Transfer pricing documentation season in China: Again new challenges ahead!

 

Previously, it is not clear whether the deadline for transfer pricing documentation will be postponed due to the pandemic. Recently, we noticed that a lot of local tax authorities have announced the requirement of the completion of the FY 2019 Local File by 30 June, 2020.
 

Since additional information is required for the Local File and Master File in China as compared to BEPS Action 13, companies have to identify the gap between group documentation template and Chinese documentation requirements and prepare the additional information to bridge the gap. Timely negotiation is therefore recommended for all Chinese subsidiaries of multinational groups. However, due to the outbreak of the pandemic in overseas countries, the information exchange with the group HQ might take more time than before. Therefore, the process of information exchange is suggested to be started earlier compared to previous years so as to ensure that the information could be collected in time.

 

Another key issue to be aware of this year for the Local File preparation is the increasing challenges from the Customs Authority. Besides the royalty arrangements which have been a hot audit target for several years, customs authorities begin to focus on directly examining the reasonableness of the intercompany transfer price for goods imported from overseas related parties. More and more companies have been required by the Customs Authority to also submit the Local File for review during a customs audit. In practice, there have already been cases in which enterprises were requested by the Customs Authorities to adjust the transfer prices for related party transactions according to the interquartile range of profit margin achieved by comparable companies based on the benchmarking study in Local File.
 

It is therefore becoming increasingly important to also consider the possible customs risks in the Local File preparation, e.g. to perform additional gross margin analysis or to adjust the functional and risk profile of the Chinese enterprise to support the deviation in the profit margin observed.

 

Due to the impact of Covid-19, it is expected that enterprises may face more challenges in the preparation of transfer pricing documentation next year as many enterprises are expected to have significant profitability fluctuations or even losses in 2020. Especially for Chinese subsidiaries performing routine functions, if they incur losses due to insufficient productivity and slack market demand resulting from the pandemic as force majeure, they shall consider how to distinguish or quantify the losses that should be borne by the routine company and the principal company.

 

In this case, enterprises are recommended to start to collect the relevant information on special factors which cause the losses this year which could then be used for conducting special factor analysis in the 2020 Local File to justify the unfavorable financial performance of the Chinese subsidiaries.