Transfer Pricing in China

Since our publication of Transfer Pricing Audits in China (Palgrave Macmillan, 2007), over a decade of economic growth and the completion of a welter of spectacular and specific achievements in China have taken place. They have given the country a more vibrant, modern, and prosperous appearance, functionally improving facilities for those who travel there, as well as for the country’s innumerable citizens, including those new classes of citizens which have produced them or have prospered from their existence.

A multinational group has its original company and headquarters in Country A. It founds companies in foreign countries B, C, and D, as in Fig. 2.1, supplying them with assets at their foundation and then continuously when they are operating normally, variously exchanging assets from them in due course. They remain related to the original company in Country A.

China has been deluged by world industries large and small. China’s experience over nearly half a century had been to differentiate between industries according to their practices, products, and potential. The following summaries reflect Chinese findings, attitudes, legislative requirements, and expectations regarding the most important of the multinationals trading in the country, including issues of transfer pricing.

A procurement agent is usually engaged entirely in procurement service activities, but the agent may also be involved in the selection of suppliers of materials. The suppliers’ relationship may not be an important intangible or the value driver for a procurement agent. The agent is responsible for passing the orders from the end buyers to the most appropriate suppliers, monitoring the suppliers’ production procedures, inspecting product quality, and ensuring the completion of orders.

When a company operating in China under foreign ownership sets out to comply with the prevailing regulations over transfer pricing, it is able to choose an appropriate pricing method from a range of five. All these methods are used to assist a company in China to identify the required arm’s length price for any traded asset imported from, and exported to, a related foreign company.

Against the background of the vicissitudes of ongoing global economic life and the consequent pressure on national budgets, it is hardly surprising that the tax authorities are continuing to increase the focus on transfer pricing. China is certainly no exception to this trend. Therefore, taxpayers in China—both outbound and inbound investors—need to place the management of their transfer pricing high on the list of their priorities. The following steps will be to their advantage.

A number of important changes in the international economic scene and internally in China itself have had an impact on the policy of the Chinese government toward transfer pricing, acting through its State Administration of Taxation. In short, recent years has produced an intensity of determination and physical effort to counter every tax evasion tactic and gather the taxation due from the economic sources in question.

Over the past decade, China has seen a rapid growth of outward-bound direct investment and has now become the world’s fifth largest investor. Shuanghui International, a privately owned meat processing company headquartered in Luohe, Henan, China, made a successful acquisition of the world’s largest pork producer, Smithfield Foods Inc., at a price of USD 4.7 billion, attracting worldwide attention. In Britain, Chinese interest has been in water, trains, cars, and electricity enterprises.

A German parent company is engaged in the research and development, production, and distribution of information technology products. Its Chinese subsidiary company provides the software development services for the parent company.

It would normally be assumed that a huge economy like China would find the largest single source of its inward foreign direct investment had come from other substantial economies around the world. Surprisingly, two small countries have led the list. Hong Kong was the top economy to make foreign direct investments into China in recent years, followed by Singapore.

In common with many other large enterprises, a multinational group founded a company in China, taking advantage of local resources, including land at a discounted cost, building-construction labor and materials, and operating labor at various levels. It was classed as a manufacturer of high-technology products, selling its output to an associated company in the group overseas and to internal markets.

Of the four categories of assets that can enter into the transfer transactions between companies and become the subject of transfer pricing arrangements, the one with the least precision of definition with its many items is services.

A multinational group with widely diversified commercial interests established a company in China for the manufacture of kitchenware. The many potential items included in this domestic consumption category gave plenty of scope for local job applicants with engineering skills and design expertise to serve the market of householders, at home and abroad, who were eager to beautify their homes and use their kitchen implements and appliances with efficiency and safety.

The multinational group produces and distributes printers and related consumable products worldwide. It opened a Chinese company for the manufacture of printers, taking advantage of the various concessions and incentives, which certain parts of China offered. In trying to dominate the international market, the group looked on the new company in China as its source of the lowest possible cost of producing printers to be marketed internationally.

Some features of the pharmaceutical industry are unique. Internationally, it is subject to high regulation in terms of permission to proceed, and the pricing they can command. Pharmaceutical products are high-value added, research and development being the main factor involved, the introduction of a new drug being a very expensive, lengthy, and risky undertaking (Fig. 15.1).

A Chinese multinational corporation sets up regional headquarters in Singapore to service the Asian region. Singapore is a popular choice of location for companies to improve the development of their markets in south-east Asia. Besides the commercial appeal, it can also be attractive from a tax planning perspective, if structured correctly.

A Chinese-owned company had previously grown up and confined its business to the home market. It produced a range of chemical dyestuffs for multifarious applications and industrial uses by its customers. With the eventual decline of the Chinese economy from the historic high levels after such a fast rate of growth, the company began to consider exporting its products to neighboring countries in south-east Asia.

This case represents the ideal growth of an economic activity from its barest, primitive origins to the maximum unit strength of a multinational organization listed on the stock exchange.

In an obscure application of the comparable uncontrolled price method, a China and US joint venture enterprise produces mainly printed circuit boards among other products. The products are sold in the US market by two agencies, an affiliated company and a separate, independent company. The circuit board products sold to those two companies are of the same quality and specification, and at the same terms of sale in contracts signed by both parties. The case is represented in Fig. 19.1.

A Japanese-owned enterprise in China purchased electronic products at the same time from its parent company and another independent foreign company, and then sells the products in the China market, as represented in Fig. 20.1.

A company manufacturing boots in China is wholly owned by a Taiwan-funded enterprise and acts as a contract manufacturer. The purchases of raw materials and sales of finished products are controlled by the parent company in Taiwan, as shown in Fig. 21.1.

The foreign parent company of a multinational group, with several foreign-based affiliates, established China Patents as a wholly owned small company, and as a new member of the multinational group. The parent company, with a large stake in electrical engineering, has an extensive commitment in research and development for its multifaceted business operations, functioning as risk-taker for its constant flow of new projects.

A foreign supermarket chain built its success by developing a distinctive package of features for presenting its stores to the consumer. They included color schemes, lighting, air conditioning, the internal shelving and layout of the store, the variety and display of the goods for sale, and the price ticketing and customer check out system. Not least, it was able to undercut prices against its competitors by adroit purchasing agreements and expert staffing dispositions.

Management personnel have long made assumptions about the vigilance and priority levels of SAT officials, seen as conducting a campaign to prevent losses to China’s exchequer, caused by a company’s deliberate or inadvertent transfer pricing policies. Loss-making or low-profitable companies were expected to be first in line for investigation, while high-margin enterprises would be overlooked in their lofty ineligibility.

For ten years, a contrived organizational structure enabled a multinational to make the most of its Chinese subsidiary company. It was used in a policy of fine-tuning the group’s overall, functional, unit dispositions, and costing practices. The subsidiary is an electronic manufacturer. The subsequent investigation to which the company was subjected lasted a further five years and was recently completed.

Following the issue of the Notice of Anti-Avoidance Examination on Significant Outbound Payments, Circular [2014] No. 146, China’s tax authorities began to use that declaration of policy for investigating the significant outbound service fees and royalty payments by multinational companies operating in their tax jurisdictions.

Using a value chain analysis approach, the tax authority in Shenyang City conducted a transfer pricing investigation on a highly profitable enterprise, following the discovery of irreconcilable charges to local and overseas customers. The item of immediate interest was the patent disparity of the prices the identical product was charged to the two sets of customers.

The Chinese subsidiary produces and exports bearing products for many applications, for the purpose of reducing friction and increasing the efficiency in machines and engines. The company received orders from its foreign parent company, all its products being exported to overseas markets.

The Chinese company is a subsidiary of a foreign-owned company in a multinational group producing electric products. The transactions with the related foreign parent company included the acquisition of manufacturing equipment and raw materials.

The Chinese company is a wholly foreign-owned enterprise, producing and selling chemical products. It obtained 8% of its raw materials from, and sold 60% of its finished products to, related foreign companies. All product orders were placed by the parent foreign company. In addition, the company paid 5% royalty fees to the parent company based on its sales revenue. Of that payment, 3% was for a technical fee, and 3% for a trademark fee, as depicted in Fig. 30.1.

As a fully fledged manufacturer shown in Fig. 31.1, the Chinese subsidiary is engaged in the research and development, procurement, production, and distribution activities of paper products. The parent company provides technical and management services as well as sales services to the subsidiary for related company transactions.

A company located in an inland city produces and sells electronic products. Figure 32.1 shows that all its products are sold to a domestic-related company in Shanghai. The related company is a high-technology company enjoying a preferential income tax rate of 15%.

The wholly owned foreign enterprise in China is funded by a reputable multinational company with a registered capital of USD 20 million, as in Fig. 33.1. From its establishment in 1995 in Beijing, the company suffered losses or very low margins.

A Chinese subsidiary sells its products to domestic-related companies as well as to the overseas parent company. It also paid technical usage fees and trademark usage fees to the parent company, as indicated in Fig. 34.1. For 12 years, the gross margins were around 24%, and, on average, the operating margin was around 9.56%.

In this book, the indirect views and forecasts of SAT officials have been incorporated. However, to put the seal on the references they have made, and expressly for the purposes of this publication, an approach was made to contemporary tax officials currently operating in the field of transfer pricing, for their relative judgments on the degree of priority they would give in their work to the variables raised in this book.

As a summary, the survey results indicate that the major transfer pricing concerns of the Chinese tax authorities will determine the practical application of their work will remain as follows.