[ By Steven Carey, Transfer Pricing Associates ]

Most of the audits conducted to date have focused on tangible good transactions, in particular those relating to contract manufacturing. Intangible transactions have not been a major area of focus for the tax authorities, until recently. However, the SAT has recently commenced a nation-wide tax audit exercise focusing primarily on royalty payments made by Chinese companies to overseas affiliates. These companies are generally from retailing and consumption goods and services industries.

In recent years, the SAT has adopted a national audit approach, whereby the authorities seek to audit MNCs with a number of subsidiaries with operations across different provinces in China. Such national audits concentrate on both cross border transactions and intra-China related party transactions.

With the release of Circular 363, many companies in a number of provinces and municipalities such as Beijing and Tianjin have received inquiries on transfer pricing matters from local tax bureaus. Furthermore, the Beijing State Tax Bureau has recently issued notices requesting detailed information on related party transactions to over 400 FIEs that are required to respond to the notice with the required information within ten days of receipt of the notice, otherwise a
penalty will apply.

In future, transfer pricing audits will become more rigorous as the Chinese tax authorities have been strengthening their administrative ability in tax collection, by using a greater degree of computerization in tax administration, the establishment of a rigorous tax inspection system and formalized tax legislation procedures for dealing with transfer pricing manipulation. As the volume of MNCs doing business in China continues to grow, and the Chinese government continues to draw on the experience of the developed economies in enforcing its own transfer pricing rules, it can be anticipated that the tax authorities in China will intensify their investigations of related party transactions over time to prevent the loss of future income.

Audit targets

The SAT has provided a very transparent list of audit targets to the local tax authorities, which has been evolving over the last few years. Local tax bureaus have been instructed to select the following key targets for transfer pricing investigation and audit:

• Enterprises which have significant amount of or various types of related party transactions
• Enterprises which have been in long-term consecutive losses, low profitability, or fluctuating profit-andloss situations
• Enterprises whose profit levels are lower than those in the same industry
• Enterprises showing an obvious mismatch between their profit levels and their functional and risk profile
• Enterprises which have business dealings with related parties in tax havens
• Enterprises which have not complied with the reporting of their related party transactions or preparation of contemporaneous documentation
• Enterprises obviously violating the arm?s length principle

The final category appears to be a catch-all provision to pick up any other transactions that are not caught within the specific criteria above. In addition to the above guidelines, contract manufacturers have particularly come under scrutiny.

Circular 236

As a response to the fact that a large proportion of contract manufacturers have been reporting losses despite having a limited function and risk profile, the SAT has identified such companies as specific audit targets. Entities with the following characteristics are being and will continue to be targeted:

• Sole function of manufacturing based on the overall business plans and production orders of overseas parent companies
• Overseas parent companies or other affiliates are wholly responsible for operating policy, product R&D and sales
• Do not bear the associated risks and losses arising from ineffective policies, under-utilization of production capacity and slow market demand

There is an expectation that such entities earn a consistent (but potentially relatively low) level of profitability and are not subject to market or capacity risks. If this is not the case they are very likely to come under scrutiny from tax authorities.
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