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China has enacted the new Unified PRC Enterprise Income Tax Law on 16 March 2007, which amongst other things, introduces several anti-tax avoidance provisions and new concepts on transfer pricing. In order to strengthen transfer pricing administration, the State Administration of Taxation (“SAT”) has issued the following circulars in Year 2007:
(1) Guoshuihan (2007) No. 236 (“Circular 236”)
(2) Guoshuihan (2007) No. 363 (“Circular 363”)
Impact of Circular 236 on processing trade in China
According to Circular 236, Foreign Investment Enterprises (“FIEs”) and Foreign Enterprises (“FEs”), which are engaged in a sole manufacturing function based on the instruction of their overseas group affiliates without any involvement in or taking any associated risks of the sales and marketing functions, production strategy, product research and development, etc., should be operating at a profit rather than sustaining a loss under the international transfer pricing principles.
In Circular 236, the SAT clearly stipulates its view in that it expects all FIEs and FEs who perform simple production function should achieve a certain level of profitability. There are a lot of production-oriented FIEs and contract processing plants operated by FEs in the South China which undertake a sole-function of manufacturing for their overseas group affiliates. For those who are currently running at a loss or a low margin should be aware of being targeted for a transfer pricing (“TP”) audit.
Impact of Circular 363 on targets under TP audit
Circular 363 standardizes the TP audit procedures which emphasizes on a function and risk analysis of the TP target.
Circular 363 requires a potential TP target to complete a Function and Risk Analysis Form (“Form I”) which gives a comprehensive analysis of the functions and associated risks undertaken by the potential TP target and its related companies under a transfer pricing arrangement. If the local tax authorities consider the intercompany transactions of the potential TP target should be investigated further, based on (a) those information stated in Form I, (b) the initial examination performed by local tax authorities, and (c) the information extracted from the tax return and financial statements of the potential TP target, the local tax authorities will complete a Function and Risk Analysis Determination Form (“Form II”). The local tax authorities will then submit both Forms I and II together with a report (“TP Audit Initiation Report”) to the SAT to initiate a full scale TP audit.
Thereafter, the SAT will determine whether it is required to carry out a full scale TP audit on the potential TP target.
Upon completion of a full scale TP audit, apart from a TP Audit Initiation Report and a TP Audit Closure Report, the local tax authorities have to complete a Related Party Transactions Financial Analysis Form (“Form III”) in respect of the TP target and submit it to the SAT. Form III includes a breakdown of export sales and local sales with related and unrelated parties, costs of sales, expenses and payments for services, royalties, technical service fees and other payments to related parties.
For those FIEs and FEs who have received Form I from the local PRC tax authorities, they are targeted for a TP audit. Special attention and due care should be taken in completing Form I as the local tax authorities will use the information from Form I to determine whether a full scale TP audit is required for that potential TP target.
We anticipate that those information / documents required to be provided in various forms under Circular 363 will form pa
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