How Transfer Pricing Disputes Arise in China – A Guide for MNEs

Transfer pricing disputes in China can arise from disagreements between companies and Chinese tax authorities over location-specific advantages and profit allocation, intragroup service fees, business losses, and royalty payments. This article explains the common causes of these disputes and how they can lead to tax adjustments and double taxation for foreign MNEs. 

With contributions from Abby Yang and Xiaohan Xu.

Transfer pricing disputes in China can arise when multinational enterprises (MNEs) and tax authorities disagree over the arm’s-length nature of intercompany transactions, profit allocation, or the treatment of royalties, intragroup service fees, business losses, and other unforeseen circumstances. Even if a company acts in good faith, differences in interpretation and documentation requirements can lead to tax adjustments and potential double taxation for the Chinese entity. 

In the first part of our two-part series on transfer pricing disputes in China, we look at how such disputes typically arise and explain how each can lead to tax adjustments and potential double taxation. 

How do transfer pricing disputes in China typically arise? 

While China has incorporated many of the OECD’s transfer pricing standards into its domestic regulations, such as the arm’s length principle, the methodologies, and the analysis of functions performed, assets used, and risks assumed, it has not formally adopted the OECD’s Transfer Pricing Guidelines, and its domestic framework reflects its national priorities and local market characteristics. 

These differences can lead to disputes between MNEs that are accustomed to applying the OECD’s guidelines and the Chinese tax authorities, leading to tax adjustments and possibly double taxation if the company’s home country disagrees with the outcome. 

Location-specific advantages 

China’s State Tax Administration (STA) is known to take a different position on location-specific advantages (LSAs) compared to most OECD countries. Crucially, the STA may consider LSAs, such as cost savings and market premiums, when assessing the contribution made by a Chinese taxpayer to value creation and determining whether the taxpayer has received an arm’s length return. 

The Announcement of the State Administration of Taxation on Issuing the Administrative Measures for Special Tax Adjustment and Investigation and Mutual Consultation Procedures (Announcement [2017] No. 6) requires comparability analyses in transfer pricing investigations carried out by the tax authorities to take LSAs such as cost savings and market premiums into consideration.

Specifically, when analysing and evaluating whether connected transactions of affiliate enterprises under investigation are in line with the arm’s length principle, and the selected comparable enterprises and the enterprises under investigation are under different economic environments, the tax authorities will look at special geographical factors, such as cost savings and market premiums, and select a reasonable transfer pricing method to determine the contribution of these special geographical factors to the profits. 

Under the Announcement of the State Taxation Administration on Matters Concerning the Improvement of the Administration of Related-Party Reporting and Contemporaneous Documentation (Announcement [2016] No. 42), companies that meet the thresholds for preparing a Local File must include factors influencing transaction pricing, including LSAs such as cost savings and market premiums. Specifically, LSAs should be analysed in terms of labour and environmental costs, market size, market competition, consumer purchasing power, substitutability of goods or services, and government regulations.

In conducting value chain analysis for the Local File, companies must also measure and attribute the contribution of LSAs to the company’s value creation. 

However, the STA does not provide statutory guidance on ultimately how LSA-related profits should be allocated, or on how they should be measured. A foreign multinational operating in China may argue that local comparables already reflect the LSAs, that the cost savings are passed on to consumers or end users, or that the benefits are shared within the group in line with the functions performed, assets used and risks assumed, thus minimising value allocated to the Chinese taxpayer.  

This can lead to disputes where the STA considers the LSAs to generate non-routine profit that belongs in China and makes an upward adjustment, which can in turn result in double taxation if the company’s home tax authority does not agree. 

Intragroup service fees and management charges 

Another common dispute is whether intragroup service fees and management charges paid by Chinese subsidiaries to overseas related parties reflect genuine services that provide an economic benefit and are priced in accordance with the arm’s length principle. 

Announcement [2017] No. 6 stipulates that related-party services must provide direct or indirect economic benefits to the recipient that an independent enterprise would be willing to pay for or perform itself under comparable circumstances. Where service fees are inconsistent with the arm’s length principle and reduce the taxable income of the Chinese company or its related party, the tax authorities may make a tax adjustment. 

The Measures also identify several categories of non-beneficial services for which the tax authorities may disallow the full amount of a previously claimed deduction. These include: 

• Services that duplicate activities already performed by the recipient
• Shareholder activities undertaken to protect investors’ interests, such as group-level supervision and reporting
• Benefits arising solely from group membership, such as an improved credit rating
• Services for which compensation has already been provided through other related-party transactions, such as royalties or loan interest 

Services that are unrelated to the recipient’s operational needs or do not generate economic benefits may also be challenged. 

These provisions may give rise to disputes even where an MNE has acted in good faith, as disagreements may arise over whether intragroup services provide a genuine economic benefit to the recipient, whether they duplicate existing activities or constitute shareholder services, and whether the fees charged and allocation of shared costs are consistent with the arm’s length principle.  

Disagreements may also arise over whether the services are sufficiently connected to the Chinese entity’s operations, whether the charges are reasonable, and whether the allocation of shared service costs accurately reflects the benefits received. 

Loss-making manufacturers and distributors 

Loss-making enterprises, particularly those with long-term losses, low or fluctuating profitability, or profitability that appears inconsistent with their functions and risks, may attract increased transfer pricing scrutiny in China. 

 Announcement [2017] No. 6 requires China’s tax authorities to focus on companies experiencing long-term losses, low profits, or fluctuating profitability; companies with low profit levels for their industry; and companies whose profit levels do not match the functions they perform and risks they assume, or whose returns are not commensurate with their costs. 

Moreover, enterprises engaged in toll or contract manufacturing and other single-function production activities for overseas related parties, as well as enterprises engaged in distribution or contract R&D activities, are required to prepare a Local File for a loss-making year regardless of whether they otherwise meet the applicable documentation thresholds. 

Announcement [2017] No. 6 explicitly states that the tax authorities may implement special tax adjustments if these companies bear risks and losses that should properly be borne by a related party, due to factors such as erroneous decision-making, underutilisation of production capacity, sluggish product sales, or R&D failure. 

These rules may give rise to disputes even where an MNE has no intention of shifting profits or avoiding tax. For example, an MNE may consider losses incurred by its Chinese subsidiary to be commercially justified by adverse market conditions or operational difficulties, whereas the tax authorities may question whether the subsidiary should bear those losses given its functions and risk profile. Disagreements may also arise over the appropriate arm’s length profit margin, the selection of comparable companies and the allocation of risks and losses within the group.  

Companies acting in good faith may as a result still face tax adjustments if the authorities disagree on the appropriate allocation of profits or consider the supporting documentation insufficient. 

Royalties and fees for intangible assets 

China’s transfer pricing rules on intangible assets focus on the economic substance of value creation rather than legal ownership alone. When determining how returns from an intangible asset should be allocated, Announcement [2017] No. 6 requires consideration of the parties’ respective contributions to the development, enhancement, maintenance, protection, application and promotion of the intangible asset, as well as the interaction between the intangible asset and the functions, risks and assets of the group’s other business activities. Accordingly, an entity that merely holds legal ownership of an intangible asset without contributing to its value should not participate in the allocation of returns from that intangible asset.

Against this background, royalty arrangements should reflect the economic benefits generated by the intangible asset for the relevant entity. Where royalties paid or received between related parties are not commensurate with such economic benefits and this results in a reduction in taxable income, the Chinese tax authorities may make a special tax adjustment. In particular, where a Chinese enterprise pays royalties to a related party that merely holds legal title to the intangible asset without contributing to its value creation, and the payment is not consistent with the arm’s length principle, the tax authorities may make an adjustment for the full amount previously deducted for tax purposes. Similarly, where the intangible asset does not generate economic benefits and the royalty payment is not arm’s length, a full adjustment may be made. 

Importantly, the appropriateness of a royalty arrangement should be considered on an ongoing basis rather than only when the arrangement is initially established. Under Announcement [2017] No. 6, the royalty should be adjusted where there is a fundamental change in the value of the intangible asset, where comparable transactions between independent parties would ordinarily provide for a royalty adjustment mechanism, where the parties’ functions, risks or assets change during the use of the intangible asset, or where either party makes additional contributions to the subsequent development, enhancement, maintenance, protection, application or promotion of the intangible asset without receiving reasonable compensation. 

How Dezan Shira & Associates can help 

Navigating China’s transfer pricing framework can be challenging, particularly where it differs from the OECD approach that many MNEs are used to applying. Dezan Shira & Associates’ transfer pricing team helps foreign investors review intercompany agreements, prepare Local Files that address cost savings and market premiums in their value chain analysis, and assess transfer pricing risks before they turn into audit adjustments or double taxation. Contact us to discuss how these rules may affect your China entity.