- China's stringent rules and complex guidelines on foreign exchange control used to make it difficult for MNCs to make direct TP adjustment payments though various local SAFEs (e.g., Shanghai SAFE) have introduced pilot programs to aid certain qualified taxpayers in making TP adjustment payments.
- The release of the Clarification attempts to align the bank procedures for processing foreign exchange receipts and payments under TP adjustments which denotes SAFE's awareness of existing hurdles relating to TP adjustment payments issues and its willingness to make progressive changes.
- Pending further clarification on the documentation needed, it is possible that the Clarification can be used to support TP adjustment payments made in relation to the TP self-adjustments made by the companies which are much more common than formal TP audits.
- MNCs or companies which are considering making direct TP adjustment payments are encouraged to monitor new developments and seek professional assistance from advisers on negotiations with the relevant authorities and the implementation of the TP adjustment payments.
In an era when base erosion and profit shifting has become a household term, the tax affairs of MNCs have been put under the microscope. Cross-border transactions between Chinese subsidiaries of MNCs ("Chinese Subsidiaries") and their overseas affiliates have been on the tax authorities' radar for many years, including in China and the other jurisdictions. To manage the transfer pricing audit risks, MNCs need to make sure their Chinese Subsidiaries' profits level is at arm's length.
The implementation of the arm's-length principle, however, is not that simple and straightforward. MNCs often find themselves off the target margins as regards their Chinese Subsidiaries, and in need of a true-up or true-down payment (transfer pricing adjustment) to manage their audit risks. The COVID-19 pandemic has exacerbated such need.
Notwithstanding the above, China's stringent rules and complex guidelines on foreign exchange control have made it difficult for MNCs to make direct TP adjustment payments. Basically, the SAFE required all foreign exchange transactions to be substantiated by valid commercial transactions, and the transfer pricing adjustment was not regarded as a valid commercial transaction for foreign exchange purposes. This had led MNCs to seek alternative approaches. A brief summary of these alternative approaches are set out in the table that follows.
TP adjustment on a regular basis (e.g., through product pricing)
This is often conducted by monitoring the product price on a regular basis (monthly/quarterly) and capturing the TP adjustments by adjusting the price of the products. This ensures that the actual profit of the company for that fiscal year is in line with the target profit margin.
- Customs could raise inquiries on any big fluctuation in import product pricing.
- It could be difficult to implement a TP adjustment regularly, which also creates a huge administrative burden.
Service fee arrangement
These are charging service fees from overseas related parties to ensure that the actual profit is in line with the target profit margin for that fiscal year.
- Tax authorities may question the legitimacy and the deductibility of these service fees.
- There could be additional withholding tax and indirect tax implications.
- The tax authority may view the service fee arrangement as a separate transaction, therefore its transfer pricing impact is ring-fenced and can't push up the margin of the transactions that needs to be trued-up.
Enterprise Income Tax (EIT)in-return adjustment
This entails making TP adjustments in the company's annual EIT filing forms or filing a voluntary tax payment form for making retroactive TP adjustments.
- There could be additional tax burdens on the company.
- There could be double taxation issues (where a counterparty cannot claim tax credits).
These approaches could assist MNCs in managing TP risks in China. However, they could also lead to inquiries from tax authorities/customs and have potential double taxation impact on MNCs.
Recent developments show that SAFE's attitude toward TP adjustments payments are gradually shifting. Various local SAFEs (e.g., Shanghai SAFE) introduced pilot programs to aid certain qualified taxpayers in making TP adjustment payments through the capital account or the current account, subject to the discretion of the local SAFE.
Overview of the Clarification
Under the SAFE supervision system, cross-border payments should be generally divided into two different categories (i.e., current account and capital account), which are governed by different SAFE regulations. However, the existing local pilot programs for TP adjustment payments do not provide a unified approach on the applicable category for the payments. This Clarification attempts to align the bank procedures for processing foreign exchange receipts and payments under TP adjustments, which explains that TP adjustment payments should be administrated under the current account according to Circular Huifa  No. 142 ("Circular 14"). The Clarification provides guidance on three schemes:
- TP adjustments: In addition to reiterating the general principle set out under Circular 14, the Clarification states that the required supporting documents for this scheme should include any relevant written documents from tax authorities or customs, any profit adjustment agreements, invoices and any other relevant materials. Additionally, the payment should also be processed according to the original trade category (i.e., goods or services) between the related parties. This basically grants TP adjustments the same status as transactions for which the TP adjustment is made for foreign exchange purposes, allowing banks to process the remittance based on the TP adjustments.
- Cost sharing adjustments: Similar to the TP adjustments scheme, the Reply clarifies the position on required supporting documents (e.g., distribution agreements, financial statements, invoices, etc.) and the detailed reporting sub-category from the SAFE perspective.
- Others: SAFE confirmed that this scheme should also be governed by Circular 14 but does not describe it in detail.
Positive aspects and impact on existing pilot cases
The Clarification denotes SAFE's awareness of existing hurdles relating to TP adjustment payments issues and its willingness to make progressive changes. Moreover, the Clarification suggests that banks can facilitate TP adjustment payments under formal TP audits and advanced pricing arrangement (APA) situations, as long as companies can provide supporting documents from tax authorities/customs. Pending further clarification on the documentation needed, it is possible that the Clarification can be used to support TP adjustment payments made in relation to the TP self-adjustments made by the companies.
Baker McKenzie recently assisted a Chinese Subsidiary in an application for a TP self-adjustment payment and reached a preliminary agreement with the local SAFE to process the inward remittance through the capital account before the publication of the Clarification. With the release of the Clarification, we understand from the relevant local SAFE that the Clarification is interpreted as a confirmation of the feasibility of TP self-adjustment payments. However, new negotiations with the local SAFE will be required, as the previous local practice of treating the TP adjustment as a capital account item is inconsistent with the Clarification. Since TP self-adjustments are much more common than formal TP audits, it is vital to get further clarifications on how cross-border payments can be made under TP self- adjustments. Nonetheless, it is still uncertain whether TP self-adjustment payments should be administrated as "TP adjustments" as mentioned in the Clarification, due to the lack of written documents from tax authorities or customs. It is also possible that the TP self-adjustment payments will be categorized under the "Others" scheme, as mentioned in the Clarification. Therefore, further observations of the developments in this regard will still be required.
It remains unclear how the local SAFEs and banks will interpret such a high-level notice, especially when the Clarification does not specify what documents are required, in the absence of the written documents from tax authorities or customs (e.g., for a TP self-adjustment payment). Based on our previous experience in negotiating with local SAFEs, we learned that certain types of documents (e.g., documents issued by reputable third-party advisers) could be deemed acceptable as a strong supporting document to facilitate the TP adjustments. However, it should be noted that the Clarification suggests that processing banks and local SAFEs may have more discretion. In practice, that may mean there will be more room for companies to negotiate with the banks and the local SAFEs on how to implement the high-level guidance set out under the Clarification.
Further to the above, companies also need to be aware of potential Customs or indirect tax implications when making TP adjustments. For example, if a company makes a TP true-down adjustment by raising the import price of the product, banks may ask for revised Customs import declaration forms and/or additional Customs verification documents, as the Clarification requires TP adjustment payments to be processed according to the original trade category. In such cases, Customs would be involved and the company may need to pay additional Customs duty and/or imported valued-added tax. It could also trigger penalties for the incorrect Customs import declaration forms.
Another consideration is the accounting treatment of TP adjustments. Generally speaking, if the TP adjustment is accompanied by the issuance of debit/credit notes and foreign exchange receipts/payments to the other party, and made before the end of the relevant fiscal year's accounting period, the accounting value should be updated accordingly. However, companies will still need to align with auditors on how to reflect the adjustments in the accounting book based on their unique factual matrix.
The Clarification serves as general guidance for local SAFEs and banks for handling TP adjustment payments. The publication of the Clarification also suggests that direct TP adjustment payments are practicable in China, which is encouraging for MNCs' Chinese Subsidiaries.
Nonetheless, given the complicated process for TP adjustment payments, more cooperation among SAFE, tax authorities and customs is necessary to provide more clarity and guidance, especially on TP self-adjustments. MNCs or companies which are considering making direct TP adjustment payments are encouraged to monitor new developments and seek professional assistance from advisers on negotiations with the relevant authorities and the implementation of the TP adjustment payments.
Baker & McKenzie FenXun (FTZ) Joint Operation Office is a joint operation between Baker & McKenzie LLP, an Illinois limited liability partnership, and FenXun Partners, a Chinese law firm. The Joint Operation has been approved by the Shanghai Justice Bureau. In accordance with the common terminology used in professional service organisations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. This may qualify as “Attorney Advertising” requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome.
This client alert has been prepared for clients and professional associates of Baker & McKenzie FenXun (FTZ) Joint Operation Office. Whilst every effort has been made to ensure accuracy, this client alert is not an exhaustive treatment of the area of law discussed and no responsibility for any loss occasioned to any person acting or refraining from action as a result of material in this presentation is accepted by Baker & McKenzie FenXun (FTZ) Joint Operation Office.
1 SAFE’s Service Trade Foreign Exchange Management Policy Q&A (part 2), Policy Q&A, 19 January 2021.
2 SAFE’s Circular on Issuing Current Account Foreign Exchange Receipts and Payments Guidance (2020 edition), Huifa Circular  No. 14, dated 28 August 2020, effective from 28 August 2020.