Transfer pricing adjustments and customs: the Chinese example

Transfer pricing models implemented by Multinational Enterprises (MNE) often rely on the Transactional Net Margin Method (TNMM) to remunerate routine functions. A proper application of the TNMM involves the transfer of risks from the routine to the Principal Operating Company (POC). Such transfers materialize through year-end transfer pricing adjustments (YE TP adjustments) which increase or decrease the operating profit of the routine entity, to guarantee a certain level of remuneration.

YE TP adjustments generally take the form of credit or debit notes issued by the POC: i.e. decrease or increase of the transfer prices applied by the POC for the goods and/or services sold during the year.

YE TP adjustments are subject to detailed scrutiny by the Tax Authorities and must therefore be carefully documented. In addition, in certain countries, due to customs and foreign exchange controls, constraints other than tax must be taken into account in order to get the right to implement YE TP adjustments. This is particularly important in situations where the operating profit of a routine entity is below the targeted remuneration. Indeed, in such situations, if the Customs and/or Foreign Exchange Authorities reject the YE TP adjustment, the MNE will pay (i) customs duties based on non-adjusted (i.e. non-reduced) transfer prices, and (ii) CIT based on transfer prices adjusted for tax purposes only. In order to avoid such situations, it is important to anticipate and prepare negotiations with the Customs and Foreign Exchange Authorities.

Negotiations with the Customs can be complex due to the fact that their interest is the opposite of the Tax Authorities’ interest. Indeed, while the interest of the Tax Authorities is to increase the taxable profit of the routine entity, and therefore ensure that the transfer prices are not “too high”, the interest of the Customs is to maximize customs duties, i.e. ensure that the transfer prices are not “too low”. It is therefore important to anticipate this complexity and start the negotiations as soon as possible in order to have time for a procedure that can last long.

Foreign exchange controls in China is a good illustration of the complexity of the procedures that must be followed in order to get the right to perform YE TP adjustments. We focus here only on the situations where the YE TP adjustment consists in increasing the operating profit of the Chinese subsidiary (i.e. cash inflows from the perspective of the Chinese entity). In China, the negotiations must be undertaken with a different Authority depending on the currency used to perform the YE TP adjustment:

  • In case of RMB, the Authority in charge is the “People Bank of China” (PBOC), i.e. the central bank in China;
  • In case of a foreign currency, the Authority in charge is the State Administration on Foreign Exchange (SAFE).

PBOC does not issue written advice/formal opinion on YE TP adjustments. PBOC delegated to commercial banks (e.g. HSBC) the responsibility to verify the authenticity and rationality of the YE TP adjustments. However, without clear guidelines from PBOC, the commercial banks are generally reluctant to grant final approval for YE TP adjustments. It is therefore required to prepare in advance a robust documentation in order to have strong arguments supporting the rationale of the YE TP adjustments proposed.

Negotiations with SAFE for YE TP adjustments in foreign currencies can also be a complex and long procedure. The general policy of SAFE is to be very strict with respect to YE TP adjustments. However, SAFE implemented a pilot program in the area of Shanghai in order to facilitate inflows TP adjustments. The following remarks are important to note:

• As part of this pilot program, SAFE designated only one bank which has the right to receive cash in foreign currencies related to YE TP adjustments: the Shanghai Pudong Development Bank (SPD);

  • MNEs that want to perform YE TP adjustments in foreign currencies as part of the pilot program in Shanghai must open a special bank account at the SPD;
  • Once an agreement is found with SAFE regarding the method to compute the YE TP adjustments, this method cannot be changed by the MNE unless another negotiation has been launched and another agreement with SAFE has been achieved;
  • SAFE classifies companies that have cross-border transactions in three categories: A, B and C. Companies in category A have access to simplified administrative procedures while the procedures are more complex for companies in category C (i.e. these companies must provide more supporting documents for cross-border transactions). Failing to comply with SAFE regulations may result for an MNE to be downgraded by SAFE from category A to B or C.