Mainland tax authorities recently launched a series of initiatives to address tax avoidance concerns, driven mainly by the question as to whether corporate taxpayers are shifting profits offshore. Transfer pricing is a key focus of these initiatives. Transfer pricing refers to intercompany pricing arrangements between related business firms. It commonly applies to cross-border transfers of tangible and intangible property between associated companies in a group. The mainland requires companies to report annually on transfer pricing transactions between associated enterprises and has been questioning situations where it perceives that arm's length prices agreed between related parties - each party earning a profit according to its functions and risks, as if it is an independent enterprise - have not been used. To strengthen its enforcement of transfer pricing, the State Administration of Taxation (SAT) issued new transfer pricing legislation in January, the Implementation Measures for Special Tax Adjustments (trial version). The circular mandates an annual compliance requirement and introduces nine new tax filing forms. It sends a strong message to taxpayers that the SAT is taking transfer pricing seriously, according to Cecilia Lee, a Hong Kong-based transfer pricing partner with PricewaterhouseCoopers. 'These measures have a much stronger compliance requirement than before. Taxpayers now need to prepare documentation and reports to support that their transfer pricing arrangement is being done on an arm's length basis,' she said. In practice, taxpayers are required to prove to the tax authorities that their intercompany transfer pricing policy is not tax-driven. To comply with special tax adjustments, taxpayers on the mainland must submit the new annual reporting forms on their intercompany transactions along with their annual tax filing forms. Among the information required is a list of related parties, transaction summaries, details of intangible assets, fixed assets and financing plus annual reporting of overseas investments and foreign remittances. These disclosures must also be accompanied by an indication as to whether the documentation is in place; an explanation on which pricing method has been adopted for related party transactions; and a comparison between key overseas related party transactions and third party transactions. There are some exemptions to the requirement. Taxpayers whose annual aggregated amount of buy-sell intercompany transactions is below 200 million yuan (HK$227.08 million), and non-buy-sell intercompany transactions below 40 million yuan are exempt. Also exempt are domestic intercompany transactions; and companies owned less than 50 per cent by foreign investors. Acknowledging that the transfer pricing rules provide a much-needed overhaul of the mainland's transfer pricing rules, Philip Wong, tax partner of Deloitte China, said they also added significant new tax reporting obligations to taxpayers on the mainland. 'Enterprises on the mainland having significant related party transactions should review their profit position, paying attention to whether the profits they earned are at arm's length and, if they are in a loss position, whether the loss can be adequately explained or supported by the risk and function profile of the enterprise.' Rose Zhou, a Shanghai-based partner with Grant Thornton, said that the focus on transfer pricing had resulted in an increase this year in the number of entities subject to tax investigations in which transfer pricing was a focus. 'If you have the obligation because you trigger the exemption threshold in either criteria, you should prepare transfer pricing documentation, otherwise the authorities could directly conduct a transfer pricing investigation and there might be some potential penalties involved,' she said. Taxpayers with a proper and timely documentation study in place, however, could avoid an interest penalty which equals an additional 5 per cent penalty on transfer pricing adjustments levied. Lee said the focus on transfer pricing, while increasing the administrative burden on companies, also offered them the opportunity to use transfer pricing strategically to mitigate taxes. 'A properly structured tax efficient business operation would certainly minimise the tax burden experienced by a taxpayer and increase its overall operational effectiveness,' she said. 'From an overall financial planning perspective that's a big advantage.' Failure to prepare the documentation is subject to a fine of 10,000 to 50,000 yuan, and may directly qualify a taxpayer as a transfer pricing audit target.