Flawed transfer pricing policies
Posted by Matthew on January 29, 2010 under Anti-Avoidance, Corporate Tax Planning, International tax | 
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The following scenario is one that we have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).
The scenario:
Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.
This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:
Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.
Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.
Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.
Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.
Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.
Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.
Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.
Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.
