Watch for the transfer pricing

Douglas Fone and Jian Li discuss the forthcoming transfer pricing documentation requirements and implications for multinational enterprises operating in China

Transfer pricing is fast becoming the most important and controversial business, not just a taxation, issue for multinational companies operating in the Asia-Pacific region. China is rapidly joining Japan, Australia and Korea in the ranks of aggressive and sophisticated enforcers of the arm's-length principle. Since there are always two sides to a cross-border transaction, the actions of these aggressive tax authorities are prompting other countries in the region to introduce and enforce their own transfer pricing regimes. As a result, multinationals operating in the region face significant challenges to satisfy the documentation requirements of multiple, competing tax authorities and avoid double taxation arising from transfer pricing adjustments.

After many months of deliberation and consultation, it is expected that within the next few months the State Administration of Taxation (SAT) will release new transfer pricing guidelines, requiring the preparation of contemporaneous transfer pricing documentation in respect of related-party transactions. The new documentation requirements will have significant tax implications for multinational enterprises operating in China.

It is expected that the transfer pricing guidelines will deal with some significant aspects concerning transfer pricing compliance and enforcement, including: what amounts to transfer pricing documentation; when and how should taxpayers prepare these documents; and what are the consequences if the taxpayer fails to comply with these requirements.

What constitutes transfer pricing documentation?

At present, companies with related-party transactions are required to file a specific disclosure form (Form either A or B) with their annual corporate income tax returns within four months after the year end. Taxpayers are only required to disclose certain basic information about their related-party transactions, such as the identities of the related parties, and the type and amount of the transactions entered into with each of the related companies.

Under the new documentation requirements, the taxpayers will be required to prepare and provide more detailed information on their related-party transactions, as well as description of the elements that affect the pricing of transactions and other relevant information associated with how prices are determined. Moreover, taxpayers will also be required to demonstrate that their transfer pricing complies with the arm's-length standard through the selection and application of appropriate transfer pricing methods.

Specifically, under the new documentation requirements, it is expected that taxpayer will be required to prepare and maintain two categories of documents, as follows.

Principal documentation

This documentation is the typical type of information that forms part of any transfer pricing report prepared in accordance with the generally accepted guidelines set by the OECD. It includes:

• Business and industry analysis, i.e. description of the industry in which the company operates
• Functional analysis, i.e. description of the functions carried out, the assets used and the risks borne by the company in question
• Identification and quantification of the related-party transactions
• Selection of the most appropriate transfer pricing methodology to analyse the arm's-length nature of the related-party transactions, and
• Application of the most appropriate methodology, with conclusions on the arm's-length nature of the pricing of the related-party transactions.

This documentation should be prepared before the tax return for the year in question is submitted, but there will be no requirement to submit the report to the SAT at the same time as the tax return. The transfer pricing report should be kept on file, ready to be submitted to the SAT in support of the tax return at any time in the future. If the taxpayer does not prepare the transfer pricing report at the time the tax return is submitted, there will be insufficient time to prepare such a report when the SAT asks to view it in the future, much of the information necessary to produce the report may have been lost and the SAT will not consider such a report prepared after the tax return is submitted to be persuasive.

Supplementary documentation

This is the type of documentation that should be kept on file to support the principal documentation, such as original entry books and transaction records, pricing documents such as invoices and shipping documents, inter-company correspondence, and other information affecting business strategies and therefore directly or indirectly affecting transfer pricing between related parties.

This supplementary documentation would only be required to be shown to the SAT in the event of a specific request during the course of a detailed transfer pricing or other tax audit.

When do taxpayers need to prepare such documentation?

At present, an annual tax return must be filed within four months of the accounting year end, after which time the tax authority may ask to be provided with a copy of the company's transfer pricing documentation (i.e. the principal documentation). Up to 60 days is allowed to respond to a tax authority's request for such transfer pricing documents, although a 30-day extension to comply may be requested.

Under the new documentation requirements, it is possible that certain parts of the principal transfer pricing documentation may have to be filed together with the tax return by the filing deadline. However, in all cases, taxpayers must submit relevant documents in a timely manner when requested by the tax authorities.

What are the penalties for non-compliance?

At present, there is no provision in the transfer pricing regulations to impose specific penalties on transfer pricing cases, in addition to the tax that would need to be paid on any increase in taxable income as a result of a transfer pricing adjustment. The punishment for late filing of the related party transactions declaration is a range of fines, ranging from RMB2,000 to RMB10,000.

However, it is understood that the new transfer pricing guidelines will impose specific and heavy penalties on any transfer pricing practices that are deemed to be abusive. Moreover, it is understood that, in some cases, penalties may be imposed when transfer pricing adjustments are made.

Implications for multinational enterprises operating in China

With the forthcoming issuance of transfer pricing documentation requirements, companies in China will face a significantly higher tax and transfer pricing compliance burden. For smaller taxpayers, complying with the documentation requirements may be a significant burden, since it is unlikely that there will be a small taxpayer exception rule to the requirements.

The SAT is clearly very serious about enforcing the arm's-length principle in China and the imposition of a requirement to prepare proper transfer pricing documentation is an important step. The key to avoiding transfer pricing problems with the SAT comes down to basic good corporate governance and designing proper transfer pricing systems. Detailed documentation of those systems to support the tax return disclosures is no longer an option for businesses in China: it makes good business sense and it will shortly be a requirement of the SAT as well. Companies that are well prepared, having done their homework by preparing the type of transfer pricing documentation expected by the SAT, will be better placed than others in the event of a transfer pricing audit in the future.

We suggest that companies should prepare transfer pricing documentations from now on to show that their related-party transactions meet the new documentation requirements.

Douglas Fone is managing director, and Dr Jian Li is senior manager, at Transfer Pricing Associates, a global independent transfer pricing services firm.