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TighteningcontrolovertransferpricingwithassociatedenterprisesItisnotuncommonforforeigninvestmententerprises(FIEs)inthePRCtoimportrawmaterialsandexportfinishedgoodstoassociatedenterprises.TheSATissuedtwocircularsinlate1998,Guoshuifa[1998]No.59andNo.25,requiringthetaxauthoritiestotakeacloserlookattransferpricingissues.SuchFIEswillbethenexttargetofexamination.Accordingtothetransferpricingregime,transactionsbetweenassociatedenterprisesshouldbeatarm'slengthprices.Ifthearm'slengthprincipleisviolated,theincometaxlawsempowerthetaxauthoritiestomaketransferpricingadjustmentsforuptothreeyears.Inmoreseriouscases,theadjustmentscouldbemadeforuptotenyears.Thetwocircularsrequirethetaxbureauxtosetupspecialisttransferpricingteamstoperformdetailedtransferpricingtaxaudits.Throughouttheauditingprocedure,theteamsareencouragedtocollaboratewithothergovernmentauthoritiestoobtainthenecessaryinformationforcross-examination.TheymayrequestinformationfromthecustomsauthoritiesforpurchaseandsalepricesandfromtheMinistryofForeignTradeandEconomicCo-operationandtheSAFEforloaninterestpaymentsandroyaltypaymentstooverseasassociatedenterprises.FIEswillalsoberequiredtocompleteformsandsubmitthemwiththeirannualincometaxreturnsdisclosinginformationrelatingtotheirtransactionswithassociatedenterprises.Inaddition,thetaxauthoritiesareusingsomesystematicanalyticaltools,suchascomputers,toperformanalyticalreviewsandaccountingratiosTransferpricing–TheStateAdministrationofTaxation(SAT)issuedtwocircularsinlate1998totightencontrolovertransferpricingwithassociatedenterprises.VATrefundonexports–Thelatestrefundpoliciesforoldenterprises(i.e.before1994)andnewenterprises(i.e.after1993)continuetodifferforanothertwoyears.Foreignexchange–TheStateAdministrationofForeignExchange(SAFE)issuedanumberofcircularsinlate1998totightenforeignexchangecontrol.IndividualIncomeTax(IIT)–RefundofIITonpropertypurchasescouldbeextendedtoallcitiesinthePRC.○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○○ChinaTax/BusinessUpdateJanuary1999Issue:1/99toassesstheprofitability,liquidityandoperationalefficiencyofFIEs.Allinformationcollectedfromtheseexaminationswillbeusedtosetupadatabase.TheSATtransferpricingteamleaderclaimsthattheyhavealreadyusedtheinternettosetuptheirowndatabase.TheSATwillalsocontacttaxtreatyauthoritiesifinformationonoverseasassociatedcompaniesisneededforexamination.Inpractice,itisunderstoodthatdiscussionswereonlyheldwiththeUS,CanadaandJapaninrelationtoincometaxandindividualincometaxissues.ThefollowingcharacteristicsofaFIEarevulnerabletotransferpricingaudits:1.Largetransactionamountswithassociatedenterprises.2.Longperiodoflosses(usuallythetaxauthoritiesexpectaprofitaftertwoyearsofoperation).3.Smallprofitsorlossesforalongperiod,yetexpansioninbusiness.4.Transactionswithassociatedenterpriseslocatedintaxhavenjurisdictions.5.Profitslowerthanothercompanieswithinthegroup.6.Asuddendropinprofitlevelafterataxholiday.Accordingtotheincometaxregulationspromulgatedin1991,therearethreemethodsoftransferpricingadjustments,namelythecomparableuncontrolledpricemethod,theresale-minusmethodandthecost-plusmethod.Ofthethreemethods,thecost-plushasbeenthemostcommonlyused.However,transferpricingadjustmentshaveonlybeenmadeonthetaxableincomeandnotonthetransactionvalue.Technicallyspeaking,theseadjustmentscouldalsohaveturnovertaximplications,whichcouldresultinVATonproductsandbusinesstaxonservicefees.Therecentcircularshaveintroducedthreemoremethodsfortransferpricingadjustments.Theyarethecomparableprofitmethod,theprofitsplitmethodandthetransactionnetmarginmethod.Unfortunately,allofthesenewmethodshaveyettobeexplained.Onewaytominimisetransferpricingexposureistoobtainanadvancepricingagreement(APA)fromthetaxauthorities.AnAPAisenteredintobetweenFIEsandthetaxauthoritieswherebybothsidesagreetoarangeofpricelevels.AslongasFIEsstaywithintheagreedrangesindeterminingpriceswithassociatedenterprises,thetaxauthoritieswillnotmaketransferpricingadjustments.APAsprovidecertaintytoFIEsandtheoreticallycanassisttheFIEsinavoidingtransferpricingadjustmentsandpenalties.Althoughthereisnothinginthetransferpricingregimethatimpliestransferpricingpenalties,itisunderstoodthatthesecircularsareunderlegislativeprocess.However,inobtaininganAPA,FIEsshouldbeawareoftheriskthatthetaxauthoritiesmaydeclinetheagreement.LatestVATrefundpolicyonexportsFIEsestFIEsestFIEsestFIEsestFIEsestablishedafter31December1993ablishedafter31December1993ablishedafter31December1993ablishedafter31December1993ablishedafter31December1993InMay1997,theMinistryofFinanceandtheSATissuedacircularconfirmingtheExempt-Credit-Refund(ECR)methodforexportsalesmadebyFIEsestablishedafter31December1993.TheECRmethodissummarisedasfollows:1.Exempt-exportsnotzero-ratedbutexemptedforVATpurposes.2.Credit-settingofftheVATrefundonexportsagainsttheVATpayableondomesticsales.3.Refund-onlytotheextentthattheVATrefundonexportsisinexcessoftheVATpayableondomesticsales.FIEsthatareexport-oriented(50%ormoreoftotalsalesisforexportduringtherelevantperiod)canobtainarefundoftheexcessVATwi