The new Enterprise Income Tax (EIT) Law and Implementation Rules signal a fundamental change in China's tax policy and will lead to significant changes in the transfer pricing and corporate restructuring landscape throughout the country. To minimise exposure to the new unified corporate tax rate of 25 percent (up from the previous standard rate of 15 percent), an FIE may consider restructuring its manufacturing operations by introducing an offshore regional principal company and converting the manufacturing operations in China to a contract or toll basis, as an alternative to traditional manufacturing structures. Preferred locations for the offshore regional principal are countries with low corporate tax rates, including Hong Kong and Singapore.

Contract manufacturing

Contract manufacturers produce based on orders provided by a related party and therefore do not bear substantial market, credit or other risks. They take title to the raw materials used in production and therefore own the work-in-progress and finished goods before sale to other group entities. They are likely to own minimal, if any, intellectual property. The contract manufacturer is generally remunerated by way of a gross margin on goods manufactured, which equates to an arm's-length cost plus mark-up or return on capital employed. Given the risk profile of such entities, they are expected to achieve lower but more stable returns than full-risk manufacturers.

However, before setting up such a structure the taxpayer should be mindful of the impact of Guo Shui Han [2007] No. 236, or Circular 236. The State Administration of Taxation has observed that a significant number of contract manufacturers have been reporting losses or low levels of profitability. Circular 236 provides guidance to local tax authorities to target these entities for tax audits, and serves as a warning to taxpayers in this position to mitigate risks with careful planning, economic analysis and transfer-pricing documentation.

The other key consideration relates to the potential impact of customs duty and value-added tax (VAT) on contract manufacturing. These critical aspects of tax planning are not covered in any detail here, but it is important to note that their impact can be a more significant component of overall tax cost than income tax if not given due attention up front.

Toll manufacturing

A toll manufacturer typically processes raw materials that are owned by a related party in return for a tolling fee. From a commercial perspective, this arrangement helps centralise the ownership of raw materials and can support a more streamlined purchasing and inventory management system. It can also be advantageous from a tax perspective, as such entities are generally remunerated by way of a cost-plus mark-up - with the cost base excluding the cost of raw materials.

However, increasingly it can be a challenge to gain regulatory approval for such structures, as authorities throughout China are attempting to move their economies into more sophisticated value-added production. Another issue is the significant risk of tax authorities challenging tolling arrangements. The argument is that as the overseas group company owns the raw materials and work-in-progress, and directs the activities of the toll manufacturer, it creates a permanent establishment, which should be separately remunerated with an additional, taxable, arm's-length return.

These two well-known manufacturing models, if planned and structured carefully and implemented with full consideration of all regulatory, direct and indirect tax implications, can create a considerable tax benefit through minimising the profit and tax paid in China.

Underlying all of these arrangements is the need to ensure that all corporate restructuring, such as the introduction of the above manufacturing models, is fully supported by commercial reality and real economic substance, as well as proper transfer pricing documentation prepared in accordance with the EIT Law and Implementation Rules. This is further emphasised by the introduction of a transfer-pricing-specific penalty and interest regime that can be applied on up to 10 years of adjustments at a compounding rate. Transfer pricing documentation is the only accepted method of giving the local tax authority a clear understanding of the transfer pricing model and commercial realities of the business. Most significantly, it is the best means of presenting the company's case to the local tax bureaux staff effectively, with a view to avoiding a lengthy and costly transfer-pricing audit.