Transfer Pricing: Practical Advice From a Tax Expert

As head of Ernst & Young’s Central China transfer pricing group, Jessica Tien knows the ins and outs of working with the vast country’s various tax bureaus. She oversees a team of more than 80 finance professionals in three locations in China.
In this final part of a two-part interview, Tien spoke to CFO Innovation’s Pearl Liu about the latest trends in transfer pricing in China, including Advance Pricing Arrangement (APA) agreements, a mechanism that allows a company to be exempted from being examined for a certain period provided it has advance agreement with the tax authorities on the calculation method for pricing foreign related-party transactions. Excerpts:  
The China Advance Pricing Arrangement Annual Report (2011) released two months ago reveals that 73 APA agreements have been signed since 2005.
APAs are extremely valuable in China because the interpretation [of transfer pricing regulations] is too decentralized [with various local tax bureaus making different tax rulings]. There are also too many new developments and new areas. Even if they try hard, companies may not get clear answers or so-called certainty.
And because companies have different evolutionary steps, they might have not done transfer pricing that well in the past and they would like to change for the better going forward. All these reasons support the use of APA.
However, an APA is a privilege in China, as opposed to a taxpayer’s right. You cannot count on your case being facilitated or even concluded. This is basically a competition for scarce resources [in the tax bureaus] to work on your APA.
Is the way China conducts APA negotiations different from those in other countries?
Compared with more mature foreign APA programmes, China puts a whole lot of emphasis on the early stages . . . After completing your pre-filing, the SAT [State Administration of Taxation] is supposed to start work on trying to get you into the programme. But even just getting into the pre-filing stage has become a very difficult step.
In order for the SAT to believe it is [worth the time] to talk to you, they should believe that you are well-prepared to proceed with APA possibilities. So before agreeing to hold a pre-filing conference with you, they practically ask companies to do a lot of work before pre-filing. That’s one difference between China and foreign environments.
Another difference is that China may or may not allow you to proceed to formal filing. This is to say, formal filing is by invitation only. In order to become eligible for formal filing, companies tend to change their positions to agree more with [what they believe the tax authorities want] in order to squeeze themselves into the programme.
Have you seen many failed cases?
I don’t see rejection, but I do see the process not moving as quickly as expected. This is due to many reasons. Because a large number of cases are in the pipeline and resources are limited, [the tax authorities] may need to think about the priority level of some cases, and thus delay the progress of others.
I’ve seen a tendency not to touch certain industries or to process [APA applications from these sectors] very slowly. In the past few years, they have hesitated getting into automotive cases. In the automotive industry, China has enjoyed tremendous profit levels while the global auto industry is more or less declining. So they really do not want to give up [taxes on] Chinese profits in the auto industry.
If a company has done really well in China or enjoys high profits and now wants to come in and apply for [an APA], the result may not be that favourable from the Chinese perspective, and thus it weakens the motivation [on the part of the tax authorities] to prioritise such cases.
Thirdly, there are many companies that intend to bring the whole of China into a basket APA, the whole supply chain. They may have 28 or 30 entities to manage in China, which requires different filings for different types of entities.
This is actually welcomed by the SAT, but these cases become very big projects because they will need to manage all these different bureaus to reach a consensus. The SAT will not say that they dislike it or anything like, that but it does take a lot of communication and planning to coordinate so many different interested parties.
What can companies do to successfully get into the APA programme?
The key is, I think, at two levels. One is for companies to be completely well-prepared with the whole analysis. To count on the SAT to develop more analysis with you is less likely [to bring success]. Basically, companies need to be completely well prepared with the whole analysis before or at the time of embarking on the process.
Secondly, how do you draw attention [to your APA application] when there are 200 other cases in the pipeline? What I have seen as being more successful are companies with strong foreign administration support. Let’s say you are the top corporation in your country. Let the SAT know that your case is the one that your country would like them to cooperate with.
Domestic influence [is very important] as well. Your advisors can sometimes be a very powerful [influence]. The bureau in charge of your case or [the tax authority] at provincial level can let the SAT know that they really want to work with you on your case.
Rightly or wrongly, Hong Kong is seen by some as a tax haven. How does China’s SAT regard Hong Kong in terms of transfer pricing?  
I think mainland China has a very pragmatic view of Hong Kong, which is after all part of China. They would like Hong Kong to blossom and progress. So I do not believe that the SAT is particularly strict or closely scrutinises the relationship with Hong Kong.
The two sides also have a healthy information exchange mechanism, meaning that the SAT has ways to get Hong Kong taxpayer filings through formal information exchange channels. Information transparency is particularly good, so they do not really treat Hong Kong as a closed-door tax haven.
Hong Kong is still a good location for building up substance or infrastructure that addresses Chinese businesses’ [ability to justify] utilising the tax rate differential between Hong Kong and mainland China [in the context of transfer pricing].
Try to look at logistics or other arrangements that beef up Hong Kong. Put people or deposits in Hong Kong and rightfully show that Hong Kong performs regional headquarters function. The SAT will expect that.
If Hong Kong is used as a shell, an empty entity, that will be too risky because information is quite transparent between the SAT and Hong Kong.
I note that the tax revenue collected from transfer pricing investigations reached  more than RMB2.4 billion in 2011, from just RMB460 million in 2005.
I think they practiced first with simple issues and gradually gathered the ability to audit the big issues, mostly intangible-related issues. They do not need to increase the number of cases too much, but each case should have much more of an impact.
To my mind, they had tended to unfortunately pick medium size entities to audit. Now they have the ability to address the top Fortune 500 companies because they have more competence. So basically, I think the per-case average will leapfrog significantly. By 2014, auditing very large cases will become more of a routine.
There are some very hot topics faced by large MNCs this year. One area of focus is China’s domestic consumption. You will see companies with a lot of brand content being challenged on whether their importation or cross-border compensation is appropriate. There will be questions on whether the cross-border use of their global brand is the reason for their profits in China or whether it is really domestic implementation/contribution.
If you think about brands, these will be luxury goods. Or you could see this happening with fast moving consumer products. These are highly subject to further scrutiny.
A second interesting issue with a big impact is the SAT picking up quite a few cases involving US corporations that charge [their subsidiaries in China] headquarters services fees, due to a US requirement in 2008. We see the SAT intending to scrutinise why China is getting charged through these headquarters shared costs or shared services. These are sometimes very large amounts.
What about transfer pricing issues around activities like research and development?
On the intangibles transactions side, China is starting to look at R&D activities conducted [within its borders]. Most companies declare this as contract R&D services, with cost plus 10% as the remuneration for China.
China first of all challenges whether this is really a contract R&D matter, or whether China is actually a collaborator or even part owner of the R&D result. Whether the cost-plus [formula] will be satisfactory at all is question mark number one.
The second question mark is, if this is creating high value intangibles, then why should we think cost-plus-10% is adequate? China may ask, for example, for 18%, 19% or 20%.
For companies, the operating procedures are very important . . . If you do not want to have the intangibles owned in China, you need to think about what kind of jobs you are placing in China. Basically, matching the substance is always the first step.
Do you see the SAT taking a ‘by industry’ approach?
There’s actually a very long list of possible industries [for the SAT] to look into. But retail has always shown up in the past few years as one of the areas that they are really looking at. Real estate, shipping, hotel, these are all quite interesting.
They used to say that the pharmaceutical industry is important; now it may not be so much. I still think the ‘old’ industries like the auto industry would still [command] attention.  
Basically, industries that have higher profit potential and high reliance on importation or other kinds of transfer pricing arrangements will be very interesting to the SAT. So luxury goods are also among the key industries.
What advice can you give to CFOs and other finance professionals about dealing with these issues?
There are three levels. First, absolutely establish that your substance matches with your tax objective. Don’t separate your tax objective from the substance of your business. If you want a certain tax result, you need to [match or even change the substance of] your business accordingly.
Second, treat compliance and disclosure ad very localized; try to understand what is required locally.
Thirdly, I highly recommend that companies that are serious about China should develop a communications strategy with the various tax bureaus. Do not just operate your business and wait for them to catch you. 
You have layers and layers of bureaus trying to get into your business. They are not waiting for audit time only to get involved. Actually, they are very involved on a daily basis or maybe quarterly basis.
I think, sometimes, the word ‘relationship’ is misinterpreted in China. It’s not about having dinners or drinks or being friends or knowing each other’s cousins. It’s not about that. You need to build trust and credibility with very different bureaus and understand when to communicate and be more transparent about your operations in general. Communication is going on all the time. It’s not just during the audit.
It is very important to take proactive steps and follow the documentation requirements, beyond just thinking it’s about doing your homework. It will serve as the first line of defense if you are audited. You have to spend the effort and resources doing documentation anyway, so do a good job.
And, of course, as we discussed, a lot of countries now are introducing new programmes to work with taxpayers. So CFOs should be aware of new regulations, new enforcement trends, and the availability of tools such as the APA.

This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Member firms of the global Ernst & Young organisation cannot accept responsibility for loss to any person relying on this article.


Photo credit: 


Click here to read Part 1 of this interview.



Suggested Articles

Some of you might have already been aware of the news that Questex—with the aim to focus on event business—will shut down permanently all media brands in Asia…

Some advice for transitioning into an advisory role

Global risks are intensifying but the collective will to tackle them appears to be lacking. Check out this report for areas of concern