Advance pricing agreements - Negotiating China's tax system and APA framework: Lessons from the November 2007 China-Korea Accord 

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Please click on the links below to view more:    The Korean National Tax Service and China's State Administration of Taxation (SAT) concluded the first bilateral advance pricing agreement (APA) between China and Korea on 7 November 2007 - also the year of the 15th anniversary of the normalization of diplomatic relations between China and Korea.  The APA involved a Korean multinational group and its two Chinese subsidiaries.  As the subsidiaries filed separate applications with their respective tax bureaus, this bilateral agreement may be more accurately referred to as the "twin APAs" from China's perspective.    China concluded its first unilateral advance pricing agreement in 1998.  However, it was not until recently and after more than 150 unilateral APAs that bilateral APAs became popular.  The popularity of bilateral APAs reflects taxpayers' increasing interest in and desire of achieving certainty and avoiding double taxation on their transfer pricing.  As China tightens up tax administration on transfer pricing and steps up its enforcement efforts, many taxpayers are finding it increasingly attractive to use the agreements to manage their transfer pricing risk in China.    The China-Korea APA is the third bilateral APA for China.  The first, with Japan, was concluded in April 2005 and the second, with the United States, was concluded in January 2007.    PricewaterhouseCoopers had the privilege of assisting the Korean multinational group with the application and conclusion of the twin APAs.  This article provides an overview of China's APA regulatory framework, both prior to and under the Unified Corporate Income Tax Law (UCIT) effective from 1 January 2008.  To help taxpayers understand the Chinese tax authorities' rationale, the article will focus on and interpret five statements made by the authorities during the APA application process.    Negotiating the system    The China tax system is a dichotomous one, comprising the SAT at the national level and the provincial and municipal tax bureaus at the local level.  The SAT, the highest-ranking tax organization in China, develops tax legislation at the national level, supervises the provincial tax bureaus, and conducts competent authority procedures with foreign tax authorities.  The local provincial and municipal tax bureaus collect taxes, select transfer pricing audit targets, and conduct audits.   Read more...... Expand / Collapse China adopts a three-tiered legislation system comprising: laws, which are enacted by the National People's Congress;   detailed implementation rules, which are issued by the State Council and provide elaborations on the laws; and   circulars, including Guoshuifa issued by the SAT, which provide further guidance on the application of the laws and detailed implementation rules. Prior to the UCIT, there were no formal APA provisions in the Foreign Enterprise Income Tax Law, which applied to foreign enterprises in China, or the Tax Collection and Administration Law, which applies to all taxpayers.  The detailed implementation rules to these sets of law, as well as international tax treaties signed between China and other countries, formed the legal basis for China's APA framework.  This was supplemented by various circulars issued by the SAT.  Milestones in China's APA evolution prior the UCIT are summarized in the table below.      Reference Year Description Guoshuifa 59 and Guoshuifa 143 Issued 1998 and 2004 The APA concept was first introduced. First unilateral APA 1998 Concluded in Xiamen. Guishuifa 118 2004 Guoshuifa 118 presented standardized rules on APA application procedures and requirements. First bilateral APA with Japan April 2005 For Shenzhen subsidiary of a Japanese electronics company. First bilateral APA with the United States January 2007 For multiple Chinese subsidiaries of U.S. retailer. First bilateral twin APAs with Korea November 2007 For Suzhou and Shandong subsidiaries of Korean multinational group.    With the promulgation of the UCIT, the APA concept has been enacted into the tax laws.  The detailed implementation rules to the UCIT supports this APA framework and the proposed transfer pricing requirements to be released soon likely will exempt taxpayers with APAs from certain transfer pricing documentation requirements.   Close What this means for taxpayers    Under the new corporate income tax regime, the APA is given enhanced legal status.  At the same time, taxpayers are facing heavier transfer pricing compliance burdens and potential penalties.  As the APA provides an option for a taxpayer to achieve certainty on its transfer pricing and eliminates transfer pricing adjustment risk of the transactions covered by the APA, the taxpayer should at least consider the feasibility of pursuing an APA application when it tries to manage its China transfer pricing risks.   Read more...... Expand / Collapse Decoding what the authorities say - and managing it accordingly    The bilateral APA between China and the United States described in a 2007 article by Burton Mader and Todd Ludeke provides good background for those planning to seek an APA in China.  This article will focus on the practical aspects of the process, sharing insights gained from the authors' interactions with the Chinese tax authorities and providing practical tips on how best to manage their demands. "We do not accept APA applications from companies that have not been audited before because we do not understand them."    What they mean: The Chinese tax authorities typically hold a skeptical view of the transfer pricing of multinational companies operating in China.  To protect the country's tax base, they are generally cautious and conservative.  For this reason, they are predisposed toward APAs with companies they already (e.g., through a previous tax audit) understand.  They are uncomfortable with unfamiliarity and hence highly selective with respect to APA candidates.    What taxpayers can do: It is important for taxpayers, in particular those without a history of audits, to win the Chinese tax authorities' endorsement of their APA applications.  Right from the initial meeting, taxpayers must be prepared to provide the authorities with ample information and technical support regarding their related-party transactions.  Second, given China's dichotomous tax system, the APA application likely will require substantial negotiations with multiple tax authorities at the state, local, provincial, and municipal levels.  In this regard, taxpayers must ensure that there is proper communication at all levels.  Thirdly, to maintain the trust of the Chinese tax authorities, taxpayers must conscientiously work to ensure efficiency in communication, and, more importantly, consistency and integrity of the information being exchanged.   "For state-of-the-art APAs, there must be a solid foundation before the APA application can be accepted."    What they mean: The Chinese tax authorities are practical and quality-driven.  They expect taxpayers to have solid transfer pricing factual and technical bases in place prior to making the APA application.  APA applications that are sloppily prepared and that have minimal chance of being concluded are prime candidates for rejection.    What taxpayers can do: Based on the authors' experience, taxpayers should be putting in approximately one-third of total effort at the pre-filing stage, building up a good business case and putting in place a rigorous analysis of the transfer pricing method supporting the arm's-length nature of the transfer prices.  Taxpayers will find it useful to anticipate the potential questions and information requests from the tax authorities and to prepare responses in advance.  This extensive preparatory work will put taxpayers in good stead when presenting their APA applications to the respective tax authorities.  Taxpayers will find it worthwhile because once the Chinese tax authorities accept it, they are likely to commit to achieving conclusion of the APA application.   "We understand that many multinational companies in China are doing more than routine functions.  Where there are substantial research and development and marketing functions, we require more than a routine level of profit."    What they mean: The Chinese tax authorities have a growing interest in intangible versus tangible asset transactions.  They believe that Chinese affiliates of foreign companies are undertaking nonroutine activities in China, such as local marketing activities.  Because these nonroutine activities potentially add value to the intangible assets of the foreign group, the Chinese affiliates bearing the corresponding risks should be allocated more income.    What taxpayers can do: Referring to the GlaxoSmithKline Case, the SAT has indicated that where there are nonroutine contributions being made in China, a simple cost plus or net margin transfer pricing method may not suffice and the residual profit split method may be more appropriate.  Bearing in mind the Chinese tax authorities' greater appreciation of intangible assets, taxpayers must review their operations carefully to ensure that all nonroutine functions, if undertaken, are appropriately remunerated.  Second, because Chinese tax authorities conduct active field work during the course of the APA application, taxpayers must ensure that their operations (i.e., the functions performed, risks assumed, and assets utilized) are in substance consistent with the facts and substance under the proposed APA.   "We are familiar with the profitability and operations of comparable companies from your industry."    What they mean: The Chinese tax authorities share tax and audit information of taxpayers efficiently at-and across-SAT and local tax bureau levels.  As a result of this, they may already have an expectation of the profits earned by comparable companies in the same industry.  For each APA application, it is also almost certain that the Chinese tax authorities will devote extensive resources toward studying the industry and market.    What taxpayers can do: Taxpayers must themselves devote efforts toward understanding the market and their market competition.  Taxpayers must ensure that their profitability is aligned to those of comparable companies in the industry, or, if it is not, be prepared to distinguish their special factors to defend the difference in profitability.  When taxpayers select comparable companies with which to benchmark profitability, they must consider both product and functional comparability carefully, as this is an area the Chinese tax authorities are very particular about even when profit-based transfer pricing methods are used.   "We believe that the APA is a good system for voluntary compliance and that it will improve the harmonious relationship between taxpayers and the tax authorities."    What they mean: The Chinese tax authorities genuinely believe that the APA system offers a less confrontational approach in transfer pricing enforcement.  As the APA system promotes voluntary compliance, it potentially improves the efficiency and effectiveness of tax administration.  To this effect, the Chinese tax authorities are generally collaborative when working with taxpayers on APAs.    What taxpayers can do: Taxpayers should view the APA as an opportunity to achieve certainty on their transfer prices before controversies arise.  In addition, taxpayers potentially can use the APA to address disputes from prior years by seeking the rollback of APAs to the APA application year.  With the introduction of transfer pricing concepts such as APAs and cost sharing arrangements under the UCIT, the tax authorities have also demonstrated that they are more receptive to more sophisticated transfer pricing arrangements. 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Conclusion
  
The authors are honored to have assisted in the bilateral APA between China and Korea.  During these interactions, the Chinese tax authorities have demonstrated themselves to be committed to the use of the APA system in transfer pricing enforcement and administration.
  
With the UCIT in effect from 1 January 2008, there will be heavier transfer pricing compliance burdens and penalties.  At the same time, the UCIT provides the APA with enhanced legal status.  Given that APAs have the potential to help taxpayers manage any ambiguity under the new law, it is expected that these arrangements will grow in importance under the new tax regime.  As the Chinese tax authorities grow in sophistication, it is expected that APAs will be used for a wider spectrum of potential transactions including transfer of tangible and intangible property and services and royalty and financing transactions. 
  
This article is reproduced from its original publication entitled "Advance Pricing Agreements - Negotiating China's Tax System and APA Framework: Lessons from the November 2007 China-Korea Accord" in the January 2008 issue of BNA International's Tax Management Transfer Pricing Report.  Copyright 2008 by The Bureau of National Affairs, Inc.  Reprinted with permission.