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Transfer pricing administration is one of the most important anti-tax-avoidance tasks throughout China’s tax administration system. In 2011, the SAT concluded 207 transfer pricing investigations with tax assessment and the market expects the trends toward increased enforcement activities will continue in 2012.
To mitigate transfer pricing related risks in China, multinational corporations and China-based companies alike share a strong interest in increasing tax certainty through cooperative approaches such as APAs.
From China’s tax administration perspective, the SAT recognizes that cooperative approaches such as APAs create significant efficiency in tax collection, especially in the area of transfer pricing where taxpayer-provided information is essential in supporting a principled analysis. Furthermore, the SAT recognizes that a bilateral or multi-lateral APA involving the treaty partner(s)’ tax jurisdiction(s) is an effective tool to achieve increased certainty on overall tax revenue allocation in the spirit of international cooperation.
Thus, the SAT aims to emphasize both preventive and investigative strategies as a means to increase the effectiveness of transfer pricing administration, noting that a comprehensive anti-tax-avoidance system should balance among “administration, service and investigation.” The SAT views the APA program and bilateral negotiations for double-tax relief as a key tool in effecting the “service” aspect of anti-avoidance work.
The APA Report in general does not represent an official circular of any tax administrative measures.
Cases signed as of 31 December 2010
The 2010 Report focuses on cases negotiated under Guoshuifa No. 118 and Chapter 6 of Guoshuifa No. 2 during the 2005-2010 period, in which China signed 61 APA agreements —45 unilateral and 16 bilateral.
The SAT signed 8 APAs in 2010, which represents a decrease as compared to the 12 APAs signed in 2009 (not including one APA agreed to but not signed as of 31 December 2009). 5 APAs were agreed to but not yet signed as of 31 December 2010.
There has been a continual decline in the number of unilateral cases with a sharp increase in popularity of bilateral cases. During the 2009-2010 period, 11 bilateral cases and 9 unilateral cases were signed, versus the 5 bilateral cases signed during the 2005-2008 period.
However, in 2010, the number of bilateral APAs signed was equal to that of unilateral APAs. This reveals that taxpayers put more emphasis on bilateral international transfer pricing issues and are trying to avoid double taxation through the Mutual Agreement Procedure (MAP) process.
As of 31 December 2010, there were 65 cases in the pre-acceptance phase (compared with 51 in 2009) and 25 applications were accepted (compared with 15 in 2009). This shows the increasing popularity of the APA program (especially the bilateral type) and may also suggest that the SAT is carefully evaluating the case merits of APA applications during the pre-filing phase.
The number of active APAs executed and monitored dropped from 29 in 2009 to 24 in 2010 and the number of APAs expired increased from 24 in 2009 to 37 in 2010. Interestingly, of the 37 APAs expired as of 31 December 2010, 34 were unilateral and of the 24 APAs executed and monitored as of 31 December 2010, more than half were bilateral, providing further evidence of the increasing popularity of bilateral APAs.
The decrease in the number of active APAs may be explained by the resource constraint of tax authorities and the fact that bilateral APAs are more complex and time consuming to conclude.
Among the cases concluded in 2005-2010, the 2010 Report shows that more than half involved tangible property transactions. However, recent applications are clearly trending towards intangible property and service-related transactions. For the first time, an application covering intercompany financing transactions was accepted in 2010.
As China’s service industry continues developing, the trend towards intangible assets, services and financing transactions should remain.
Bilateral APAs negotiated by region
The report shows that among the 16 bilateral APAs signed, the majority of the APAs, i.e., 12 of them, were signed with Asian countries; 3 were signed with European countries; and one was signed with the United States. Of the bilateral APAs signed in 2010, 3 out of 4 were with Asian countries; 1 was with a European country.
Time required for concluding cases
The SAT’s goal is to sign unilateral APAs and bilateral APAs within 12 and 24 months, respectively, of the submission of the formal APA application.
Of the 45 unilateral APAs signed during the 2005-2010 period, 24 cases were signed within 12 months; the rest were signed within 24 months. Of the 16 bilateral APAs mentioned, one took over three years to sign; 12 cases were signed within 24 months; and 3 cases were signed within 36 months.
In 2010, 2 bilateral APAs were signed within 12 months; and 2 within 36 months. As for unilateral APAs, 1 case was signed within 12 months; and 3 cases were signed within 24 months. Compared with 2009, the average time to complete unilateral and bilateral APAs increased in 2010.
The increase in average time to complete APAs has much to do with the covered transactions’ complexity, the quality of the application submitted along with the taxpayer’s cooperation, the in-charge bureau’s review resources, and the negotiating country (in the case of a bilateral APA).
Transfer pricing methods
During the 2005-2010 period, the Transactional Net Margin Method (“TNMM”) using Return on Sales ratio as the profit level indicator (“PLI”) was by far the method most frequently used to conclude APAs, although similar approaches such as TNMM using Full Cost Mark-up ratio as PLI or the Cost Plus Method were also used.
Among the 8 cases signed in 2010, 7 cases relied on the TNMM; of which 4 cases used the Full Cost Mark-up ratio as PLI and 3 cases the Return on Sales ratio; and one case relied on the Cost Plus Method.
As at December 2010, no APAs were concluded using the Berry Ratio or using TNMM with Return on Operating Assets as PLI. Nor were any APAs concluded using the Resale Price Method, as the SAT observed that a Resale Price Method application would require the taxpayer to provide sufficient details on a transactional level as well as market price information.
The Comparable Uncontrolled Price (“CUP”) Method was used for 4 of the 61 cases —this application rate seems to reflect that the CUP Method is much less applied in common transfer pricing analyses due to the high requirement of comparability.
And although only 4 cases were concluded applying the Profit Split Method and un-prescribed other methods, based on our communications with the SAT the trend is that more intangibles-transactions will be introduced to the APA program; thus, we anticipate the use of the Profit Split Method in APAs going forward to likewise increase.
Protection of taxpayer’s rights obtained during the AP
An additional chapter (Chapter IV) was added to the 2010 Report to stress the importance of confidentiality, for both the taxpayer and tax authority, of the information A process. This new chapter formalized that anonymous APA discussions between the taxpayer’s representative and the tax authority is acceptable during the pre-filing phase.
Chapter IV also clarify that both the taxpayer and the tax authority have the right to suspend or terminate the APA negotiation after the formal negotiation phase and before signing the APA. In cases where the tax authority and the taxpayer fail to reach an agreement for an APA, it is specified in this chapter that any non-factual information, such as suggestions, inferences, ideas and conclusions obtained by the tax authority during the APA process, shall not be the cause to any future tax investigations of the transactions covered by the proposed APA.
The new chapter should be welcomed by taxpayers contemplating an APA with China as the chapter provides more protection to taxpayers.
APA procedures: revised wording in Chapter III
The wording in the section dealing with APA termination in Chapter III was slightly amended; one condition for termination was added specifying that the tax authority may cancel an APA if it is discovered that the taxpayer withholds the truth or refuses to implement the APA following the terms and conditions agreed.