Transfer pricing is a key international tax issue that significantly impacts many businesses, particularly multinational corporations. In response to global concerns over tax base erosion and profit shifting (BEPS), Chinese authorities have stepped up enforcement to ensure compliance with transfer pricing regulations. Once mainly a concern for large multinationals, transfer pricing issues are increasingly affecting small and medium-sized enterprises (SMEs) operating in China. This trend highlights the need for all businesses to develop effective transfer pricing strategies to manage risks and adhere to regulatory requirements.
Transfer pricing refers to the pricing of transactions between related entities within the same company, especially when these entities operate in different tax jurisdictions.
Under Chinese law, a business is considered related to another if it meets any of the following criteria:
One party directly or indirectly owns more than 25% of the equity interests in the other.
A third party directly or indirectly owns more than 25% of the equity interests in both entities.
One entity provides loans to another that represent more than 50% of the borrower’s total paid-up capital.
One entity’s business activities rely on the proprietary technologies of the other.
One entity controls the purchasing, sales, or services of the other.
More than half of the directors or senior management of one entity also hold positions in the other.
Control of one entity’s activities through other means, such as family relationships.
Two entities that are not directly connected but share substantial common interests.
Purpose of Transfer Pricing
The primary goal of transfer pricing regulations is to prevent profit shifting between entities based in high-tax and low-tax jurisdictions, where limited economic activity occurs. This prevents companies from avoiding taxes in higher-tax jurisdictions.
The "arm's length principle" is central to transfer pricing. This principle requires that transactions between related parties be treated and priced as if they were between unrelated parties.
Transfer Pricing in China
Although China is not a member of the OECD, it has developed its transfer pricing framework based on the OECD’s BEPS Action Plan 13, incorporating local regulations. China's framework consists of:
Disclosure of related party transactions during annual CIT filing and reporting.
Preparation of transfer pricing documentation for enterprises exceeding certain thresholds.
Transfer Pricing Documentation in China
In 2016, the Chinese State Administration of Taxation (STA) introduced a 3-tier transfer pricing documentation framework under ‘Bulletin 42’, which includes:
Master File: Outlines the transfer pricing policies and activities of larger multinational corporations, including details on investment structure, business activities, intangible assets, financing activities, and the group’s financial and tax status. This must be prepared in Chinese.
Local File: Focuses on the Chinese company and its transactions with related companies in other tax jurisdictions. It must be prepared if specific transaction thresholds are met, including:
Annual related party transactions of tangible goods exceeding RMB 200 million.
Annual related party transactions of intangible assets exceeding RMB 100 million.
Annual related party transactions of financial assets exceeding RMB 100 million.
Annual related party transactions of other types exceeding RMB 40 million.
Country-by-Country Reporting: Required for Chinese companies if they are the ultimate holding company of a group with consolidated revenue exceeding RMB 5.5 billion or if nominated as the reporting entity by the holding group.
Special File: Required if the Chinese enterprise has a cost-sharing arrangement or has exceeded the related party debt-to-equity ratio (5:1 for financial institutions and 2:1 for other enterprises). This must be completed by 30 June of the fiscal year.
Related Party Transactions and Transfer Pricing Methods
In addition to the required documentation, all foreign-invested enterprises in China must submit the “Enterprise Annual Reporting Forms for Related Party Transactions of the People’s Republic of China” during their annual CIT filing.
The arm’s length principle guides the selection of transfer pricing methods in China, which includes:
The comparable uncontrolled price method.
The resale price method.
The cost-plus method.
The transactional net margin method.
The profit split method.
Chinese regulations do not prioritise one method over others, allowing flexibility in choosing the most appropriate method.
Transfer pricing is closely linked to how an entity's profits are taxed. Therefore, it is crucial for any business operating in China to carefully consider these aspects and their potential impact.
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