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CORPORATE TAX accounts for about a fifth of total tax revenue in China.

But according to state-generated statistics, foreign-invested enterprises contribute little to overall tax revenues because they are either not profitable or just breaking even.

But China has successfully attracted about US$1 billion in foreign direct investment every week for the past two years. This begs the question 'where is that money being spent if not on making foreign-invested enterprises profitable?'

The apparent shortfall in corporate tax revenue is one area of focus for the government, which is planning to revamp the structure of the corporate tax regime. It hopes to rectify the deficit by modifying existing regulations and issuing new ones.

One of the regulations undergoing modification concerns transfer pricing.

China requires the annual reporting of transactions between associated enterprises.

General guidelines to be followed regarding transfer pricing were originally promulgated in 1998 and  modified in 2004 and 2005.

Transfer pricing refers to the prices paid for goods, services and financing among related entities. These could be payments among divisions within a company, or payments between a company and a subsidiary or joint venture partner.

Such transactions often occur across international boundaries. But even when they don't, there can be serious regulatory and tax implications.

As in many countries, China's transfer pricing rules stipulate that transactions between related parties be conducted on an arm's- length basis.

This means the two parties trade at the same price or generate returns similar to those they would with any third party.

The tax authorities can make taxable income adjustments to related-party transactions, which are not carried out at arm's length. Updating the transfer pricing rules will have the greatest effect on foreign-invested enterprises, which have enjoyed generous tax breaks in return for their investment dollars.

Peter Kung, partner of KPMG's China Tax division, said transfer pricing rules in China were more aggressive than in Hong Kong.

'China produces a lot of goods for export as well as to meet domestic market demand. It is not that difficult for mainland tax officials to review the export prices versus the domestic selling prices and deduce where transactions are not being correctly reported,' he said.

In the past, foreign investors were sceptical about parking profits in China - not necessarily for tax reasons but because of foreign exchange controls or concerns about the potential devaluation of the yuan.

'To some extent, China was a tax haven,' Mr Kung said. 'But from a pure tax point of view, allowing China to have its fair share of profits could help save global tax. So it makes sense to park more profits in China.'

Mr Kung said the mainland tax authorities were taking a relatively lenient approach to foreign-invested companies enjoying  tax breaks and transferring profits out of China. But this approach may change with the emphasis on updating the transfer pricing regulations.

The major problem for foreign-invested enterprises is that even though they may want the corporate tax regime to be updated, at this point there is no indication as to what the changes may be.

There is no standardised corporate tax rate - it varies according to where an enterprise is located and the industry.

As such, a foreign-invested enterprise could face an increase in tax from a single digit figure to more than 20 per cent under new regulations.

'It is time for the Chinese government to announce as soon as possible what the new tax regime is going to be because at the moment foreign-invested enterprises don't know whether or how they may be penalised,' Mr Kung said.

The government is apparently on the last leg of the reforms and plans to take them to the State Council  in summer. If approved, they will be submitted to the National People's Congress for  review in March 2007.

For accountants practising in China and keen to mitigate the risk of a tax dispute with a local tax authority, being familiar with the tax rules pertinent to their operations is crucial.

Regular reviewing of all tax filings to ensure they were done properly and were in full compliance with these rules should not be underestimated. And keeping good relationships with the local tax bureau officials was advisable, Mr Kung said.

'Practising accountants in China, particularly those involved in exporting, must understand the whole supply chain. If we are talking about transactions among various companies, accountants need to understand who should earn what along the entire value-added chain and how to do the benchmarking to support the desired results.'



Focus on foreign tax shortfall