By Steven Carey, Douglas Fone and Dr. Jian Li
HONG KONG, Jan. 22 – The Implementing Regulations that have been in effect from January 1, 2008 for the new Corporate Income Tax Law are the result of several years of deliberation by the State Administration of Taxation on transfer pricing. Tax authorities globally have been focused on transfer pricing for some time and in most countries have introduced tough laws requiring taxpayers to demonstrate compliance with the arm’s length principle for pricing of transactions within multinational groups. It is no surprise that the Chinese authorities are doing the same in their bid to claim a fair share of the global tax pie, through the introduction of transfer pricing penalty provisions and rigorous documentation requirements.
The new CIT Law and Implementing Regulations
Although transfer pricing has been around in China for a few years, and several SAT circulars have been released providing guidance to local authorities on enforcement, the new CIT Law and Implementing Regulations now provide the necessary legislative framework and send a very clear signal to taxpayers that transfer pricing is at the top of the SAT’s target list for the foreseeable future.
Two of the key measures are the introduction of a contemporaneous documentation requirement and an interest and penalty regime specific to transfer pricing adjustments, the first time that interest has been imposed on transfer pricing adjustments.
Interest is computed on the amount of underpaid tax using the standard interest rate plus an additional five percent penalty rate. Given that adjustments can be made ten years into the past the combined impact of interest and penalties following a transfer pricing adjustment can be onerous to say the least. Importantly, the penalty component will not be applied if the relevant transfer pricing documentation has been prepared and submitted by taxpayers in a timely manner.
The final piece in the SAT’s transfer pricing toolkit will be the release of a circular that provides detail on what information should be included in the annual tax filing as well as how contemporaneous documentation should be prepared and presented. Although a draft of the circular is not yet available, there is a broad understanding of what will be in it.
It is expected that taxpayers will be required to prepare and maintain two categories of documents as follows:
This documentation is the typical type of information to be contained in the annual tax return in respect of transactions between related parties. It includes a list of related parties and their relationship with the taxpayer; country and region where the related parties are situated; terms of the transactions between the related parties; types of transactions; number of transactions between the related parties and their proportions to all transactions of the same type; profits or losses arising from these transactions; transfer pricing methods used in these transactions; and an indication of whether the requirement to prepare and retain relevant documentation and other documents to be provided on request of the tax authorities, have been met.
This supplementary documentation would only be required to be shown to the SAT in the event of a specific request during the course of a detailed transfer pricing or tax audit. It will be largely consistent with OECD template reports and include global organisational structure; overall business operations; details of related party transactions; functional and risk analysis; comparability analysis; selection and application of transfer pricing method and reasons why other transfer pricing methods are rejected; details of cost sharing arrangements if applicable; and other relevant documents. Such documentation must be provided to the SAT within 30 days of a request, although taxpayers can seek an extension of a further 45 days: this means that taxpayers should prepare such documentation in advance of the request being made. Documentation of reasonable quality is unlikely to be able to be prepared from scratch within 30 or 75 days of a SAT request, and in any case documentation prepared some time after the end of the year in question would almost certainly be viewed as less reliable by the SAT.
Preparation the key
Preparing documentation is the only accepted means of giving the SAT a clear understanding of the transfer pricing model and commercial reality of a business. It is the key to avoiding a lengthy and costly audit, and as noted above, is the best means of ensuring that penalties will not be imposed on any adjustment made. You should note at this stage there are not expected to be any exceptions or concessions for small and medium sized enterprises, so this requirement will affect all multinationals doing business in China, no matter how big or small.
Taxpayers should assume that they will be audited at some uncertain time in the future, so preparation carried out on a timely basis will represent a very wise investment. Importantly it may also enable transfer pricing planning opportunities to be identified that can result in significant tax savings and lower effective tax rates across the group. The preparation of transfer pricing documentation files will allow taxpayers to design an optimal transfer pricing system, respond promptly to future requests by the tax authorities, and to defend their transfer pricing practices from a position of strength.
The authors are associates at Transfer Pricing Associates (Hong Kong) Limited.
Asia Briefing Ltd. is a subsidiary of Dezan Shira & Associates. Dezan Shira is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in China, Hong Kong, India, Vietnam, Singapore and the rest of ASEAN. For further information, please email email@example.com or visit www.dezshira.com.
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