Impact of New APA Guidelines on MNCs in China - Research Paper Example

Abstract

This paper evaluates the impact of Bulletin 64 on the transfer pricing activities in MNCs in China. It begins by highlighting the research question, which is the primary focus of the study. The historical analysis of the development of China’s APA program gives a deep insight into China’s tax system. There is a comprehensive evaluation of the key taxation changes of Bulletin 64 including the APA program process, prioritization and rejection of APAs, and value analysis process. The next section proposes the most effective solution that MNCs should adopt in response to Bulletin 64. The final aspect is the conclusion that summarizes the research findings, and any insight gained in the course of the study.

Impact of New APA guidelines on MNCs in China

The primary purpose of this paper is to investigate the effect of the new transfer pricing laws specifically Bulletin 64 on the multinational corporations (MNCs) in China. Formulation of effective tax policies for the administration of transfer pricing issues is a significant goal for the State Authority of Tax (SAT) in China. China is a host to numerous multinational corporations that have a considerable stake in its economic development. The MNCs often take advantage of transfer pricing arrangements, which refers to transactions between related parties, with the aim of reducing their taxable revenue. To minimize the cases of tax avoidance in the state, China uses the Advance Pricing Arrangement (APA) program to monitor various issues of transfer pricing. Moreover, the SAT continuously improves the APA to better its services and keep-up-to-date with the changing business environment. Through the critical analysis of Bulletin 64, which presents the latest guidelines on APA Program, multinational corporations will easily enroll into the program.

First of all, it is crucial to understand the operational meaning of the term APA in China’s tax system. An APA program is an arrangement between a company and the tax authority, where the two parties negotiate on the transfer pricing methods and calculation techniques with various related parties. There are three critical types of APAs in China including unilateral agreement, which is between an organization and its country’s tax authority, bilateral cooperation, which takes place between a company and two tax authorities from the foreign and local nations. Lastly, it encompasses the multilateral agreement that is between a group and more than two tax authorities from foreign and home states. In China, there is a high prevalence for bilateral APAs as organizations seek to address the double taxation problem that affects many MNCs operating in the country.

The SAT produces annual reports to disclose the number of successful APA agreements and requests for each particular year. Typically, the unilateral, bilateral, and multilateral agreements take less than one year, 12-24 months, and more than three years of negotiations respectively. From the SAT’s statistics, the number of signed APAs between the 2005-2015 periods has been declining at a gradual rate. Unfortunately, many MNCs are still unaware of this report; hence, it takes them a more extended period to successfully apply and get admittance in China’s APA program. However, adherence to the new SAT guidelines will lead to different results as the APA applications from these companies are bound to capture the attention of the tax authority. The paper will, therefore, be divided into the following sections namely; the historical analysis of the development of the APA program, evaluation of the critical provisions of Bulletin 64, discussion of the impact of the new changes on MNC.

Number of APAs approved 2005-2015

Historical Development of China’s APA Program

The development of China’s APA program has been systematic. APA programs in the country began in the late 1990s. Due to the prevailing uncertainty regarding transfer pricing adjustments in the economy, it was critical for the government to find a way to deal with the challenge. In 1998, the SAT acknowledged the need to develop an efficient APA program to regulate the interrelated parties’ transactions in the country. Consequently, there was a formal introduction of the APA program in the country. Since then, the SAT has shown a high level of commitment to develop more comprehensive guidelines and procedures to aid in the effective execution of the APA programs among the MNCs in the state.

The year 2004 was a significant period in China’s history of transfer pricing rules and regulations with the introduction of new taxation rules. The period saw the promulgation of the key rules in the country’s APA program on a trial basis; it provided important guidelines including negotiation procedures, requirements for third party transactions, monitoring, and execution of the APA arrangements in the state. Moreover, the tax authority began a practical trial to implement a number of APA programs with the Chinese residents to determine the applicability of the new regulations. Although it is impossible to find exact statistics regarding the number of successful APAs that were completed during the trial period, there was a major breakthrough in the Chinese tax system.

Standardization of China’s APA program in China has been a significant challenge for the country. The condition led the SAT to set a new requirement for all APA programs in 2005. According to the new guideline, the local authorities were charged with the responsibility of submitting drafts of filed unilateral APA applications to the SAT for approval by the authority. Besides, these authorities should also meet all the legal requirements of APA programs, hence make sure that there will be more approvals in the future. Under the new standardized APA program, China made significant progresses in transfer pricing through the approval of 41 APA applications. Also, there was a successful completion of the first bilateral arrangement between China and Japan in 2005, and another bilateral APA agreement with Korea in 2007.

The ability of the SAT to make further improvements in the transfer pricing guidelines law has been central to the acceleration in the implementation of APA programs in China. The Corporate Income Tax (CIT) of 2008 provides deeper legal understanding about the requirements of APA in China, thus make it easier for more MNCs to enter into the programs. From 2008, the SAT has approved different types of APA programs as shown in the table below:

Several changes in APA laws introduced in the last year will have a significant impact on the transfer pricing taxation system. Bulletin 42 was the first phase of change prescribes the types of documents and files that organizations should submit to the tax authority. According to the provisions of this law, enterprises should submit three types of files to disclose third party related transactions. They include a master file, organizations that earn more than RMB 1 billion sales revenue from consolidated transactions with related firms should submit this file. The second change is the local file that serves companies whose interrelated party sales amounts to greater than RMB 100 million or consolidated sales revenue is greater than RMB 200 million. The last aspect is the special issue file that helps enterprises to prove that the related party transactions uphold the arm’s length principle in spite of having a debt-to-equity ratio above the prescribed value. Moreover, corporations with CSA agreements with the SAT should report the status of the agreement in the special issue file.

Another significant change in China’s APA program was the introduction of Bulletin 64 after Bulletin 42 on 11 October 2016. The new guidelines will help to ease the administration of APA programs in China through the clarification of critical issues affecting these arrangements. The SAT has gone forward to launch Bulletin 6 in 2017 as part of the authority’s objective to provide complete the requirements of Bulletin 42 and 64, the primary focus of bulletin 6 is clarification of several aspects of transfer pricing issues in the country. It is obvious that the SAT has a high interest in revamping tax laws affecting transfer pricing taxes in the state. However many stakeholders remain ignorant of these laws particularly Bulletin 64, which has been in existence for many months. Therefore, it is essential to undertake a comprehensive analysis of the requirements in Bulletin 64, and highlight the motivation behind the creation of numerous regulations within the tax system.

Bulletin 64 Guidelines

What is bulletin 64?

To answer this question that first comes to the minds of foreign and local businessmen requires one to use the official SAT definition of the tax law. Bulletin 64 is a new publication of guidelines in the administration of China’s APA program; it supersedes the Chapter 6 of Circular Guoshuifa of 2009. The primary focus of Bulletin 64 is to offer important guidance to companies on how to file for the APA program, and ensure that the prioritization of their applications. Through the bulletin, the SAT provides significant clarifications about the advanced pricing arrangements that will be extremely beneficial to all the stakeholders by steering them in the right direction. However, it is imperative to understand the key motivation behind the creation of this new legislation.

Motivation for the development of Bulletin 64

China’s high GDP expansion rate places the country at an advantageous position in the world. Since 2002, the country’s economy has grown at an average rate of 7.8%, hence the need to include the state in the formulation of various business policies that affect the global business environment. In 2015, China gained entry into the Organization for Economic Cooperation and Development (OECD), and it is highly involved in all the projects commenced before and after the country’s membership in the body. One of the biggest projects of the OECD is to ensure the implementation of the base erosion and profit sharing (BEP) plans that will help to reduce the tax disputes that arise from taxation of income from different jurisdictions. Through the preparation of bulletin 64, China is one step closer to fulfilling its duty as an OECD and G20 member. The introduction Bulletin 64 is a fulfillment of the SAT’s promises to the Chinese people to improve the country’s tax regime. Also, the foreign businesspeople will benefit as they will easily compute and pay their taxable revenue, and remit accurate taxes to the government to evade any detrimental legal actions against their companies.

Evaluation of Bulletin 64

Undertaking a critical analysis of Bulletin 64 will highlight the essential issues regarding the transfer pricing transactions. Foreign companies particularly the MNCs need to carefully consider the results of the evaluation in their future decisions. Bulletin 64 begins with the identification of the parties that qualify for an APA arrangement with the government. According to the new law, a firm must meet two critical conditions before submitting an APA request to the government. One, the company should realize more than RMB 40 million in interrelated party transactions and, two, an enterprise must have recorded the RMB 40 million value of such sales for three consecutive years. Therefore, it is evident that the APA program is only available for companies with continuous operations in China.

APA Stages

Bulletin 64 outlines the six critical stages of the APA program. Under the new regulations some of the phases of an APA in Circular 2 are retained and specific lists of all the vital documents necessary for each stage of the negotiation process. The first stage is the pre-filing meeting between the tax-payer and the SAT, and the meetings must not be anonymous. During these meetings, several details are discussed including the type of APA, related party transactions, length of the agreement, location savings, market conditions, or premiums that the enterprise experience from operations. Since the pre-filing meeting is the necessary foundation of any further negations, it is essential for the taxpayer to disclose all the relevant details. Therefore, the applicants should reveal their intentions to reach an APA deal with the government, and clarify any issues as queried by the SAT.

Secondly is the intent for the APA. After the relevant discussions in the first step, it is imperative for the applicants to file a letter to indicate their interest in the creation of the APA and outline all the crucial details affecting the APA. Information requirements at this stage include the taxpayer’s value chain and risk analysis, transfer pricing methods, business scale, and proposed APA plans. Besides, it is crucial for the applicant also to provide information about the international or domestic tax laws that will affect the APA. The SAT then uses the document to make further deliberations about the suitability of the APA application; the authority has the liberty to either abandon or continue with the APA.

The next phase is analysis and evaluation of the APA. During this stage, the tax authority examines whether the APA meets the arm's length principle, which requires the transactions between related parties to be carried out as if they are independent. The elevation or reduction of the commodities prices in transfer pricing is an avenue through which the MNC reduce their taxes. Therefore, the tax authority may decide to carry-on onsite visits to take a closer look at the organization’s operations, and risk interviews to certify the availed information. Other inquiries like the related parties and value analysis can also be undertaken at this stage. From the gathered insight, the SAT may require the taxpayer to amend the application to suit the new findings or retain the document without altering.

The third aspect of APA is the submission of the formal application in the Chinese language. The presentation should capture crucial knowledge about the APA in a detailed manner. Some of these facts include the group structure, financial records of the past three years, related party transactions, allocation risks, market conditions, business performance reports, risk analysis, and financial arrangements involved. Besides, the document should also explain double taxation concerns arising from the advanced pricing arrangement with China. The SAT then replies to the taxpayer by either accepting or rejecting the application within a reasonable amount of time. In case of rejection, the SAT has a role to explicitly state the basis for the refusal of the APA after the extensive negotiation period taken to reach this stage.

Phase five covers the negotiation and signing of the APA. The types of bargaining depend on the nature of the APA, and for unilateral agreements, the SAT deals directly with the taxpayer. On the other hand, bilateral and multilateral agreements require the SAT to bargain with other tax authorities in different jurisdictions of the world. Also, more specifications on the APA are provided including the duration, renewal procedures, tax adjustments, and notification procedures. After the completion of the negotiations, all the parties sign the APA to show the approval of the arrangement. Due to the sensitive nature of the bilateral and multilateral APAs, it takes the SAT a considerable amount of time to reach agreements that will allow the Chinese people the privilege of conducting businesses in a favorable environment. Therefore, applicants should be patient and ready to wait for two or more years to achieve their goals.

Implementation and execution phase of the APA is the last stage of the six steps. Throughout the execution of the APA, the taxpayer should remain in contact with the relevant tax authorities. Annual compliance reports should be submitted to the SAT, which evaluates whether the transactions are within the allowed limits. The statements should include the prices on all the related party transactions, profit level, and organizational performance of the covered period.

Prioritization of APAs

Bulletin 64 provides adequate elaboration of situations where the SAT will make APA applications from companies a priority. In dealing with the annual problem of APA backlogs, it is crucial for MNCs to meet the given conditions to fulfill their objectives. The submission of correct and complete information on the related party transactions and the types of transfer pricing methods is the first point of consideration. Since the information allows the SAT to determine whether an enterprise qualifies for this program, it is bound to capture the attention of staff at the tax authority.

A company’s historical records of tax compliance have significant influence on the prioritization of its APA application. According to research, SAT does not collect nearly half of the tax revenue that the domestic and foreign companies should pay. The SAT uses a system to rate the level of tax compliance for corporations, and the rating determines the prioritization of the APA. Enterprises with an A rating receive more attention; thus, their APA programs get completed sooner than their counterparts with a lower rating.

Meeting the individual company audit tax requirements is a strategy for prioritization of the APA in China. Typically, companies in China should employ competent professionals to review the implementation of the right taxation guidelines over a particular period. The tax authority also examines the special tax adjustment in a corporation through audit procedures. If a firm ensures that there are no cases of tax evasion, the APA is more favorable.

Rejection of APAs

Additionally, Bulletin 64 enumerates situations leading to the dismissal of the APA. The circumstances are the opposite of the prioritization issues discussed above. They include the failure to submit the APA document requirements, disagreements during the pre-filing meeting, unreasonable transfer pricing methods, or lack of information on related party transactions. Unwillingness to collaborate with the SAT to clarify on matters affecting the program may form the basis for a rejection of the application. Besides, foreign jurisdictions may also be disinterested in bilateral APA, forcing the taxpayer and the SAT to look for other avenues to lower the double taxation effect. From the above discussion, MNCs should introduce several changes to meet the new requirements, and improve their chances to get accepted into the APA program.

MNCs Response to Bulletin 64

Clearly, it is urgent for the MNC’s to prepare for the implementation of Bulletin 64 by China’s tax authority. What next for the MNCs under the new regulations? This is the primary question in the minds of millions of foreign shareholders that have business interests in China. The role of MNCs in fostering economic growth in China cannot be underscored, these enterprises provide employment to citizens, contribute tax revenue, and sell commodities in the marketplace. To ensure total compliance with the new law on APAs, the MNCs will need to implement the following aspects in their businesses.

MNCs should carry out a complete evaluation of their legal structure in China to understand how it affects their taxation. There are several business registration options for foreigners in China including joint ventures, company, and partnerships that define their legal structures. According to China’s law, all foreign and domestic corporations pay the Enterprise Income Tax (EIT), while the government taxes the partners and sole entrepreneurs individually. Since all the MNCs in China are companies, they are subject to the EIT taxation system. It is vital for the MNCs also to evaluate how the new APA changes will affect their interests to find double taxation relief in the country and on related party transactions. For example, the organizations need to merely compare their sales value with related parties to determine their qualification for APA application in the state. Consequently, the number of MNCs in China’s APA program will gradually increase.

MNCs should prepare quality transfer pricing documentation for all operations over the recommended three year period. Every day, the MNCs conduct businesses with related parties, and the data is subject to the application of transfer pricing regulations in the country. It is vital for the enterprises to take note of various issues on a day to day basis including the value of related party transactions, stakeholders, and their commercial interests in the business association. Note that the MNCs should ensure consistency in the data collection methods, and report because the documentation will justify their transfer pricing positions in the country. For instance, examination of the selling prices of goods between the related parties will establish the extent to which an enterprise observes the arm's length principle. Besides, the MNCs also use the documented information to prove that the total sales revenue from related party business activities is RMB 40 million and for three business years. Through the efficient utilization of the documents during the submission process, the SAT will prioritize their APA applications.

The procedure for the selection of a transfer pricing strategy is discussed below. How do MNCs select the transfer pricing method? The organization should consider some factors to pick one calculation technique. These include the features of the assets or services that are involved in the related party transactions, economic circumstances in the country, business strategies, and risks associated with related party operations, and business strategies. Since MNCs also disclose the transfer pricing technique from the first stage of negotiating for APA, it is crucial for the management team to know how to use these methods. As a result, the MNCs will be in a position to convince the SAT why these methods are the best for their institutions.

Furthermore, MNCs should continuously monitor the intergroup transactions to ensure they are compliant with all the transfer pricing rules in China. As earlier stated, an organization’s rating of their past compliance behavior determines the level of urgency that the SAT will accord an APA application. Some of the most crucial transfer pricing regulations include maintenance of arm’s length transactions, the complete disclosure of related party transactions, and timely filing of appropriate reports with the tax authority among other requirements. Typically, the MNCs that adhere to these laws rarely face special investigations from the SAT apart from the routine procedural checks. Moreover, these enterprises also pay their taxes and retain close correspondence with the local Chinese authority to ensure that they are up-to-date with any changes in the nation’s tax system. Consequently, the MNCs obtain an A rating for their efforts to meet the SAT’s threshold and enjoy high chances for making successful APA applications than peer organizations.

However, it is impossible for the MNCs to apply for APA without comprehensive risk analysis tool for transfer pricing issues affecting the organization. In the recent past, there have been numerous discussions of the risks associated with transfer pricing in the international and local markets. According to the OECD, different factors increase uncertainties in the regulations of related party transactions for the MNCs. Some of these risks include the deal with the potential to erode the tax base such as royalties, management fees, or buying of significant assets for the organizations. Besides, the transactions with nonresident companies from jurisdictions with better tax systems is a significant risk, as the enterprises may decide to leverage these relationships to reduce cost. Moreover, profitability anomalies reported by the MNC also raises several questions about the trends, and it is the management’s role to explain the variations to the SAT.

How can MNCs evaluate the risk affecting their transfer pricing methods?

MNCs should be proactive in evaluating the transfer pricing risks affecting their operations. They should not wait for the SAT’s assessments of their risk factors to take appropriate actions to combat the uncertainties affecting their operation. Instead, the firms should be proactive to identify the risks and solution to the problems in various ways. They should first establish the different types of related-party transactions in their operations, and the uncertainties that management experiences it their attempts to manage these transactions. Subsequent reporting of the identified transactions also helps to pinpoint the organizations in the high-risk areas. The transactions that require the management to take extra time in the reporting process are often complicated, hence the need for the enterprise to carefully consider their documentation and reporting in the financial reports. Besides, it is imperative for the MNCs to be careful of a huge transfer pricing transaction that has a higher risk of errors compared to the smaller deals. Consequently, the MNCs will meet the different measures of threats from the tax authority, and fulfill the SAT requirements of risk analysis in the APA program.

It is imperative for the MNCs to also undertake a comprehensive audit of the transfer pricing activities in the organization. Over a decade ago, the MNCs doing business in China were not subjected to the strict tax regulations that are present in the current market. As a result, many of them ran their businesses without the interference of the tax authority and enjoyed remarkably higher profitability levels. However, the increased awareness about the potential of tax revenue generated from these entities has led to the introduction of Bulletins 42, 64, and six that regulate the activities of these entities. As the SAT continues to issue new laws to provide guidelines on related party transaction in the state, it is imperative for the affected parties to hire professionals to audit their treatment of the transfer pricing activities. Note that some of the audit companies in China like PWC, KPMG, and EY publish various articles on transfer pricing audits to educate the MNCs about the needs for investing in these services. After the elimination of any weaknesses identified during the audit process, the MNCs will be ready for the APA program.

Conclusion

The above discussion highlights some of the critical changes in the administration of the APA program in China. Before the introduction of bulletin 64, many MNCs were in a state of uncertainty on how to make APA applications and secure their approval within the shortest time possible. Moreover, the annual SAT reports on advanced pricing arrangements showed that numerous APA applications were either rejected or pending the support of the authority. Bulletin 64 solves these problems in three key ways namely provision of guidance on the APA program, prioritization and rejection of APAs, and MNCs value chain analysis. The MNC must respond to these changes in a positive way; they should make the right adjustments to meet the new requirements. As such, they will be more successful in the APA program. Moreover, the standardization of APA program in Bulletin 64 will help China to enter into more bilateral and multilateral agreements with other nation, hence meets the requirements of the BEP project.