China’s New Transfer Pricing Rules Keep Arm’s-Length Approach

China’s new transfer pricing rules, effective May 1, endorse the continued use of the arm’s-length standard—the internationally agreed bedrock for pricing transactions within multinational enterprises.

The new guidance, Bulletin 6, augurs well for resolving tax disputes between China’s State Administration of Taxation and the U.S. Internal Revenue Service over the pricing of related-party transactions between U.S. parents and their Chinese subsidiaries, practitioners said.

“U.S. taxpayers will be reassured to learn that there are 11 mentions of the arm’s-length principle” in the new bulletin, Glenn DeSouza of Dentons in Shanghai, told Bloomberg BNA April 2.

China’s Bulletin 6, “Administration Measures of Special Tax Investigation Adjustments and Mutual Agreement Procedures,” issued March 17, puts “a greater focus on the arm’s-length principle before disallowing royalty and service fee deductions,” said David G. Chamberlain, executive director of transfer pricing for Ernst & Young China, who is based in Shanghai. There is also “recognition that use of local comparables may be sufficient to account for location specific advantages,” he told Bloomberg BNA in an email March 31.

Draft guidance issued in 2015—Draft Circular 2—threatened to move away from the arm’s-length approach, and practitioners worried that traditional transfer pricing methods that rely on comparable data would no longer be acceptable. Instead of the traditional benchmarking methods, the draft introduced a “value creation method” that would have required allocating the combined profits among related parties by analyzing how much they contribute to value creation.

Companies in China

Fortune 500 companies with Chinese operations include:

•  Apple Inc., which has subsidiaries Apple Asia Ltd. in Hong Kong and AuthenTec (Shanghai) Co. Ltd. in Shanghai;
• Berkshire Hathaway Inc., which has Duracell (China) Ltd. in Donnguan and Leader Metal Industry Co. Ltd. in Zhongshan;
• UnitedHealth Group Inc., which has ChinaGate Company Ltd. in Shanghai; and
• General Motors Co., which has SAIC General Motors Sales Co. Ltd. in Shanghai, SAIC GM Wuling Automobile Co. Ltd. in Liuzhou and Shanghai GM (Shenyang) Norsom Motors Co. Ltd. in Shenyang,

Related-Party Services

Bulletin 6 emphasizes that related-party service transactions shall be in line with the arm’s-length principle, said Jeff Yuan, PwC China’s transfer pricing leader. The related-party services must be beneficial, and the service fee paid, or received, should be made at arm’s length.

Where an enterprise pays service fees to its related parties for services that aren’t beneficial, tax authorities may disallow the deduction already claimed in full and make a special tax adjustment, Yuan said.

International Consensus

“While there are still significant differences in the Chinese approach, Bulletin 6 moves mainland Chinese transfer pricing rules and proposed rules into closer alignment with the new international standards,” Chamberlain said.

In an April 1 “Interpretation to Bulletin 6 (JIe Du),” the SAT said the guidance reflects the consensus reached at the Group of 20 countries’ Hangzhou summit to implement a tax policy that stimulates economic growth and promotes amicable relationships between business and the tax authorities.

Chamberlain said Bulletin 6 contains long-awaited guidance on applying the arm’s-length principle, including guidance on intangible property transactions, intercompany services transactions, location-specific advantages, transfer pricing methods and various procedural matters.

The guidance also addresses mutual agreement procedures under double-tax treaties. Chamberlain said Bulletin 6 reflects the importance that the SAT places on those treaties and on the international consensus that has developed over the course of the Organization for Economic Cooperation and Development’s project to combat large-scale tax avoidance.

2015 Draft Circular

After the SAT issued Draft Circular 2 in Sepbember 2015, the Ministry of Finance became concerned that its proposed aggressive approach to transfer pricing might adversely impact foreign investment. The March 17 guidance walks back from that approach.

“Under Bulletin 6, there is a hard focus on multinationals who are using aggressive tax-planning via low-tax entities without substance,” DeSouza said. “But at the same time, Bulletin 6 is also a kinder and gentler version” of the draft September 2015 circular.

“Bulletin 6 dials back on some of the more extreme positions” of the draft circular “and stresses cooperation over conflict,” the Shanghai economist said. “Notably, taxpayers are encouraged to step up and voluntarily adjust policies and pay taxes.”

More Adjustments

Bulletin 6 provides for a profit monitoring system.

DeSouza said the new system includes three measures that will flag companies that warrant further inspection by the tax authorities: review of related-party transaction forms filed with the annual tax returns, transfer pricing documentation and a company’s profit level.

Based on these analyses, a “Notice of Taxation Matters” would be issued, DeSouza said. “The SAT is looking to leverage ‘Big Data’ and this system will allow it to significantly increase the number of companies who are going to have to make transfer pricing adjustments,” he said.

Multinational Profit Levels

Qisheng Yu, a transfer pricing partner with PwC in Beijing, said the SAT in recent years has released notices requesting that regional and local Chinese tax authorities strengthen their profit-level monitoring of multinationals.

Bulletin 6 “begins by the key point of strengthening the monitoring of enterprises profit level, and improving enterprises’ compliance with the tax laws through special tax adjustment monitoring and administration, as well as special tax investigation adjustments,” Yu told Bloomberg BNA in an email April 3. “And this is aligned with the global trend of conducting tax audits for the main purpose of managing risks.”

Yu said Bulletin 6 differs from the September 2015 draft because the draft had a separate chapter to provide standard guidelines to tax authorities on how to monitor enterprises’ profits. Bulletin 6 “does not provide detailed measures in this regard,” he said.

“However, we believe those proposed provisions in the discussion draft, although deleted in the enacted Public Notice 6, still conveyed important messages to taxpayers regarding Chinese tax authorities’ positions,” Yu said. These standard guidelines include requesting the tax authorities to develop their own mechanisms to rate the risk arising from related-party transactions, launching special tax investigations on enterprises with high risks and low tax compliance status and conducting follow-up administration on the enterprises that have made special tax adjustments.