[Eoibhe Hall]: Hello, everyone. It's my pleasure to have this opportunity to share with you some recent trend regarding transfer pricing.
[Eoibhe Hall]: So, to start off, Shirley, for those of us who have no background in transfer pricing, can you summarize the concept in just a couple of sentences?
[Shirley Chu]: It is necessary for companies to put a price tag on properties, services, intangibles or other types of transactions for trading purposes. Putting a price on the dealings between associated companies is called Transfer Pricing. "Transfer Pricing" itself refers to pricing for transactions incurred between related parties.
[Eoibhe Hall]: Does this mean transfer pricing is a relatively new idea? How did it come about?
[Shirley Chu]: Well, my understanding is that early on in the 20th century, as FDI from the US and UK rapidly expanded, some companies began to use transfer pricing as a method of tax avoidance through transactions with related parties. Understandably, this phenomenon was brought to the attention of national governments. Transfer pricing has maybe 100 years of history. However, the key points to remember regarding early transfer pricing were 1) the concept developed slowly; 2) most countries held a relatively tolerant attitude to the phenomenon.
In the mid-1980s, the global economy entered a new era. The introduction of the computer and new communication technology, accelerated the pace of globalization. As a result, multinational business groups developed rapidly, establishing branch offices and subsidiaries across the globe. MNCs utilized transfer pricing as an effective way to shift profits, and relevant nations saw significant erosion in their tax base. This became an international issue that could not be ignored.
[Eoibhe Hall]: So, what is the transfer pricing environment like now? Have any regulations come into effect recently that are worth noting?
[Shirley Chu]: As previously mentioned, the mid 1980s saw the start of a new era of globalization that called for the evolution of transfer pricing regulations. There was this global consensus that we needed tighter legislations and a strengthening of transfer pricing administrative practices. Transfer pricing related legislation is constantly being updated. In recent years, with the introduction of the BEPS Action Plan by G20/OECD countries, transfer pricing has entered into a new stage of development.
[Eoibhe Hall]: What is BEPS?
[Shirley Chu]: BEPS stands for Base Erosion and Profit Shifting. It refers to taking advantage of loopholes and gaps in tax regulations to shift profits to an alternate location to achieve tax avoidance, double non-taxation, or long-term deferral. Its increasing significance on the international stage has made it one of the hottest taxation topics in the world today. As countries become more and more economically interconnected, Base Erosion and Profit Shifting has become increasingly severe, drawing attention from global political leaders and the public alike. In June 2012, the G20 Finance Ministers and Central Bank Governor Meeting reached an agreement to address BEPS through international cooperation, and appointed the OECD to conduct relevant studies and research. Following the release of the report entitled "Addressing Base Erosion and Profit Shifting," the OECD and G20 countries adopted a 15-point Action Plan to address BEPS in September 2013.
[Eoibhe Hall]: What is the BEPS Action Plan? How does it relate to transfer pricing?
[Shirley Chu]: Following the release of the report Addressing Base Erosion and Profit Shifting in February 2013, the OECD and G20 countries adopted a 15-point Action Plan. The Action Plan identified 15 actions along three key pillars:
1. introducing coherence in the domestic rules that affect cross-border activities,
2. reinforcing substance requirements in the existing international standards,
3. And improving transparency as well as certainty.
After two years of work, the OECD finally released the 15 points in October of this year.
[Eoibhe Hall]: Back to transfer pricing, can you talk a little bit about how it works?
[Shirley Chu]: Transfer pricing refers to the pricing between related parties within a group. Independent companies will take different factors into account when pricing, but most of these factors relate to market behavior. That's why we call it fair market value. However, for intercompany transactions incurred between related parties, their relationship will often take precedent, which may sometimes include a taxation avoidance consideration.
This is very basic example illustrating how transfer pricing works. As you may see from the chart, the transactions look alike. The difference is that the chart in right side is an independent transaction, while the chart on the left side is related party transaction. You may see that the legal entity A and B purchase the products from a third-party at the same price. But the selling price to a related party can be artificially high or low compared to a fair market price incurred between independent companies. Where the selling price is higher than 250, more profit will be retained in China, while the selling price is lower than 250, more profit will be shifting to the outbound related party.
Currently, in the field of transfer pricing, there are five major methodologies, which are the comparable uncontrolled method, the resale method, the cost-plus method, the transactional net margin method, and the profit split method. The former three methodologies are jointly known as the traditional method, while the latter two methods are known as the transactional profit method. Additionally, there are other methods that follow a non- arm's length approach, such as global formulary apportionment, and valuation techniques.
The CUP method compares the price charged for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. If there is any difference between the two prices, this may indicate that the conditions of the commercial and financial relations of the associated enterprises are not arm's length, and that the price in the incomparable transaction may need to be substituted for the price in the controlled transaction. When it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm's length principle. Consequently, in such cases the CUP method is preferable over all other methods. However, in reality it may be difficult to find a transaction between independent enterprises that is similar enough to a controlled transaction such that no differences have a material effect on price.
The resale price method begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This price is then reduced by an appropriate gross margin on this price representing the amount out of which the reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed, make an appropriate profit. What is left after subtracting the gross margin can be regarded, after adjustment for other costs associated with the purchase of the product, as an arm's length price for the original transfer of property between the associated enterprises. This method is probably most useful where it is applied to marketing operations.
The cost plus method begins with the costs incurred by the supplier of property in a controlled transaction for property transferred or services provided to an associated purchaser. An appropriate cost plus mark-up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions. What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm's length price of the original controlled transaction. This method probably is most useful where semi-finished goods are sold between associated parties, where associated parties have concluded joint facility agreements or long-term buy-and-supply arrangements, or where the controlled transaction is the provision of services.
The transactional net margin method examines the net profit relative to an appropriate base that a taxpayer realizes from a controlled transaction. Thus, a transactional net margin method operates in a manner similar to the cost plus and resale price methods. This similarity means that in order to be applied reliably, the transactional net margin method must be applied in a manner consistent with the manner in which the resale price or cost plus method is applied. This means in particular that the net profit indicator of the taxpayer from the controlled transaction should ideally be established by reference to the net profit indicator that the same taxpayer earns in comparable uncontrolled transactions. When this is not possible, the net margin that would have been earned in comparable transactions by an independent enterprise may serve as a guide. A functional analysis of the controlled and uncontrolled transactions is required to determine whether the transactions are comparable and what adjustments may be necessary to obtain reliable results.
The transactional profit split method seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction by determining the division of profits that independent enterprises would have expected to realize from engaging in the transaction or transactions. The transactional profit split method first identifies the profits to be split for the associated enterprises that are engaged.
In addition to the five transfer pricing methods mentioned above, there are other non- arm's length approaches like global formulary apportionment and valuation techniques for some special cases.
[Eoibhe Hall]: To give us a bit of a better understanding of the subject, can you walk us through a typical TP case for you?
[Shirley Chu]: In our day-to-day experiences with transfer pricing, our most frequent cases involve helping foreign multinational companies who are planning to invest or have already invested a manufacturer, service company, or trading company in China to establish a transfer price for a transaction, or review their transfer pricing documentation.
For example, I'll give you one case that I dealt with several months ago. My client was a multinational company which is engaged in the online sale of custom made leather products. The shoppers may choose the shape, color and other features of leather products and make orders online. The China located entity is responsible for producing the products based on the online order. The final products are distributed to the end users through either physical stores located in North America or by courier directly posted from China manufacturer. Through a quantitative analysis of the functions performed by the company, we helped the client to establish the arm's length price and prepared the necessary documents.
[Eoibhe Hall]: Can you give us an introduction to the current TP environment in China?
[Shirley Chu]: China's transfer pricing legislation started fairly late compared to countries like the US, UK, and Japan. However in the last 10 years, China's transfer pricing legislation has entered a period of rapid development. As a result, China's Transfer Pricing regulations have been very successful. The nation's current transfer pricing legislation includes the related party transaction reporting rule, the contemporaneous documentation rule, the special tax adjustment rule, the APA rule, the cost sharing arrangement rule, the controlled foreign company rule, thin capitalization, mutual negotiation mechanisms, etc. Among all of them, the related party transaction reporting rule, the contemporaneous documentation rule, and the APA rule have become fairly comprehensive through 10 years of development. As a G20 member country, China has actively participated in the BEPS Action Plan drafting process, and based on the key pillars, has started to revise the relevant domestic tax laws. Firstly, for related party transaction reporting and TPD, it introduced the concept of the master file and local file, which are addressed in the BEPS Action Plan and CbC report for the annual related party transaction reporting, and set forth certain thresholds in accordance to China's actual situation. Secondly, the Chinese tax authority recently released a new rule which revised and updated the existing APA rule. Additionally, in early 2015, China also released a new provision regarding intra-group outbound payments. This shows that China's tax authority will gradually increase the implementation of tax policies meant to reduce tax base erosion through outbound service fee and royalty payments.
[Eoibhe Hall]: What are some of the documents relating to transfer pricing which have to be submitted by companies doing business in China?
[Shirley Chu]: Currently in China, there are two major types of documentation relating to transfer pricing issues that should be prepared for submission to the tax authority. One is the annual related party transaction reporting form, which should be submitted to the tax authority at year-end tax filing. Currently, the annual related party transaction reporting documentation is made up of 9 forms. However, beginning in 2017, which is applicable for the 2016 fiscal year, a new set of more complicated forms will be introduced by the tax administration. Included in these new forms is the CbC report, which was developed as a part of the BEPS Action Plan.
Another type of document that should be proactively prepared by taxpayers is the TPD. As with the annual related party reporting forms, starting from 2017, which actually covers the 2016 fiscal year, the TPD preparation should follow the new transfer pricing rule. The new rule introduces the concept of the master file, local file, the concept of which is also developed in BEPS Action Plan.
The master file should be completed within 12 months of the end of the fiscal year for the group's main holding company. Local files, as well as special files should be completed by June 30th of the following year after the transaction. The TPD shall be submitted within 30 days upon request by the tax authority.
[Eoibhe Hall]: Do you have any tips for preparing TP documentation?
[Shirley Chu]: Starting in 2017, a brand new TPD rule will be implemented. This is not only a rule for the taxpayer, but also for the tax authority. It firstly requires taxpayers to judge whether or not they will be subject to the obligations under the new rule. If they find that they are in fact obligated to fulfill them, then it is important for the company involved to get to work on the documentation as soon as possible. Last minute correspondence should be avoided. In addition, TPD preparation is absolutely essential for compliance and all content should be disclosed in the TPD. Actually, I would recommend that the taxpayer find a more experienced firm to deal with this as they would have sufficient experience to identify potential transfer pricing issues and would be able to provide advisory as well.
[Eoibhe Hall]: We’ve talked a lot about transfer pricing for tangibles, but what about intangibles such as trademarks or even services? How does this work?
[Shirley Chu]: As with tangible goods transactions, intercompany intangible transactions must also comply with the arm's length principle. However, unlike tangible transactions, each intangible transactions is unique, which can make it difficult to find a comparable transaction. To deal with this pricing issue, we look to special approaches such as the valuation technique. As a matter of fact, intangible related transfer pricing issues have started to draw more attention from the tax authority. Still, we need to recognize that intangible related TP legislations are still a work in progress. In reality, a lack of practical guidance concerning TP is also a problem. However, early on in 2015, China's tax authority released a new rule pertaining to tax base erosion brought about by intragroup outbound service payments and royalty payments. At the moment, China's practice is that when a taxpayer wants to make an outbound payment, they need to file and record the intercompany service/licensing agreement with the relevant tax authorities before making the payment. The tax authorities will only conducts a pro forma review on the agreement itself. It is unlikely for the taxpayer to be challenged by the tax authority at this stage of the payment. However, with the impact of the BEPS Action Plan and the recent global attention on intangibles, tax authorities are paying increasing attention to this issue by a substance over form principle, which follows the "aligning the transfer pricing outcomes with valuation creation" concept raised in the BEPS Action Plan. This is especially true when the payment amount is significant, as it will be more likely to draw attention. Tax authorities will track the transaction through the government database. Keep in mind, an unreasonable payment may be challenged years later. Therefore, it is wise for taxpayers to understand the most recent TP trends in China and plan in advance before signing a contract and starting the payment process.
[Eoibhe Hall]: Shirley, I know that you handle transfer pricing issues every day. What are some of the most common questions you are faced with?
[Shirley Chu]: In our day-to-day experiences with transfer pricing clients, one of the most frequently asked questions we get are "What is China's TP Policy? What do we need to do to comply?" In response to these questions, we usually tell our clients the most recent TP rules, and help them understand those directly relating to their situation. In addition, we usually advise our clients to pre-check the transfer price and ensure that it complies with the arm's length principle. They should also read up on China's transfer pricing laws, prepare relevant documentation, and make any necessary revisions/adjustments in advance to avoid any potential headaches in the future.
Another reoccurring issue that we see among our clients is that because they may not fully understand China's TP regulations, many clients are not sure how to go about reviewing their TPD. TPD is necessary for compliance, which means that as long as the transaction amount lies above the threshold, you should have it prepared for submission upon the tax authorities’ request. However, this does not mean that companies whose transaction amount lies below the threshold will be 100% safe and should disregard TP issues. Although you don't necessarily have to prepare the documentation, unreasonable TP such as outbound payments still run the risk of being audited or adjusted in the future.
Another topic that we are frequently asked questions about is outbound payments. Many multinational business groups set up entities in China. Many of them think that because they are providing some manner of assistance to the local entity regarding finance, HR, IT, or Marketing, the local entity should follow certain arrangements or by certain mean such as management fees, service fees, or royalty to bear the cost. According to our experiences, most of these charges or arrangements are not reasonable and are without basis. Even if there is some basis for it, it may not apply to transfer pricing transactions. The legislation relevant to these circumstances are still being developed in China. However from the tax authority's practice such as publicly opened audit cases, experienced consultants will know where the exposures are and how to mitigate the risks.
[Eoibhe Hall & Shirley Chu]: Q&A