The State Administration of Taxation (SAT) has released a circular urging taxation bureaus to strengthen supervision of cross-border transactions, to prevent loss of tax revenue during the international financial crisis, China Business News (CBN) reported on July 29. The aim is to prevent multinational enterprises from using transfer pricing mechanisms to report spurious losses in China and thereby avoid taxation.

The circular said multinationals were entitled to make reasonable profits, but noted that, according to their annual reports, about 55 percent of foreign-invested enterprises (FIE) were in the red before 2005. A 2007 survey by the National Bureau of Statistics showed that almost two thirds of apparently loss-making FIEs had deliberately made false reports and used transfer pricing to avoid paying 30 billion yuan (US$4.39 billion) in taxation.

The circular said it was strange that while FIEs showed losses in their annual reports, foreign direct investment in China continued to hit new peaks year after year.

It is well known that multinationals use transfer pricing as a way of avoiding taxes. Branches located in high tax areas sell goods or services to other divisions at artificially low prices. Conversely they buy raw materials or services from other divisions at artificially high prices. Both practices result in profits being transferred to low tax jurisdictions.

Moreover, in joint ventures, foreign investors may report spurious losses to swallow up the share of their Chinese partners. According to CBN, Double Coin Holdings Ltd. announced on July 17 that it was selling its 28.5 percent share in Shanghai Michelin Warrior Tire Co. Ltd because of continuous losses. Michelin, which owns 70 percent of SMWT, was the probable buyer.

According to insiders, SAT has stepped up supervision because many multinationals are facing difficulties due to global financial crisis while their Chinese subsidiaries remain in good shape. This has increased incentives for multinationals to reduce taxable profits by fixing transfer prices on cross-border transactions.

Deloitte Beijing partner Zhang Baoyun told China Business News that between two and three hundred enterprises are formally investigated by the tax authorities every year and, of these, between one third and one half were ordered to pay back-taxes.

The New Enterprise Income Tax Law and Implementation Rules of the People's Republic of China, which took effect in 2008, contained new provisions designed to counter tax avoidance.

Zhang added that lower overall tax revenues due to the crisis were another likely motive for the SAT move.

Advance pricing agreements (APA) are considered the most effective way to solve the problem of tax avoidance through transfer pricing. They are agreements between taxpayers and tax authorities on appropriate transfer pricing methodologies (TPM).

But tax authorities remain skeptical about the value of APAs. "Signing APAs with enterprises the authorities don‘t fully understand will lead to losses for state finances," an expert from Deloitte told CBN.

(China.org.cn by Ma Yujia July 30, 2009)