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Latest insights on China's transfer pricing documentation requirements
The State Administration of Taxation ("SAT") of China has been planning for more stringent transfer pricing ("TP") documentation requirements since as early as 2005. As mentioned in our earlier News Flashes, a set of administrative measures for TP documentation, "Measures for Administration of Documentation on Related Party Transactions", (the "Documentation Requirements") has been drafted and circulated around the Chinese tax administration system. We understand that the prolonged deliberation has been due to concerns regarding the increased compliance burden that the Documentation Requirements would place on taxpayers.
Our latest information indicates that the Documentation Requirements are in final draft stage. In this News Flash, we aim to summarise the various important provisions included in the final draft, and more importantly, to share our insights on what the Documentation Requirements would mean for taxpayers. Taxpayers should take note of the potential implications arising from the final draft Documentation Requirements, evaluate the impact on their operations, and exercise the early advantage of taking proactive actions, where applicable, in anticipation of the promulgation of the final Documentation Requirements.
(To note, the content below is prepared based on insights gathered from frequent dialog with the legislative bodies as well as our understanding of the key provisions in the latest draft of the Documentation Requirements, as at the time of writing. We wish to highlight that prior to the receipt of statutory approval, the draft is still subject to further debate and changes.) Please click on the links below to view more:
Background 
The concept of TP and the arm's length rule first appeared in the China's Foreign Enterprise Income Tax Law ("FEIT Law") which currently applies to foreign investment enterprises ("FIEs") and foreign enterprises ("FEs"). In 1998, the Chinese tax authorities took more definite steps towards regulating TP with the issuance of Guoshuifa 59, and subsequently, various other tax circulars covering specific TP issues. As part of their increasing focus on TP enforcement, the SAT proposed, as far as back in 2005, TP Documentation Requirements which should address important aspects of TP administration including what constitutes TP documentation, when and how it should be prepared, and the consequences in cases of non-compliance. It would also provide clarification and guidelines on TP methodologies which are currently unclear, causing difficulties in TP administration. Under the new Corporate Income Tax Law ("CIT Law") regime, preferential tax treatment previously enjoyed by FIEs and FEs under the old FEIT Law is abolished and a unified tax rate of 25 percent is applied to FIEs, FEs, and domestic enterprises. In view that FIEs and FEs may potentially shift profits out of China into lower tax jurisdictions, the Chinese tax authorities have incorporated enhanced anti tax avoidance and TP provisions into the CIT Law. These provisions are expected to be reinforced by the Detailed Implementation Regulations to the CIT Law ("DIR"), to be released soon. The new CIT Law and the DIR effective on 1 January 2008 have set the scene for the proposed Documentation Requirements to formalise the TP regulatory framework in China. We understand that the finalisation of the Documentation Requirements has been delayed due to the lack of trained TP resources within the Chinese tax administration, time required in collecting reference information on international practices, and concerns that the Documentation Requirements would increase the compliance burdens of taxpayers. With respect to this, the SAT has in recent years, expended efforts in training local level tax bureaus and seeking inputs from both international counterparts and professional firms. The SAT has also simplified earlier drafts of the Documentation Requirements to ease part of the tax compliance burden. The latest draft of the Documentation Requirements, albeit simplified, would still impose significant tax compliance obligations on taxpayers in China. We provide a summary of the latest draft below.
Draft Documentation Requirements
The latest draft Documentation Requirements has a total of sixteen articles addressing important aspects of TP compliance and enforcement. 1. Content, format and timing
The draft Documentation Requirements adopts a two-prong approach. The first prong occurs at the time of annual income tax filing, when taxpayers are required to submit a detailed TP disclosure form together with their annual CIT returns before the end of May in 2009. We understand that this form consists of 8 elements, including:
- Relationship with the related parties;
- Location of the related parties;
- Form of trade of the related parties;
- Nature of related party transactions;
- Amount of the related party transactions and what is the proportion of the related party transactions to the total amount of similar type of transactions;
- Profit and loss positions of the related party transactions;
- TP methods adopted; and
- Confirmation whether the company has TP documentation in place as at the time of annual CIT filing.
The second prong of the draft Documentation Requirements deals with TP documentation which a taxpayer is required to prepare and maintain by the time of annual tax filing for each tax year. This documentation is not required to be submitted to the tax authorities at the time of annual tax filing; it is only to be submitted within 30 days upon request by the tax authorities. Based on the above, the draft Documentation Requirements give clarity on the contemporaneous nature of the TP documentation required under the CIT Law and DIR. We understand that the format of this documentation comprises seven sections, including:
- Global organisational structure, including the effective tax rates of the related parties;
- Detailed analysis of business operations;
- Details of related party transactions;
- Comparability analysis;
- Selection and application of TP method, including reasons why other TP methods are rejected;
- Details of cost sharing arrangements ("CSAs") if applicable; and
- Other relevant documents.
The documentation must be submitted within 30 days of the tax authorities' request. Taxpayers may apply in writing for a one-time extension of 45 days where there are special circumstances but this is subject to approval by the tax authorities. Information to be submitted to the tax authorities at annual income tax filing, and upon request by the tax authorities must be in Chinese. Information submitted to the tax authorities under the second prong must additionally be certified authentic with official stamps and signature. Where information is submitted with respect to overseas related party and transactions, they must be notarised or certified true by certified public accountants. 2. Penalties
Failure to file the relevant information would subject taxpayers to penalties under the general tax administration laws. In cases where taxpayers refuse to submit, or submit false information, the tax authorities are empowered to deem the amount of taxable income for adjustment purposes. In addition, an Interest Levy, as under the new CIT Law, would be applied on anti-avoidance tax adjustments. The Documentation Requirements provide that taxpayers who have entered into advance pricing arrangements ("APAs") with the Chinese tax authorities are exempted from preparing TP documentation.
PwC observations (increased compliance burden, TP administration and enforcement, impetus for tax planning)
Increased compliance burden
Although the current version of the Documentation Requirements appears less rigorous than the U.S. and Australia TP regulations (both of which require contemporaneous TP documentation) and the India TP regulations (which require certain mandatory TP documents to be submitted at the point of annual tax filing), it would no doubt cause additional compliance burdens on taxpayers to at least have some TP documentation in place. For small-size taxpayers, complying with the Documentation Requirements may be a particularly significant burden given their limited operations. In addition, since group consolidation is generally not allowed in Chinese tax return filing, multinational groups with multiple entities in China may find it particularly difficult to comply as the documentation would need to cover both cross-border as well as intra-China transactions. Because TP documentation can be a time consuming and potentially costly exercise, taxpayers must manage the compliance exercise in a time and cost efficient manner. To this effect, we recommend that taxpayers consider adopting the 2-step approach below:
- Assess your level of TP risk. Generally, taxpayers with low or fluctuating profit levels, history of prior TP audit etc. are at higher risk of being audited by the tax authorities.
- Decide the TP documentation needed. Generally, the higher your level of TP risk, the greater the breath and depth of documentation you should have in place, to manage the risks of being challenged by the tax authorities.
For low-operational risk taxpayers such as simple contract manufacturers earning low but stable levels of profits, a simple functional analysis and defensible benchmarking should suffice as TP documentation. Whenever possible, these entities can be grouped to share a single benchmarking analysis and reduce preparation costs. Conversely, taxpayers at higher risk of being challenged by the tax authorities should have more comprehensive documentation in place, including special factor analyses to substantiate their low profit margins or losses earned. TP administration and enforcement The Chinese Documentation Requirements are generally aligned to Organisation for Economic Co-operation and Development ("OECD") TP principles and international practices. This would seemingly suggest a predictable and manageable compliance burden for multinational corporations experienced in TP compliance internationally. However, the loosely worded Chinese provisions could also allow the SAT flexibility in further interpretation, during the course of TP administration. Upon closer examination, one can expect some of the requirements to be further extended to impose a heavy compliance burden on taxpayers, if the Chinese tax authorities so decide. This same allowance in interpretation when granted to local-level tax bureaus could also work against the SAT, and may lead to potential disorder during the early stages of enforcement if not managed well. Impetus for tax planning Finally, taxpayers should note that early preparation is the key to manage the implications of the Documentation Requirements. Assuming the Documentation Requirements are finalised and effective from the tax year 2008, the first of the Documentation Requirements would theoretically be submitted to the tax authorities by 31st May in 2009. Taxpayers should use the window of opportunity between now and then to review their related party transactions. With respect to high-TP risk taxpayers, we recommend that they take proactive measures to prepare TP documentation, or to rectify any misalignments to the arm's length principle. This would improve their TP risk profile and give them a stronger position if challenged by the tax authorities. In addition, although the Documentation Requirements do not explicitly require contemporaneous TP documentation to be in place at the point of filing, it nonetheless effectively necessitates such documentation by including under the second prong documentation such as inter-company agreements which should rightly be executed before the related party transactions occur. In this regard, taxpayers can no longer wait until the end of a tax year or the time of annual tax filing to get their documentation in order. Taxpayers should note that Interest Levy under the new CIT regime comprises two elements: (1) financing cost for the tax adjustments; and (2) an additional 5 percentage points of penalty interest. The penalty interest may be waived if the taxpayers have diligently fulfilled the Documentation Requirements. Hence, besides being a new deterrent against tax avoidance, the Interest Levy should provide taxpayers with the motivation to get their TP documentation in order. Notwithstanding this, it is still too early to ascertain the extent of documentation required by the Chinese tax authorities, for taxpayers to have fulfilled their requirements diligently. Given that taxpayers with existing APAs with the SAT are exempted from the Documentation Requirements under the second prong, taxpayers should also assess the feasibility of using the APA as an efficient tool in managing their TP risks and the compliance burden imposed by the Documentation Requirements. We understand that the Documentation Requirements would take the form of a separate circular rather than be incorporated in the DIR. In addition, it would be termed "Provisional Measures". It is interesting to note the unique legal status the SAT has given the Documentation Requirements. This may be an indication that the SAT is not totally comfortable with laying down China's first TP Documentation Requirements and is hence prepared to make further amendments or elaborations wherever necessary. While it is understandable that the Chinese tax authorities would prefer to keep flexibility on their side, such a stance might hinder the development of a comprehensive and predictable TP regime. Taxpayers will find it to their interests to keep themselves abreast of this and other new China TP developments. On a positive note, taxpayers should be using the TP documentation required under the Documentation Requirements as their first line of defence, should controversies arise with the Chinese tax authorities. To this end, they should ensure that they do a reasonably good job in preparing the TP documentation.
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