggest they begin the exercise sooner rather than later because it could save them significant financial and administrative burdens.

Why new entities and businesses should plan ahead?
Devising a new and sustainable transfer pricing policy should be a top priority for newly established entities and business lines. With new transfer pricing rules in the pipeline, they need to consult external transfer pricing advisors and prepare transfer pricing studies. Such steps will help them to maintain solid and arm's length transfer pricing mechanisms from day one, while simultaneously satisfying future compliance requirements.

Existing entities with related-party transactions below the threshold still need to evaluate the risks
Entities whose related-party transaction volumes fall below the di minimis threshold are exempted from legal documentation obligations. However, the following are advised to start a risk-evaluation process right away:

	entities with recurring losses - especially those with contractual relationships to related parties, such as contract manufacturers and contract service providers;
	entities whose profitability fluctuates - especially those whose profits have consistently declined in recent years;
	entities with substantially different profitability levels on third-party and related-party transactions;
	entities that engage in transactions with domestic affiliates who have different effective tax rates; and
	entities whose profits fall upon the expiry of tax holidays.

Such entities may wish to start preparing documentation or conduct planning studies immediately if they have a certain level of China transfer pricing exposure.

Existing entities with significant related-party transactions must document them appropriately and make improvements if necessary
Entities that engage in significant numbers of related-party transactions are advised to prepare transfer pricing documents appropriately and contemporaneously, as they are now legally obliged to do so. Transfer pricing compliance for groups with a large number of subsidiaries in China can be particularly time-consuming and burdensome, so they should promptly seek professional advice about the best documentation strategy.

Although the Draft Rules may be changed in the coming months, the time to act is NOW. Otherwise, businesses may find it too late to effect proper transfer pricing policies and practices.

Rose Zhou
Transfer Pricing
rose.zhou@grantthornton.com.cn

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