Transfer Pricing Administration under the Epidemic – Q&As

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The Chinese State Administration of Taxation (SAT) recently responded the daily concerns of enterprises about transfer pricing (TP) during the Covid-19 period. As the year-end is approaching, multinational groups are now beginning to evaluate and review the implementation results of their TP policies and the responses from Chinse tax authority provide official guidance on how enterprises shall deal with TP investigations under the epidemic. The main points are as follows:

TP investigations by the tax authorities - Are pandemic effects taken into account?

The tax authority has emphasized in the answers that the pandemic has a very different impact on businesses in different industries. In some industries, the impact on companies is greater, while in other industries, new development opportunities arise. In addition to industry affiliation, the market positioning of the company under study or even its role in (global) supply chains also plays a crucial role. Companies should therefore specifically analyze potential VP risks with regard to the pandemic and its impact on the company, rather than making sweeping generalizations.

Therefore, when conducting TP investigations, the tax authorities will take into account the epidemic impact on related party transactions on a case-by-case analysis, while complying with the arm’s length principle.

How do tax authorities take into account losses caused by the epidemic?

The tax authority mentioned that in the investigation the epidemic impact would be considered in the context of functions and risks of the enterprises, related party transaction characteristics, industry features, comparable enterprise conditions and other factors. In the comparability analysis, the difference of costs and expenses would be adjusted with reference to the situation of independent third parties.

It is worth noting that the SAT Public Notice 2017 No. 6 stipulates that enterprises engaged in simple production activities such as toll manufacturing or contract manufacturing, simple distribution or contract Research & Development activities for overseas related parties, should maintain a reasonable profit level in principle.

However, according to “OECD Covid-19 Transfer Pricing Guidelines”, it is still possible for such entities to incur losses in the short term due to the epidemic. Therefore, it is recommended that enterprises engaged in simple production, limited risk distribution and contract R&D activities should prepare sufficient documents to prove that independent third parties do bear the same risks or additional costs under comparable conditions to avoid potential TP risks in this regard.

Profit fluctuation: How can enterprises prepare the local file for TP -documentation? 

The tax authority requires enterprises to specify the specific impact of the epidemic on related party transactions and value chains when preparing local file, and focus on comparable object information for the same year, region, industry, product and functions and risks when conducting comparability analysis to reflect the impact of the epidemic on profit level in the industry.

Considering that financial data for comparable companies in the public database for the relevant year may not be available at the time of preparation of the local file, the following methods could be taken into consideration when preparing the local file to reflect the impact of the epidemic to the profit level of the industry:
  • Adopting multi-year data from the tested company instead of the current year data during the epidemic for validation
  • Adopting but-for-analysis for specific factor adjustment
  • Adopting interim financial data (quarterly/semi-annual data) of the relevant year for comparison, if possible

In addition, when required by tax authority to submit local files, enterprises could check again whether the financial data of comparable enterprises for the year under review has been updated in the public database and make corresponding supplements to better reflect the impact of the epidemic on the profit level of the industry engaged in.

Does government assistance affect price adjustment for related party transactions?

During the epidemic, the Chinese government introduced a series of assistance policies in areas of rent, taxes and financing. The tax authority clarifies that if enterprises believe that government assistance has an impact on TP arrangements, they should provide relevant information in the TP documentation to support the analysis, while the tax authority will identify the comparable factors to ensure the fairness and consistency of the results of the comparability analysis.

The above response indicates that the Chinese tax authority will consider the government subsidies as a special geographical specific factor during epidemic and therefore simply taking the relevant subsidies into account in the TP arrangement (e.g. reducing costs when adopting cost plus method or reducing marketing expenses when adopting resale price method) may lead to potential TP risks.

In addition, it is also recommended that enterprises search for comparable companies in China to perform comparability analysis during the epidemic to reduce tax authority’s requirement to adjust for relevant location specific factors (such as government assistance and market differences).

How to execute APA under epidemic impact?

The tax authority points out that if enterprises do experience material changes affecting the implementation of Advance Pricing Arrangement (APA) due to the epidemic, they may report to competent tax authorities in written form with relevant information to explain the epidemic impact on implementing APA in details. The competent tax authority will analyze and assess the situation to revise or terminate the unilateral arrangement or the SAT to negotiate with the parties to the agreement to settle the bilateral arrangement.

Our View

At present, most enterprises have submitted their first TP local file under Covid-19 to tax authorities. The responses from tax authority indicates that the Chinese tax authorities will recognize the impact of the epidemic on enterprises when reviewing the documentation for TP investigations. However, in view of the loss and profit fluctuation caused by the epidemic, enterprises should perform a quantitative analysis based on various factors proposed by the tax authority, and retain relevant supporting documents that independent third parties would suffer similar losses under the same circumstances, so as to reduce the TP risks of their Chinese subsidiaries. In addition, the tax authority also emphasizes the difference of the impact on enterprises in different industries in the response, which also indicates that tax authorities may adopt more detailed industry analysis in the future TP administration to evaluate the reasonableness of the TP policies implemented by different enterprises.

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