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Please click on the links below to view more:   Notice of SAT's position on expected profitability of foreign investment enterprises and foreign enterprises with sole-function of manufacturing    The State Administration of Taxation ("SAT") has issued Guo Shui Han [2007] 236 ("Circular 236") on 28 February 2007 to state their position with respect to the expected profitability of the Foreign Investment Enterprises ("FIEs") and Foreign Enterprises ("FEs") in China which undertake a sole-function of manufacturing for their overseas parent companies.   China has been regarded as the "world factory" and many foreign investors set up their manufacturing base in China.  There are quite a number of FIEs and FEs undertaking a sole-function of manufacturing of products for their foreign investors.  So this SAT circular would have widespread implications to this group of FIEs and FEs.   Read more...... Expand / Collapse Important aspects of Circular 236    Pursuant to Circular 236, the SAT is concerned about the profitability of those FIEs and FEs in China with the following mode of operations: FIEs and FEs in China which undertake a sole-function of manufacturing based on the overall business plans and production orders of overseas parent companies.   Whereas, overseas parent companies or other affiliates are wholly responsible for operating policy, product R&D, and sale functions, etc.   Since these enterprises do not take part in the decision making process of business policy, market development and sales functions, they should not bear the associated risks and losses arising from ineffective policies, under-utilization of production capacity and slow market demand. Based on internationally accepted transfer pricing ("TP") principles, enterprises undertaking sole-function of manufacturing shall maintain a certain level of profits and not sustain losses.  The SAT has urged local-level tax bureaus to carefully examine FIEs and FEs with the above-mentioned mode of operations in their locations.  For those sustaining losses or achieving low level of profits, the SAT has requested the local-level tax bureaus to evaluate their profit levels by conducting economic analysis with reference to comparable prices or companies.    PwC observations    We observe that Circular 236 carries a few messages of the SAT's positions on TP as follows: The SAT is taking an aggressive stance against the related party arrangements between the FIEs and FEs undertaking the sole-function of manufacturing in China and their overseas affiliated companies (not merely parents).  Obviously, in the opinion of the SAT, there are cases where the FIEs and FEs with such function are taking inappropriate TP policies, resulting in little profit or even losses sustained in the Chinese FIEs and FEs.   The SAT points out that it is necessary to examine the actual functions and associated risks of the target in the TP audit, and making reference to comparable prices and companies as benchmarking to measure the reasonableness of the profit level.   This Circular reflects the SAT's concerted effort to alert the local-level tax bureaus about the "high-risk" areas in conducting TP audits. Circular 236 sets the scene that the local-level tax bureaus should take such approach and position as requested by the SAT in their evaluation and TP audits of such FIEs and FEs in their locations.  However, we believe that there could be situations where the FIEs and FEs having such sole function in China would still sustain losses for valid commercial reasons, e.g. the skill-level of local labour force may not be up to the standards as set by the overseas parents (or affiliated consignors) at the beginning stage of the new set up or new products and has caused inefficiency and thus losses.  If there are such cases, then it is imperative to justify it with facts and proper documentation.  So we would urge the FIEs and FEs undertaking such function, especially those with sustained losses, to look into the commercial justifications and prepare their documentation just in case they are selected for TP audits.   Close Notice of the SAT's announcement of enhanced functional and financial analysis during transfer pricing audits    The SAT also issued Guo Shui Han [2007] 363 ("Circular 363") on 27 March 2007 stipulating specific documents and information to be submitted by enterprises and the local-level tax bureaus to the SAT during TP audits.  The objective of this is to increase the quality of functional and financial analysis conducted on related party transactions during TP audits.   Read more...... Expand / Collapse Specifically, the forms to be submitted to the SAT include: Form "Table of Entity's Functional Analysis", to be filled out by the enterprise being TP audited;   Form "Summary Table of Entity's Functional Analysis", to be filled out by the local-level tax bureau based on Form "Table of Entity's Functional Analysis" received from the enterprise, as well as other relevant information gathered during their TP audits; and   Form "Table on Financial Analysis on Related Party Transactions", to be filled out by the local-level tax bureau and submitted together with the relevant audit-initialisation and audit-finalization reports. Broadly, these forms lay down the flow of analysis work to be undertaken during TP audits, including guidelines on the types of functions and risks to be analyzed, as well as the provision of financial information of the enterprise.  The SAT has stated that the forms should serve as a standard template and the information to be collected should be subject to specific audit situations.   PwC observations   Based on our experience, the format of the forms is generally consistent with international practice and the same would possibly be required under the TP Documentation Requirements in future.   It is clear that the SAT is placing significant emphasis on giving greater clarity to the rationale and methodologies applied during TP audits.  In this regard, we recommend that enterprises follow up this development closely and take a proactive approach in managing their TP risks.  To note, whilst the TP Documentation Requirements may not require full TP documentation to be available at the point of annual tax return submission, it is possible to require taxpayers to have prepared and maintained TP documentation to the fullest extent, and to submit them upon request of the tax authorities within a certain period of time. 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