Tax holiday is over
ABOUT 80 foreign-invested export companies turned up in April for a seminar at the Shenzhen local tax bureau. It was 'Tax Collection Promotion Month' and the firms were being offered the chance to learn more about China's transfer-pricing laws. Attendees got a shock when they realised they had not been invited at random, and the meeting's purpose was not solely educational.
Officials were looking for targets to investigate: top of the list were companies that failed to take up the bureau's 'invitation'. Those that did were next.
Soon after the seminar, the majority of the companies received an investigation form requiring them to submit five years of financial data, to be followed by interviews with investigators and factory visits.
China is getting serious about transfer pricing, a development that reflects the maturing of its export industry and changing priorities in the post-World Trade Organisation era.
Transfer pricing is a notoriously complex area of accounting, but boils down to a simple issue: where does a company book its profits? Countries have different tax rates, and many companies operate in more than one country. A multinational that can report its profits in a lower-tax (or zero-tax) jurisdiction will therefore reduce its overall tax bill.
Inter-group dealings - when one arm of a company sells goods or services to another - have the potential to shift profits across borders. This is the nub of a global game of cat and mouse that sees tax authorities around the world pore over company accounts to ensure that the prices at which such inter-group transfers are recorded are justified.
Until recently, transfer pricing was not a big issue in China, for the simple reason that the country offered preferential tax rates and tax holidays to attract foreign investment. If foreign-invested enterprises are paying no tax to start with, they have no incentive to shift profits out of the mainland: the reverse, in fact.
However, times are changing. Tax holidays are running out for many foreign-invested firms, while membership of the World Trade Organisation will help to level the playing field for all companies. Preferential tax rates for foreign companies in special economic zones (SEZs) and 49 smaller development zones would be phased out as part of a drive to conform with WTO terms, the London-based Financial Times recently reported.
At the same time, China's need to attract overseas capital is perhaps not as pressing as it was. The country has already developed into an export powerhouse, and is continuing to suck in the lion's share of foreign direct investment in Asia.
The growing zeal of tax authorities may signal a shift in priorities. At one time, China was happy simply to attract foreign investors: now it is more concerned with seeing them contribute to state coffers.
'The market is maturing. More companies are making their first profits, so any [tax] adjustment will give rise to real dollar revenue,' said Spencer Chong, a tax partner at PricewaterhouseCoopers who specialises in China transfer pricing.
Shenzhen and the other SEZs offer foreign investors a zero tax rate for the first two years and 7.5 per cent for the third to fifth years, according to Mr Chong. Most other places in China offer a preferential rate of 12 per cent after a two-year exemption. That compares with Hong Kong's 16 per cent corporate tax rate, which is low by international standards, and about 37 per cent in the United States.
'Transfer pricing is becoming a hot topic in China,' said Lee Chee-weng, international tax partner for Greater China at Andersen. Authorities were becoming more vigilant and scrutinising multinational companies more closely, he said.
By late 1998, utilised foreign investment in the mainland had reached US$257.8 billion and there were more than 320,000 foreign-invested enterprises. That year, China issued detailed rules on transfer pricing, which included plans for all provincial tax authorities to set up specialist teams. The nationwide taskforce now numbers about 1,000, including part-timers. The changes that will follow WTO entry have been a key motivator in the drive, according to Mr Chong.
'China understands that, once it opens its economy, a lot of companies will come in and try to make a fortune from the Chinese market,' he said.
'In the past, they were mainly manufacturing companies, but with WTO there will be service companies, financial institutions - all are big multinationals, from the United States, Britain, Europe. The Chinese believe that if they don't step up their transfer-pricing enforcement, their tax base could be eroded . . . it will all go to the United States or Europe.'
More tax paid in the US will mean less for Chinese tax authorities.
'From the revenue point of view, they are competing for the tax base,' said Mr Chong.
At the same time, reductions in customs duties to comply with WTO will erode China's tax base, increasing the pressure to raise revenue from other sources.
For the time being, Japanese, Taiwanese and Hong Kong investors - accounting for the vast bulk of export-oriented companies in Guangdong - are the main targets.
The Shenzhen tax bureau, with a taskforce of 30, has taken the lead in pursuing transfer-pricing tax audits. To satisfy the tax bureau, a company must show its returns are reasonable, by reference to industry peers or its operations in other countries. However, the process is complicated by lack of experience among Chinese officials.
'The trouble with China is that transfer-pricing laws are in place but the tax authorities have no expertise in terms of how they apply the methodology,' Mr Lee said.
Already, officials are becoming more sophisticated in targeting companies for investigation. There are many tell-tale signs of transfer-pricing manipulation, but with hundreds of thousands of companies to monitor, finding offenders can be like looking for a needle in a haystack. After examining the data, authorities usually try to reach a negotiated settlement. The process can be arduous, often taking months.
What is considered a proper return may depend on how a company's activities are viewed. Take an export-processing company that polishes diamonds for a Hong Kong associate. The appropriate return for such activity might be cost plus 5 per cent, say, but what should the cost include? Should it include the cost of the diamonds, or the cost of the labour only?
'What the Hong Kong company is looking for is cheap labour so they can produce goods at a lower cost,' said Mr Chong. 'So basically, they just send all the raw materials to the Chinese company, take back the finished goods from them and sell them to their customers in Hong Kong or elsewhere.
'We argue this is only a processing situation: ie, the Chinese company is just providing a manufacturing service. However, for Chinese regulatory purposes, a Chinese company needs to set up in the form of a fully fledged manufacturer. It needs to be seen as purchasing the raw materials from the Hong Kong company and selling the finished goods to the Hong Kong company,' Mr Chong said.
'For transfer-pricing purposes, the result of these two arrangements could be totally different.'
Either way, the transfer-pricing issue is here to stay.
'I think China understands their position pretty well,' Mr Chong said. 'They know everybody is looking at China, firstly as a cheap production site for the world and now a potential market for consumption goods.
'So, even though they strengthen their tax system, they don't believe this will scare away foreign investors. The US is the most aggressive place and still they get most of the world's investment.'