Transfer Pricing Management in a post-COVID world

Transfer Pricing is a tool used worldwide to assess the pricing model set for goods and services exchanged between related parties in a company’s wider corporate structure to benefit properly pay taxes in a jurisdiction in line with the activities carried out. A detailed understanding of Transfer Pricing and compliance with the associated rules and regulations is critical for all businesses currently operating in China.

The presentation was hosted by Kari Hakanen, the Chair of the Chamber’s Financial Services Committee. The presentation focused on what methods are available, what companies need to do and how to reduce being flagged for an unexpected audit.

Key takeaways:

• Transfer Pricing is an art form. Justifying pricing for two different tax jurisdictions with different regulatory frameworks cannot be quantified or qualified via a pre-set formula, and there is no specific right or wrong. It’s about creating an equilibrium balancing activities carried out by each entity, the regulatory framework, and ultimately finding reasonableness in the pricing.

• The onus is on the company to defend its pricing strategy to the tax bureau. If subjected to a review, it is important to be able to justify the methodologies used. The taxpayer bears the burden of proof in China during Transfer Pricing disputes, not the tax bureau.

• The tax bureau has detailed information on every industry for comparison of company margin and, based on a standard deviation chart, can locate the outliers in the lower quartile. A company should aim to fall within the pricing range of companies in the same industry or explain why there is deviation. If facing an audit, it is most commonly because of being red-flagged for being an outlier from the industry norms, or there is a state/local-level directive to look into the industry. Because transfer pricing considers so many variables, being in the lower quartile can be fine if a solid and supported explanation can be provided, for example, selling low and making no margin to break into a market segment and gain market share.

• It is important to run a comparable analysis of other companies in the industry to compare if the pricing is reasonable and justify reasons if the comparables show that the pricing is out of the median range. The key is to be convincing with qualitative explanations with documentation support.

• If the nature of functions and risks changes, then a company can adjust its transfer pricing methodology to better support the nature of these. Consistency is not crucial though preferred. Margins will also vary throughout the process depending on who is taking more risk and the circumstances at that time. For instance, Covid has affected all companies in some way or another, and so normal margins were not a good comparable to the situation of most businesses.

• A lot of countries have double taxation treaties with China but if there’s a Transfer Pricing review and penalties are applied, they are not covered under the relevant treaty.

• In China, if related party transactions in a fiscal year are over RMB200mfor products or RMB40m for services/ passive income, there is a requirement for a company to do an annual Transfer Pricing report filing every June. MNCs must have a Transfer Pricing report Masterfile at all times under OECD guidelines at HQ level, but then local files in each jurisdiction. Businesses in China that do not meet these levels still will have to include related parties details in their annual Corporate Income Tax filing.

• There is also a matter of timing when the tax bureau conducts a review. The authorities contact a company about their margins and transfer pricing policies and request a reply within a short time, which could be as little as 7 days, or up to 60 days Failure to respond could result in an adjustment being made.

• It is therefore important for companies to have a Transfer Pricing report ready on hand in case there is a request to justify or defend the methods used. A well-managed Transfer Pricing defence helps minimise adjustment risks and reduces potential tax exposure. Also, it is important to note that the tax bureau could review a number of years back, depending upon the nature of the business, and so in the company, are all of the historical records easily accessible and are current finance staff familiar with the history.

Considerations for the process:

An accountant should undertake the following:

1. Identify the business context;
2. Design and implement the structure;
3. Document the implementation;
4. Apply risk management; and
5. Operate a fully defendable transfer pricing system.

Consider how COVID impacted the industry for review for 2020 and 2021 relative to 2019 and before.

Consider what is a reasonable margin for the risks and functions carried and the nature of the business, e.g. manufacturing, trading, sales, etc. Transfer Pricing policy should be reviewed relative to group structure, including a parent company, distribution companies, regional centre companies, and manufacturing companies in different locations, with different risks and functions.

Currently, there is a rule in China that if all sales or purchases are inter-company, then a margin must be made. However, the impacts of COVID could change this, as many have faced losses globally. If claiming losses, the methodology must be clearly outlined and then a demonstration of the impacts.

Possible Transfer Pricing Methods:

TRANSACTIONAL METHODS

1. The Comparable Uncontrolled Price Method (CUP) effectively compares a companies price to others in the industry and is the preferred method;
2. Resale price method (RPM); and
3. Cost Plus Method usually depends on the industry and is most common in a limited function business.

PROFIT-ORIENTED METHODS

1. Transactional Net Margin Method (TNMM) is the most common in manufacturing; and
2. Transactional Profit Split Method is less popular because it requires providing overseas financial.

OTHER METHODS

The Chinese authorities will consider methods not listed as long as they can be justified as common in the industry.

Investigation considerations:

Transfer Pricing audits can often develop into a full tax audit. Therefore, it is important to first try to understand why the audit is being done and be careful with providing information, which always extends cooperation. The tax officers are there for a reason, either industry review, margins are lower or otherwise, and they are merely performing their duties in carrying out the review. Therefore, the company’s goal should be to strive for a reasonable settlement or closure as quickly as possible. If the company is well prepared and can support its practices, and educate the tax officers of this, then this allows the case to be closed quicker.

Challenges in the future:

It is likely that there will be more requirements for Transfer Pricing documentation and an increased focus on conduct in assessing Transfer Pricing compliance, with China part of BEPS and being supportive of OECD initiatives. And in a post covid world, countries are going to review the practices of larger businesses with more scrutiny.

Key Questions:

There has already been a crackdown on the technology sector; is it likely that it will face more attention with audits? 

Yes, it’s likely as the authorities need to make sure that a reasonable margin is being taken for the sale of services. If everything is being done overseas, but delivery and support are done in China, they need to consider if China is taking a proper margin. There’s a global push for a minimum tax rate for global corporations of 15%, but it is about capturing the value of what is being delivered when coming from overseas.

If your price was not high enough initially, can it be corrected by creating two Transfer Pricing policies?

Yes, because pricing is not fixed and is based on the circumstances, risk and function at the time. Where COVID impacted a company’s circumstances, firms may adjust pricing methodologies to match. Once the structure is set up, adjust it as part of your ongoing financials.

Is there a general rule of thumb for what level of annual revenue authorities will investigate Transfer Pricing?

Smaller companies have less risk than bigger but there is no official rule. Smaller company audits are usually a result of local initiatives. There may be no size limit and it could become more industry dependent in the future. Aim to be in the median of the standard deviation curve to lower risk.