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China
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Most subsidiaries of multinational enterprise (MNE) groups in China adopt a limited risk business
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Performing retrospective TP adjustments in China, however, is more complex in practice than in many
other jurisdictions, primarily due to the strict foreign exchange controls of the State Administration of
Foreign Exchange (SAFE). The difficulty of settling foreign exchange would mean that the TP adjustment
entries could not be booked in the accounts of the MNEs, thereby increasing their TP risks.
Retrospective TP adjustments would also have an impact on customs duties and indirect taxes, and
MNEs should also consider these impacts. Managing TP adjustments from a customs perspective is vital
to ensure customs compliance so that trade is not disrupted.
TP adjustments can go either way – an upward adjustment is to increase the profitability of the MNE,
while a downward adjustment reduces the taxable profits of the MNE.
Upward adjustments are more commonly seen in China. Generally, the adjustments would not likely
create adverse reactions from the tax authorities as this would enable MNEs to eventually pay more
corporate taxes, although the adjustments do not protect the MNE from future TP audits.
Often, upward TP adjustments in China are processed as service fee transactions. The China foreign
exchange controls provide that foreign exchange is processed either through the trade route (i.e. physical
goods trades) or the non-trade route (generally services or royalties). If the TP adjustment is not related
to goods transactions, then the banks would process the adjustment as a service transaction despite the
fact that it does not involve the provision of services. This could raise issues for the overseas related party
whereby the substance of the “service” transaction is questionable. Furthermore, VAT would need to be
charged by the local MNE to the overseas related party when the adjustment is processed as a service fee.
This would be a leakage to the overseas related party given that China VAT is not creditable in its
jurisdiction.
Even if the TP adjustment is related to goods transactions, it is generally not possible to obtain
documentation from the customs authorities to re-adjust the import prices. In an upward TP adjustment,
a refund on the customs duties and import VAT already paid should in theory be due, but there has not
been any precedent where an MNE importer has been able to obtain a refund.
SAFE has piloted certain programmes to streamline the procedures for Chinese MNEs to receive TP
compensations from overseas related parties and, if ascertained as authentic transactions and compliant,
they could be processed through other accounts instead of the trade or non-trade accounts. As a result,
there are some successful cases where upward TP adjustments are processed through the new category
and not as service transactions. The process, however, is not straightforward. It commonly requires
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multiple rounds of communication with the bank (or multiple banks, because the practices vary) and also
discussions with SAFE to obtain specific approvals. The tax authorities would also need to be consulted
so that they agree that the adjustments would not be subject to VAT.
In contrast, retrospective downward TP adjustments are generally difficult to execute in China. Chinese
tax authorities would not endorse any adjustments that reduce the tax base of the MNEs. MNEs would
usually put in place transactions like service fees or licensing transactions to manage their profit margins
prospectively. These are not necessarily effective if the profits are high, plus there are withholding taxes
and VAT implications. Tax authorities, meanwhile, target these transactions as low-hanging fruit for TP
audits.
Profitable MNEs also face scrutiny by the customs authorities on the import prices for being low due to
TP. The risk is elevated if these MNEs also pay royalty fees. The licensing arrangements are construed by
customs authorities as a way to reduce prices of imported goods, thereby reducing the payable duties.
Performing a downward TP adjustment would, in theory, mitigate the customs risk by adjusting upwards
the import prices and paying the additional duties and import VAT. However, in practice, the Chinese
customs authorities do not usually re-open filed declarations or issue a proforma customs declaration
(i.e. declarations that do not refer to underlying imports) to adjust the import prices upwards, hence
creating difficulties for MNEs to provide the necessary documentation to banks to process the downward
adjustments.
Recognising the lack of clarifications on how foreign exchange regulations process TP adjustments and
collecting the experience from the SAFE pilot programmes noted above, SAFE issued a notice titled
“Questions & Answers Regarding Foreign Exchange Administration for Services and Trade (II)” (SAFE
Q&A) in January 2021, wherein one part of the SAFE Q&A is aimed at TP adjustments and clarifies how
banks process inbound or outbound cashflows as a result of TP adjustments.
The Q&A provided three approaches where TP adjustments could be processed: (1) Foreign exchange
inflows or outflows based on TP methods; (2) Foreign exchange inflows or outflows using the cost
sharing method; and (3) Foreign exchange inflows or outflows using other methods.
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Under the first approach, the banks processing TP adjustments would need to “review the relevant
written documentation issued by tax authorities or customs authorities, profit adjustment agreements,
and invoices”. The foreign exchange payments or receipts would then be processed to follow the original
transaction types. The SAFE Q&A does not provide further clarification on the format of the
documentation issued by the authorities that can be accepted by banks.
In practice, the tax authorities generally will not issue any official written documentation or notices to
taxpayers. The written documentation that can be issued is usually limited to when there is an advance
pricing agreement (APA) in place or when TP audits had been concluded. From a customs perspective, as
discussed above, customs authorities do not entertain the re-opening of customs declarations or the
issuing of a proforma declaration even if there is additional duty to be collected, except for the
conclusion of a customs audit.
Under the second approach, the SAFE Q&A’s reference to cost sharing method is not the general TP
understanding of a cost contribution arrangement. In substance, MNE groups may centrally appoint a
group member to enter into contracts with third parties or related parties. MNEs would thus need to
prepare the relevant TP documents to demonstrate that the cost sharing method is consistent with the
arm’s length principle. It is then up to the interpretation of the banks to review the relevant
documentation to affirm that these transactions are not related to insurance compensation.
The third approach is a catch-all statement to allow SAFE bureaus and banks the flexibility to deal with
foreign exchange cash movements to take into account the different TP arrangements or business models
of MNE groups.
The SAFE Q&A has been issued for over a year but it is still generally difficult to have a harmonised
practical approach. There is a need for MNEs to discuss with banks and/or local SAFE individually to
determine the local interpretation of the SAFE Q&A.
Longer-term solutions
TP adjustments are only short-term solutions performed in any one year to bring the MNEs’ profitability
to meet the arm’s length principle. The complex process of communicating with banks, SAFE, customs
and tax authorities as discussed above would have to be repeated whenever a TP adjustment is required.
The most efficient way of managing TP policies is to have a strong monitoring mechanism to identify any
deviations early on and undertake measures to mitigate the deviations. This is where operational TP
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conceptualisation to implementation. The OTP solutions take into account process and policy
improvement, governance and controls, finance system readiness and technology automation to achieve
successful implementation of TP policies.
Alternatively, MNEs could also explore other ways to manage their TP policies more effectively, such as
applying for an APA, either bilateral or unilateral, so that TP arrangements and adjustments can be
agreed in advance. An APA agreement is a document issued by the tax authorities, thus fulfilling the first
approach of the SAFE Q&A. The APA is also generally respected by the Chinese customs authorities and
as such any customs risks could also be mitigated to a large extent.
Despite the benefits, APAs often take a long time to negotiate and conclude regardless of whether the
APA is unilateral or bilateral. A unilateral APA process would typically take two to three years and the
process could be longer for bilateral APAs.
China’s State Taxation Administration (STA) issued a regulation in July 2021 introducing a new set of
simplified procures for unilateral APAs (but not bilateral APAs). MNEs will need to meet certain criteria
to be able to apply the simplified procedures. The new regulation reduces the APA process from the
general six stages to three and also provides specific timelines for each stage of the process. This means
that unilateral APAs could potentially be concluded within one year of submitting the application. This is
part of the STA’s continuous innovation to improve its services to taxpayers. Prior to the official roll-out,
when the rules were trialled in southern China, the authors successfully obtained agreements through
the simplified procedures within nine months of the date of application.
Continuing with the theme of innovation, China is also trialling a pilot case in southern China to resolve
the double taxation of corporate income and import pricing under an APA/joint-ruling framework
between tax and customs authorities. The case discussions are at an advanced stage, and if the case is
successfully concluded, it would pave way for future cooperation between the STA and the customs
authorities at the central level to make this dispute resolution channel available to other provinces and
cities. This will undoubtedly facilitate cross-border trades and, as far as the authors are aware, would
also make China the first country to be able to resolve the issue of tax and customs double recognition
and taxation of the same transactions.
Key takeaways
Managing TP policies is arduous, particularly if there are no systematic processes in place that would
provide an accurate view of the MNE’s profitability before the accounts close. The concerns discussed in
this article would not be an issue if MNEs were able to manage their TP prospectively deploying solutions
such as the OTP mechanism. If a TP adjustment is unavoidable at the year-end, MNEs should provide
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For longer-term solutions, APAs could be considered as they effectively minimise the relevant tax and TP
risks. China’s introduction of simplified procedures that effectively reduce the timeframe to conclude a
unilateral APA is an attractive alternative for MNEs. Further, if the tax and customs joint-ruling
mechanism is successfully introduced in China in the future, it would be a powerful dispute resolution
mechanism whereby tax/TP and customs risks can be mitigated at the same time.
Click here to read all the chapters from ITR's TP Special Focus
Xiaoyue Wang
Director
KPMG China
T: +86 21 2212 4527
E: choonbeng.teoh@kpmg.com
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Choon Beng graduated with a law degree from the London School of Economics
and is a chartered accountant with the Institute of Chartered Accountants in
England and Wales. Prior to joining KPMG China, he practised in another leading
accounting firm in London in the area of international tax and TP matters.
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