With the issuance of Circular No. 363 (Strengthening the Monitoring and Investigation of Cross-Border Related Party Transactions, Guo Shui Han [2009] No 363) (“Circular 363”), the China State Administration of Taxation (“SAT”) has substantially extended the documentary burden with respect to transfer pricing administration. Multinational groups with cross-border related party transactions will be placed under strict scrutiny going forward to ensure that offshore losses are not allocated to “Single Function Enterprises” (“SFE”) in China.

The consequence for failing to comply with Circular 363 is grave: if, after an audit of the SFE’s accounts, income tax adjustments were imposed after an assessment had been made with the appropriate transfer pricing method to determine the arm’s length return, penalty interest on the additional income tax amount would be payable at five per cent above the People’s Bank of China’s base loan interest rate.

Background

Prior to the issuance of Circular 363, China’s extensive contemporaneous documentation requirements were governed by the Implementation Measures of Special Taxation Adjustments (Circular Guo Shui Han (2009) Number 2) (“Circular 2”), which provided the following:

• Contemporaneous documentation with detail content requirements is to be prepared for companies with related parties transactions by 31 December 2009 for the tax year 2008 and 31 May for subsequent tax years;
• Contemporaneous documentation needs to be prepared by the company in advance but does not need to be submitted to the tax bureau unless requested. Upon request, documentation is to be submitted within 20 days;
• Companies meeting any one of the following criteria are exempt from preparing contemporaneous documentation:

1. where the aggregate annual related-party purchases and sales are less then RMB 2000 million and the aggregate other related-party transactions are less then RMB 40 million;
2. where an advance pricing arrangement is in place;
3. where all related parties are within the PRC and the company is not majority foreign-owned.

Circular 363

The key points of Circular 363 are as follows:

• a SFE (being an enterprise that undertakes a simple production (processing of supplied materials or processing of purchased materials), distribution, contracted research and development or has limited functions and risks) shall not bear financial or business risks related to the financial crisis;
• if a SFE does generate losses, it must submit documentation by June 20^th of the year following the year in which such losses were incurred; and
• tax authorities should reinforce the control of cross-border related party transactions, and focus on investigating companies that ‘shift overseas operating losses (including potential losses) to domestic enterprises’ and ‘shift domestic profits to tax havens’.

Some observations

Abolition of exemptions contained in Circular 2
Under Circular 363, enterprises will no longer benefit from the exemptions set out in Circular 2 and any SFE which has incurred losses should prepare and submit contemporaneous documentation, regardless of the intercompany transaction amount.

Timing
Circular 363 does not specify its effective date and whether it will have retrospective effect for the year 2008. Our understanding is that contemporaneous documentation for the year 2008 should be prepared by 31 December 2009 whereas documentation for the year 2009 and thereafter should be prepared by June 20^th of the subsequent tax year.

TP environment more rigorous in China
As pointed out above, while Circular 2 only required the submission of contemporaneous documentation on request, Circular 363 requires the automatic submission of contemporaneous documentation. How rigorously Circular 363 will be enforced remains to be seen, and much will depend on how broadly the local tax authorities interpret ‘single function enterprises’ and whether the concept of SFE includes an enterprise performing several limited-risk functions simultaneously for various overseas related companies. In addition, clarification is needed on the definition of ‘loss’ and ‘potential loss’.  Do losses apply to accounting as well as to financial losses? Is the contemporaneous documentation requirement trigger where losses are incurred in relation to the enterprise’s overall annual financials and is it sufficient that losses are incurred by one of the several limited risk function performed by a SFE?

Our recommendations

Taxpayers may wish to consider the following strategies when mounting a defense for a TP audit:

1. Show that comparables are in loss-making position: Traditionally, in selecting reliable comparable date and benchmarking information, comparable companies with negative profits may be rejected. Taxpayers should seek to analyze market, industry and competitor data to support the loss-making position.
2. Argue that it is not a SFE: Taxpayers could use functional analysis, contractual review and other evidence to argue that the enterprise in question is not a single function enterprise, and should therefore have the benefit of, or be subject to, any financial upside or downside.
3. Demonstrate that losses are not due to related party transactions: Taxpayers could try to demonstrate that losses are due to third party transactions and ‘related-party relationships[1]’.
4. Use CUP analysis: Using CUP analysis, the taxpayer could try to demonstrate that unrelated parties transacting at market prices would have still incurred losses. 

To successfully defend against a TP audit, robust contemporaneous documentation containing functional analysis should be prepared highlighting, if appropriate, the special factors supporting the arm’s length nature of the related party transactions.

[1] Related party relationships are referred to in Article 109 of the Implementation Rules of the CIT Law, Article 51 of the Tax Collection Law Implementation Rules and Article 9 of Circular 2