China claims that more than 50% of foreign companies which have invested in China are currently reporting losses as the result of aggressive transfer pricing.  China has improved its tax sophistication and enforcement over the last several years and plans to increase the number of its audits to ensure that these companies are reporting an appropriate amount of tax.

Foreign owned entities prepare and file a Declaration Form annually with their corporate income tax return, reflecting cross-border related party transactions.  China’s audit procedures provide that the tax authorities must review these forms and audit at least 30% of entities identified as "key targets" each year.   "Key targets" include entities that:

• have a significant amount of related party transactions;
• report losses for extended periods (for more than two consecutive years);
• report marginal profits or marginal losses but continuously expand their operations;
• have transactions with related parties established in tax havens; and
• have lower profit margins than other entities in the same industry and region.

The governing tax bureau has the right to request related party information, and the company must provide the information within 60 days (although it can request a 30-day extension).  Although China has not yet issued formal documentation rules, a company must have a well supported transfer pricing policy to be able to provide the information within a 90-day period.

If an audit results in an adjustment for any year, a retroactive adjustment can be made for up to 10 prior years  A company can appeal an adjustment, but to do so it must first pay the tax and any late payment penalties.

Companies should consider seeking an Advance Pricing Agreement ("APA") to avoid the vagaries of audit and appeal.  China first began processing APAs in 1998.  Draft implementation rules were issued in May 2003, and formal rules were issued in September 2004 under the title "Implementation Rules on Advance Pricing Agreements for Related-Party Transactions."  In 2004 alone, China concluded 178 APAs, as reported by Wang Yukang, deputy director of the International Taxation Department of the State Administration of Taxation, at the December 2005 annual international tax conference sponsored by George Washington University and the Internal Revenue Service.  All of these APAs were unilateral, except for one bilateral agreement with Japan that was completed in April 2005.

The Implementation Rules provide detailed procedures about requesting a pre-filing conference, preparing a formal APA application, review and evaluation by the tax authorities, negotiation and signing the APA.  Although in general the rules are similar to the US rules on APAs, in China a taxpayer must identify itself at the pre-filing conference, whereas in the US the taxpayer can remain anonymous until later in the process.  Nonetheless, this possible disadvantage seems to be outweighed by the benefits of an APA, particularly in light of China’s aggressive tax audit strategy, a new transfer pricing adjustment penalty that Wang expects to be enacted in 2008, and new documentation requirements expected to be issued soon.  These developments favor recommending the  certainty provided by an APA.

For further information, please contact a member of our Corporate Practice Group.