Transfer pricing is the pricing of transactions between related parties — a WFOE and its foreign parent, a WFOE and a related company in another country. The tax authorities in every major jurisdiction enforce transfer pricing rules to prevent companies from shifting profits from high-tax jurisdictions to low-tax jurisdictions. China’s transfer pricing rules are among the most actively enforced in the world, and a WFOE that engages in cross-border transactions with related parties should be prepared for transfer pricing scrutiny.
Here’s what the Chinese tax authorities are actually looking for, the documentation they require, and how to manage the risk.
The Arm’s Length Principle
The Chinese transfer pricing rules are based on the arm’s length principle — the principle that transactions between related parties should be priced as if the parties were independent and dealing at arm’s length. A WFOE that pays a royalty to its foreign parent at a rate of 5% of net sales should be able to demonstrate that an independent company would agree to pay 5% for the same technology. A WFOE that buys raw materials from a related company at a price of 100 RMB per unit should be able to demonstrate that independent suppliers charge 100 RMB for the same materials.
The arm’s length principle is the international standard — the OECD Transfer Pricing Guidelines, which the Chinese rules largely follow, are built on the arm’s length principle — and it’s the standard that the Chinese tax authorities apply. A transfer price that’s not at arm’s length can be adjusted by the tax authorities, and the adjustment can result in additional tax, interest, and penalties.
The Chinese tax authorities have become increasingly sophisticated in their transfer pricing analysis. They have access to databases of comparable transactions — the same databases that multinational corporations and their advisors use — and they employ economists and transfer pricing specialists who can challenge the company’s transfer pricing analysis with their own analysis.
What the Tax Bureau Is Checking
The tax bureau’s transfer pricing review starts with the company’s financial results. A WFOE that reports persistent losses or below-market profitability — a company that’s been in business for five years and has never made a profit, or that makes a consistent 1% profit margin when comparable independent companies make 8% — is a transfer pricing red flag. The tax bureau asks why the company is unprofitable or under-profitable. The answer “because the Chinese market is competitive” is not sufficient if there are comparable companies that are profitable.
The tax bureau looks at the company’s functions, assets, and risks — the FAR analysis. A WFOE that performs limited functions — contract manufacturing, contract processing, or distribution with limited marketing and sales functions — should earn a limited return. A WFOE that performs significant functions — research and development, marketing and sales, strategic management — should earn a higher return. The function analysis determines the expected profitability range for the company, and a profitability that’s outside the range is a transfer pricing adjustment candidate.
The tax bureau looks at the company’s related-party transactions individually and in the aggregate. The individual analysis examines each transaction — the royalty, the service fee, the goods purchase, the interest on the intercompany loan — for arm’s length pricing. The aggregate analysis examines whether the total related-party transactions result in the appropriate total profitability for the Chinese company, considering the functions the company performs.
The tax bureau has specific areas of concern. Management service fees — fees charged by the foreign parent to the Chinese WFOE for management, administrative, and technical services — are subject to heightened scrutiny because they’re easy to inflate and hard to benchmark. The tax bureau asks what specific services were provided, how the fee was calculated, and what benefit the Chinese company received from the services. A management fee that’s described as “general management support” without a detailed description of the services, the time spent, and the benefit to the Chinese company is likely to be challenged.
Royalties — payments for the use of technology, trademarks, and other intellectual property — are subject to heightened scrutiny for the same reason. The tax bureau asks whether the royalty is commensurate with the value of the IP, whether the IP is actually used by the Chinese company, and whether the royalty rate is comparable to the rates in arm’s length license agreements. A royalty rate that was set when the Chinese company was established 15 years ago and hasn’t been reviewed since — despite changes in the technology, the market, and the company’s profitability — is vulnerable to challenge.
The Documentation Requirements
China has adopted the OECD’s three-tier transfer pricing documentation structure — the master file, the local file, and the country-by-country report. The master file provides a global overview of the multinational group’s business, its transfer pricing policies, and its global allocation of income and economic activity. The local file provides a detailed analysis of the Chinese company’s related-party transactions, its functional analysis, its transfer pricing method, and its comparability analysis. The country-by-country report provides a country-by-country breakdown of the group’s revenue, profit, tax, and economic activity.
The master file and the local file must be prepared annually by companies that meet the transaction thresholds — generally, companies with annual related-party transactions exceeding specified amounts. The threshold is 1 billion RMB of annual related-party transactions for the master file and 200 million RMB for the local file, with lower thresholds for certain types of transactions — royalties, service fees, and intangible property transactions.
The documentation must be contemporaneous — prepared by the time the annual corporate income tax return is filed, generally by May 31 of the following year. A company that prepares the documentation after the filing date is not compliant with the contemporaneous documentation requirement, and the non-compliance can result in penalties and an increased risk of a transfer pricing adjustment.
The documentation must be in Chinese — or translated into Chinese — and must be submitted to the tax bureau on request. The tax bureau can request the documentation at any time, not only during a formal audit, and the company must produce it within the specified period — generally 30 days.
A company that maintains the required transfer pricing documentation in compliance with the rules is entitled to a penalty reduction if a transfer pricing adjustment is made — the penalty for the additional tax is reduced or waived. The penalty protection is a significant incentive to comply with the documentation requirements, because the potential penalty for a transfer pricing adjustment can be substantial.
The Transfer Pricing Method
The company must select and apply a transfer pricing method that produces an arm’s length price for each category of related-party transactions. The Chinese rules recognize the same methods as the OECD Guidelines — the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, and the profit split method.
The comparable uncontrolled price method compares the price charged in the related-party transaction with the price charged in comparable transactions between independent parties. A WFOE that buys the same raw material from both a related supplier and an independent supplier can compare the related-party price with the independent-party price. If the prices are consistent, the related-party price is arm’s length.
The resale price method is used for distribution transactions. The method starts with the price at which the WFOE sells the product to independent customers and subtracts an arm’s length gross margin — the margin that an independent distributor would earn — to arrive at the arm’s length purchase price from the related supplier. The margin is determined by reference to the margins earned by comparable independent distributors.
The cost plus method is used for manufacturing and service transactions. The method starts with the cost of goods sold or the cost of providing the service and adds an arm’s length markup — the markup that an independent manufacturer or service provider would earn — to arrive at the arm’s length price. The markup is determined by reference to the markups earned by comparable independent manufacturers or service providers.
The transactional net margin method — the most commonly used method — compares the net profit margin of the Chinese company on its related-party transactions with the net profit margins of comparable independent companies on comparable transactions. The net profit margin is typically the operating profit margin — operating profit divided by sales — or the return on assets or the return on costs. The method is flexible and can be applied to most types of transactions with sufficient comparables.
The profit split method is used when the related parties contribute valuable intangibles to the transaction and the contribution of each party can’t be benchmarked separately. The method allocates the combined profit from the transaction between the related parties based on the relative value of their contributions — the functions they perform, the assets they use, and the risks they assume.
The Audit Process
A transfer pricing audit begins with a notice from the tax bureau — or, in the case of a self-initiated review, with a request from the tax bureau for information and documentation. The first step is the submission of the transfer pricing documentation and the responses to the tax bureau’s information requests. The tax bureau reviews the documentation and identifies the issues for further investigation.
The second step is the functional analysis interviews — the tax bureau interviews the company’s management and staff to understand what the company actually does, how it makes decisions, who bears the risks, and how the related-party transactions are conducted in practice. The interviews test whether the company’s transfer pricing documentation is consistent with the company’s actual operations.
The third step is the economic analysis — the tax bureau conducts its own comparability analysis, using its own databases and its own selection of comparable companies, to determine whether the company’s transfer prices are at arm’s length. The tax bureau’s analysis may produce a different result from the company’s analysis because the bureau uses different comparables or a different interpretation of the comparability data.
The fourth step is the adjustment — if the tax bureau concludes that the transfer prices are not at arm’s length, it issues a notice of adjustment that states the amount of the adjustment, the additional tax, the interest, and the penalty. The company can accept the adjustment and pay the additional tax, or it can challenge the adjustment through the administrative appeal process and, if necessary, the court process.
The audit can cover multiple years — the tax authorities can audit the open years, generally five years from the filing deadline for each year — and the cumulative adjustment for multiple years can be substantial. A company that has been under-reporting its Chinese taxable income through transfer pricing for five years faces a five-year adjustment, plus interest on each year’s underpayment and penalties.
The Advance Pricing Agreement
A company that wants to eliminate the transfer pricing uncertainty can apply for an advance pricing agreement — an APA — with the tax authorities. An APA is an agreement between the company and the tax authorities that establishes the transfer pricing method and the acceptable range of results for a specified period — typically three to five years. The company applies the agreed method, stays within the agreed range, and files annual reports confirming compliance. The tax authorities accept the results and don’t audit the covered transactions.
The APA process requires the company to submit a detailed analysis of its functions, assets, and risks, its proposed transfer pricing method, and its proposed arm’s length range. The tax authorities review the analysis, conduct their own functional analysis and economic analysis, and negotiate the method and the range with the company. The process takes 12 to 18 months from application to agreement.
An APA provides certainty — the company knows what the transfer pricing result will be accepted as arm’s length, and it avoids the risk, the cost, and the distraction of a transfer pricing audit. The certainty is valuable for a WFOE with significant related-party transactions where the transfer pricing risk is material.
