The Chinese economy has enjoyed high and sustained economic growth for many years, however recently there are indications that domestic growth is coming under pressure. For this as well as other reasons including the high accumulation of capital in Chinese companies and the appreciation of the yuan, overseas expansion has become a realistic and attractive option for Chinese MNCs as part of a diversification strategy. According to the 2015 Ministry of Commerce Publication of Statistics on Non-Financial Foreign Direct Investment from China, Chinese investors made direct investment overseas in 6,532 enterprises in 155 countries and regions in 2015.
However, “when the going-abroad movements are stepped up by the companies, the overseas tax-related risks are also increasing”, as expressed by Fu Shulin, Vice President of the State Administration of Taxation Institute of Science, in the recent “Tax Risk Prevention Summit Forum” held in April 2014. With this background, this article highlights some best practices adopted by many established global MNCs to engage in early and legitimate transfer pricing planning, which not only minimize the tax risks from overseas operations, but also create tangible and sizable shareholder value.
How does transfer pricing come into play in a “going abroad” strategyIn the course of “going-abroad” for Chinese companies, the following fact patterns are commonly seen:
In light of the above, related party transactions will occur in various forms, and the prices of related party transactions, or transfer prices, can have a significant impact on the MNC’s profit recognised in each jurisdiction in which it operates, as each are subject to different income tax rates. For example:
In short, transfer pricing will arise whenever a Chinese company is “going-abroad” to set its global footprint. Careful design and planning as early as possible in the implementation of the going-abroad approach helps to ensure transfer pricing can be an effective part of an overall tax planning strategy and realise savings in effective tax rates across the group.
Why does transfer pricing matter
Related party transactions are perceived to be controlled and not determined by arm’s length negotiation. Revenue authorities all over the world are more or less aware of the implications of transfer pricing arrangements, and they would usually question if MNCs have used inappropriate transfer pricing to shift profit (tax base) out of their own jurisdictions. As such, tax authorities globally, including in China, require companies to demonstrate compliance with the arm’s length principle for transfer pricing by preparing TP documentation and benchmarking studies and in some cases submitting them annually with the tax return. Nowadays, more and more tax jurisdictions have transfer pricing legislation in place, and transfer pricing is already a powerful tool used by tax authorities to attribute profits to their jurisdictions. The table below provides an overview of the transfer pricing regimes in the key Asia Pacific tax jurisdictions.
(Please click to view the enlarged photo.)
The key for transfer pricing compliance is to keep sufficient documentation to evidence the arm’s length nature of the related party transactions based on the expectations of the tax authorities where the transactions occur. There is a cost associated with such compliance – internal staff time, accounting systems and potentially the cost of external consultants. However, non-compliance carries a higher cost, including business disruption during audits and penalties based on transfer pricing adjustments. For example:
On the other hand, given the differentials in tax regimes and the availability of tax treaties or other local tax/fiscal incentives, there are legitimate opportunities in operating across jurisdictions, as a necessary consequence of “going-abroad”, to reduce the group overall effective tax rates (ETRs) by upfront transfer pricing planning. Such planning would help MNCs enjoy various incentives available across the region as well as avoid tax losses being trapped and unutilised in a specific jurisdiction. For example, Apple Inc. was using complex tax structures to shield profits from US tax to achieve an ETR as low as 9.8% for its global operations in 2011, and its transfer pricing played a critical role in this.
The benefit from upfront transfer pricing planning is not limited to reduction of tax burden. Chinese companies going abroad always find themselves with more flexibility offshore compared with Chinese forex control and rigid customs supervision. A well-structured transfer pricing model would help significantly in terms of cash flow management, external financing and forex management.
Global best practices in transfer pricing planning and implementation for MNCs
There are several best practices followed by global MNCs in respect of their global transfer pricing planning and implementation:
1) Set up specialised in-house tax team to take part in the international business planning and management, and seek professional advice when there is a need of particular expertise. The objective of the involvement of the specialised tax team in the “going-abroad” strategy planning and implementation is to ensure the following risks and opportunities of the international businesses are considered and planned in advance:
2) Design a sustainable transfer pricing system most suitable for the intended overseas business operation with a clear manual which ensures the profitability and tax consequences of the overseas related parties follow the planned characterisations and substance. This is usually a critical step that involves specialised studies. A robust and sustainable TP system design will bear fruit in achieving optimal tax efficiency throughout the supply chain. The typical questions need to be considered are:
- Do the tax regimes (including tax/fiscal incentives, tax treaties) in the country/region of interest provide the opportunity to enhance business value?
- Is the intended legal form and business activities of the overseas company consistent with how it is to be perceived by a tax authority from a transfer pricing/economic perspective?
- If the profit level of the overseas company is a long way below expectations, does this create tax and regulatory limitations or risks for the business?
3) Adopt a ‘masterfile’ approach to prepare centralised/regional TP documentation to minimize the cost of compliance. It is well recognised by most established MNCs that centralised TP documentation management would substantially reduce the cost of TP compliance on a country by country basis. However, there are critical considerations for developing an efficient and effective central TP compliance management tool:
- Which TP models, methods and policies should be adopted in respect of price-setting and price-checking to ensure the intended operational results are achieved on a regular basis?
- What profitability level should be targeted by each of the related parties involved in the TP model?
- Is the TP system simple enough for the operations team to implement and to be adjusted when operational results fall short of expectations?
- What are the common practices and expectations in TP documentation (e.g. level of information disclosure, acceptance of OECD methodologies, etc.) for those various tax jurisdictions involved?
- What are the peculiarities in TP documentation (e.g. documentation submission threshold, timeline, need of local certification, etc) across the tax jurisdictions and how can these be accommodated by leveraging existing resources?
- How often the masterfile and local-country files should be updated and to what extent?
This article provides a starting point for understanding how to integrate transfer pricing planning and compliance into a “going abroad” strategy for Chinese companies. In future articles we would like to further explore some of these topics in more detail as well as case studies of how we have worked with our clients to design and implement sustainable and cost effective transfer pricing solutions in line with the regional or global going-abroad ambitions.
Source: Quantera Global