At arm's length

The new mainland China-Hong Kong double taxation treaty has important implications for corporate transfer pricing

----By Douglas Fone and Jian Li

The increasingly global nature of business is giving rise to many more cross-border transactions within multinational companies, including the transfer of tangible goods (raw materials, finished goods, etc), royalties for the use of intellectual property and a wide array of management and support services.

The pricing of these transactions affects the amount of profit that is recognised for tax purposes in the countries on each side of the transaction, so the tax authorities of those countries are very keen to ensure that the pricing is carried out on a fair and reasonable basis (the internationally accepted "arm's length" principle).

How to determine what is "arm's length" is a complex task requiring deep specialist technical knowledge of the rules in a variety of countries and advanced economic and analytical skills. If a multinational cannot support the arm's length nature of its transfer pricing policies, the risk is that one tax authority will disagree with the outcomes and seek to raise an adjustment. Such an adjustment can amount to many millions of dollars, and the transfer pricing audit that would precede such an adjustment can occupy significant management time and resources over a considerable period of time (typically a matter of years).

Risk of double taxation

One form of double taxation ("economic") arises when one tax authority disagrees with the other tax authority over the arm's length profit to be taxed on one or other side of the border. Where a comprehensive tax treaty exists between the two countries, the economic double taxation that would arise from this disagreement is usually, but not always, resolved by way of the "mutual agreement procedures" included in the treaty.

Another form of double taxation ("juridical") may arise from a difference in the way that two countries determine which profits fall to be taxed in their jurisdiction. Taxation in Hong Kong operates on a territorial-source basis, whereby profits derived from sources outside Hong Kong are exempt from Hong Kong taxation. By contrast, the taxation system in the Mainland is more complicated, with a combination of residency, establishment and source concepts. The juridical double taxation that may arise from these differences may also be resolved by way of a comprehensive double tax treaty.

China/Hong Kong double tax treaties

In 1998, the Mainland and Hong Kong entered into a limited double taxation arrangement to avoid the "juridical" double taxation of income, but until recently there has been no treaty to protect companies from differences of opinion over transfer pricing affairs (the "economic" double taxation referred to above).

However, this situation has now been rectified with a comprehensive double taxation treaty between the Mainland and Hong Kong, which will become effective from 2007 once ratified by each party.

Impact

The treaty provides for significant reductions of withholding taxes paid by Chinese companies to related companies in Hong Kong. For example, Chinese withholding taxes on dividends will be reduced to between five percent and 10 percent for Hong Kong investors, whilst withholding tax on interest and royalties will be cut to seven percent.

The fairly relaxed taxation system and low profits tax rate of 17.5 percent in Hong Kong may tempt Hong Kong investors to divert profits away from their Chinese-related companies to avoid higher tax payments on the mainland. This temptation may increase once the "unified" corporate tax rate of around 25-28 percent is introduced on the mainland.

However, under the new treaty, there will be greater exchange of information between the State Administration of Taxation (SAT) on the mainland and the Inland Revenue Department (IRD) in Hong Kong, which will make the profits recognised by multinational companies on either side of the border more visible to each of those tax authorities. Since the SAT is well aware of the temptation being faced by multinational companies to shift profit out of China and into Hong Kong, this is likely to increase further the level of transfer pricing scrutiny carried out in China. As a consequence, the IRD is also likely to increase its attention to this area.

Strategies

Taxpayers should seriously consider taking proactive measures to reduce the risks being faced by the business due to transfer pricing issues, and to legally and justifiably shift profits to reduce the group's overall effective tax rate.

Establishing an appropriate system

In Hong Kong, the IRD generally accepts the transfer pricing principles and guidelines issued over the years by the OECD. The mainland China transfer pricing rules are more complex but are also based on the OECD guidelines. Therefore, to be effective, the transfer pricing system of any multinational company should be designed not only to achieve internal corporate objectives but also in line with the OECD guidelines to stand a good chance of meeting the requirements of the interested tax authorities. Hence, taxpayers must be able to demonstrate to the tax authorities that their transfer prices conform to the arm's length principle, which requires an in-depth knowledge of the OECD guidelines as well as the local country requirements. Since the substance of transactions may change on a regular basis, the transfer pricing system must be regularly reviewed, amended and upgraded to retain its effectiveness.

Preparing and maintaining sufficient documentation to support the transfer pricing system

To avoid disputes or penalties, the transfer pricing documentation should be prepared at the time that the inter-company transactions are entered into or at least before the tax return for that year is submitted. By preparing and maintaining contemporaneous documentation, a company will reduce the risk of a detailed transfer pricing audit and of transfer pricing penalties, by establishing that its selection and application of a pricing method provides the most accurate measure of an arm's length result. In February 2005, a ruling requiring the preparation of contemporaneous transfer pricing documentation was drafted by the SAT, and it is understood that the final ruling will be issued at the end of 2006 or early 2007.

Restructuring to achieve a reduction in overall effective tax rate

If the review of the existing transfer pricing system and policy indicates that there may be certain valuable functions, intangible assets or key business risks that may be moved from a high tax jurisdiction to a lower tax jurisdiction, this could justify a change to the transfer pricing system to shift a greater proportion of profit to the low tax jurisdiction, having the effect of reducing the overall effective rate of tax. It is essential that specialist transfer pricing assistance is obtained in this area, as there are many pitfalls awaiting companies that embark on this strategy poorly prepared.

Applying for advance pricing agreements

An advance pricing agreement (APA) is an agreement between the taxpayer and the tax authorities. The APA programme provides an important mechanism for taxpayers to obtain certainty that their transfer pricing policies and procedures meet the requirements of the arm's length standard. One proactive way to reduce transfer pricing risks and possible adjustments imposed by tax authorities is therefore to apply for an APA. On September 20, 2004, the SAT issued the "Implementation Rules for APAs for Transactions between Related Parties". The Implementation Rules set out detailed guidelines on APA procedures.

Seeking expert advice and assistance

The enforcement of the transfer pricing regulations in the mainland is becoming much more widespread and effective, as considerable resources are being devoted by the SAT to this task. The SAT has an elite team of transfer pricing experts to monitor, develop and interpret the transfer pricing regulations in the mainland and to render support to specialist transfer pricing audit teams in the local tax bureaus. Furthermore, in mainland China, reliable comparables may be difficult to identify for transfer pricing purposes. All these factors increase the difficulties faced by corporate finance/tax directors when dealing with transfer pricing issues without outside support. Due to the significance of the risks involved in this area, coupled with the opportunities of minimising the group's overall effective tax rate by adopting sound transfer pricing principles, taxpayers should seek professional assistance.

Establishing a good relationship with the tax authorities

Finally, on the mainland a friendly working relationship with tax authority officers is always to the taxpayer's advantage for reducing a potential transfer pricing dispute.

Conclusion

The new comprehensive tax treaty between the Mainland and Hong Kong will inevitably increase the importance for taxpayers to proactively manage their transfer pricing risk on both sides of the border. There are very significant risks for any taxpayer that fails to prepare adequately, but there are also very significant opportunities for companies to achieve a competitive advantage by designing their transfer pricing system to minimise their overall effective tax rate, within the reasonable limits of the arm's length principle.

Transfer Pricing Associates is a global independent transfer pricing services firm. Douglas Fone is Managing Director and Dr Jian Li is a Senior Manager in the Asia Pacific region