Transfer pricing – the pricing of cross-border transactions between related parties – has become such a hot topic globally. In Mainland China, similar to other G20 countries, the aim is to find solutions to prevent companies from base erosion and profit shifting (BEPS) for tax purposes. Transfer pricing itself is not a problem – it is the potential for transfer pricing manipulation that the government fears and wants to prevent through regulation.
Tax-induced transfer pricing has generally been studied in three different contexts: between affiliated companies in different jurisdictions; between affiliated companies within a jurisdiction; and for the same firm across a period of time. Therefore, transfer pricing is an important issue in both international and national tax because it applies not only to affiliated companies across countries but also to these companies within a single country. Compared to international transfer pricing, domestic transfer pricing, namely whether affiliated companies shift income to reduce the group’s overall tax burden and whether a firm shifts income from one period to another for tax reasons, attracts much less government attention.
However, the tax environment in Mainland China is changing.
The reasons for strengthening the monitoring of domestic transfer pricing are not hard to understand. Firstly, intrafirm trade in goods and services represents a substantial proportion of the Chinese economy and corporate business groups are a significant source of tax revenue for the government. Secondly, there are variations in income tax rates across regions and industries even after the 2008 income tax reform. Lastly, the current arrangement, in which affiliated companies can calculate their current taxes on an independent legal entity basis, creates strong tax incentives for group members to shift income within the group. Research (e.g. by Lin, Mills, and Zhang published in Journal of the American Taxation Association 2014) shows that Chinese companies exploit variation in income tax rates across member companies and industries to avoid subnational taxes through income transfers.
The government has made serious efforts to detect and deter corporate tax avoidance via transfer pricing. The current income tax regulation gives Chinese tax authorities more teeth to enforce the transfer pricing legislation. For example, with the implementation of the BEPS action plan in Mainland China, companies are now required to complete a total of 22 transfer pricing-related forms as part of their annual income tax return packages and to provide a comparison of profitability between related parties and non-related parties for segmented financial reports. When selecting audit targets, tax authorities particularly focus on companies with 1) a significant amount or numerous types of related party transactions; 2) business dealings with a related party in a tax haven; and 3) lack of tax return disclosures relating to transfer pricing or ones which “obviously violate the arm’s length principle.” Failure to submit contemporaneous transfer pricing documentation is subject to heavy penalties. What is worse, companies found to have tax deficiencies are placed under a five-year post-audit review, during which contemporaneous documentation must be submitted on an annual basis. It is clear that the government has now focused not just on onerous documentation requirements, but also on transfer pricing enforcement mechanisms.
The Chinese tax authority directs its domestic transfer pricing investigation mainly on cases in which differences in tax rates or profit-and-loss status exist within the group. For example, in 2014, Xuzhou Tax Bureau of Jiangsu province found that an agreement for sharing management and research and development expenses lacked economic substance and represented abusive transfers of profit between two differently taxed companies within the group, resulting in a tax deficiency of RMB5 million.
However, there are institutional constraints for the effective enforcement of tax laws in Mainland China. In a big country with multilevel governance, goal incongruence with the central government reduces local governments’ incentives to effectively enforce tax laws for the state. Tang, Mo, and Chan (The Accounting Review 2017) found that local governments actually help their companies avoid income taxes belonging to the central administration. So, how effective is the Chinese tax authorities’ monitoring and enforcement of domestic transfer pricing regulation? To help answer this question, authors Lin, Mills, Zhang, and Li (Contemporary Accounting Research 2018) modelled a firm’s tax incentive to shift income as a joint function of the spread in tax rates among members of the consolidated group and the magnitude of intragroup transactions. They used aggregate data from the China Tax Audits Yearbook to construct a provincial-level tax enforcement index that captures the probability of a tax audit and prosecution, the manpower sufficiency of tax offices to monitor taxpayers, the educational and professional level of the tax officers in a region, and the economic consequences of the tax audits in terms of additional tax payments and monetary punishment for tax underreporting.
The authors found that firms headquartered in regions with stricter tax enforcement exhibit less tax avoidance through transfer pricing. They also found that raising the enforcement intensity from the lower quartile to the upper quartile reduces tax avoidance via transfer pricing and hence, increases effective taxes, on average, by one percentage point for the average firm.
The above findings have implications for practice as CPA firms often face conflicting demands to give clients tax minimization advice on the one hand and to detect material cases of corporate earnings management on the other. From a practice perspective, the findings suggest that to minimize litigation and reputation risk, tax practitioners should understand the enforcement behaviour of tax authorities as government scrutiny appears to vary according to geography, firm attributes, and year.
This article is contributed by Kenny Lin, Professor, and Shanshan Shi, MAcc Programme Director, at the Department of Accountancy at Lingnan University.