Risk minimization in China – Customs inspection for related party transactions

published on 22 September 2023 | approx. reading time 4 minutes

In recent years, China Customs has continuously tightened its review of related party transactions, especially the review of significant non-trade related payments made to related parties and the purchase price of goods imported from related parties.

Significant non-trade transactions »
Purchase price of imported goods »
Our recommendation »

Significant non-trade transactions

In recent years, the Chinese Customs administration has shifted its focus to examining significant non-trade transactions with related parties, particularly license fees.

License fees are charges for the use or transfer of intangible assets such as patent and trademark rights, know-how, copyrights, distribution rights, or sales rights paid by an owner and its authorized licensor. In practice, related party transaction arrangements of multinational groups often involve the situation where the parent company or the owner of intangible assets within the group authorizes the subsidiary to use its intangible assets and charges license fees accordingly. These fees can include, for example, technology license fees for manufacturing companies, or trademark license fees for sales and distribution companies.

According to the “Measures of the Customs of the People's Republic of China for the Determination of the Customs Value of Imported and Exported Goods”, license fees that the buyer must pay, directly or indirectly, to the seller or the relevant party should be included in the customs value of the imported goods, unless one of the following conditions is met:

the license fees are not related to the imported goods; or
the payment of the license fees is not a condition for the sale of the goods to the territory of the People's Republic of China.

However, in practice, proving that these two conditions are met can be challenging for companies. This can often lead to complex negotiations with the authorities, especially when an enterprise lacks the necessary records and documentation for the relevant transactions.

It should be noted that, according to Bulletin [2019] No. 58, importers are required to assess whether the license fee is related to the imported goods or not and declare any possible license fees at the time of importation. However, the two conditions mentioned in the “Measures of the Customs of the People's Republic of China for the Determination of the Customs Value of Imported and Exported Goods” are relatively vague. This can lead to divergencies in opinions in practice. If an enterprise declares on its own that the license fees are not related to the imported goods, but it is later discovered during a customs audit that the license fees are indeed related to the imported goods, not only will the underpaid customs duties and import VAT need to be paid but will also be required to calculate and pay the late payment fees from the date of importation.

In addition, other non-trade payments to related parties, such as procurement commissions and service fees, have also received increasing attention from the customs. When examining whether the specific substance of the transaction is related to the procurement and production of imported goods, it is assessed whether the payments should be subject to the customs duties. Especially for certain service fees, the pricing of which is directly related to sales revenue, customs will require additional information to prove the substance of the transaction to determine whether it should be included in the dutiable value of imported goods.

Purchase price of imported goods

In recent years, the design of transfer prices for imported goods has come under greater scrutiny by customs authorities. More and more customs authorities are demanding that companies submit contemporaneous documentation or benchmarking studies of profit margins of companies in the same industry. These are intended to assess the appropriateness of transfer pricing policies for purchases from related parties.

It is important to note that customs and tax authorities have different priorities when it comes to transfer pricing matters. For example, the customs authorities place particular importance on ensuring that the import price is not set too low to prevent underpayment of customs duties and import VAT. Tax authorities focus on ensuring that the purchase price from related parties is not set too high, which could lead to a decrease in profit margins and underpayment of corporate income tax.

For example, customs authorities focus on gross profit margins, while the tax authorities pay more attention to the net profit margins at the overall level of the enterprise and require the enterprise to achieve a reasonable return based their functions, risks and contributions to the value chain.

In practice, balancing the different transfer pricing requirements of tax and customs authorities poses a significant challenge for enterprises. For example, the preferred year-end one-time adjustment of transfer prices by many multinational groups is difficult to implement in China if it does not obtain simultaneous approval from the customs and tax authorities. Such an adjustment to the accumulated deviation from the target profit through the transfer prices of the last few batches of goods at the end of the year will cause distortion of the unit price of goods in the customs system, thus triggering warning from the competent customs authorities.

Adjustments to profit margin resulting from non-trade transactions such as service fees or license fees, are contested by both Chinese tax authorities and customs authorities due often lacking sufficient business substance to support the adequacy of these transactions. Therefore, we recommend that companies establish a regular review and adjustment mechanism to absorb price deviations in a timely manner and avoid significant one-time price adjustments.

Our recommendation

As China Customs intensifies its scrutiny of related party transactions, we recommend that multinational groups consider the corresponding customs and transfer pricing regulations.

Compliance Measures

Ensure that the pricing policy for transactions with related parties complies with the current customs and transfer pricing regulations. Also, make sure to integrate a structured and continuous compliance system to ensure adherence to these regulations.

Documentation

Companies should pay careful attention to the meticulous creation and retention of relevant documents, such as contracts, invoices, technical documents, and especially transfer pricing documentation, internal records, or other documents. Ensure that the documentation reflects the substance of the transaction, as it will be used for potential audits by customs and tax authorities and as a basis for their conclusions.

Review and Adjustment

To counteract the differing perspectives of customs and tax authorities, implement regular review mechanisms. Ideally, these should be scheduled quarterly or semi-annually to detect and adjust price deviations in a timely manner. Regular review can also help avoid the need for significant one-time price adjustments.

Professional Assistance

In the event of a customs audit, companies should react proactively and seek professional help from experts as soon as possible. Experts can help avoid further losses, such as downgrading of creditworthiness with customs authorities, late payment fees for delayed payments, or disruptions in import and export declarations, production, and operations.