On May 18, 2022, Shenzhen Customs (“SZ Customs”) and Shenzhen Tax Service of the State Taxation Administration (“SZ STA”) jointly issued “Notice on Matters Relating to Implementation of Collaborative Administration of Transfer Pricing of Associated Imported Goods” (No.62[2022], SZ Customs and SZ STA, “Notice No.62”), and decided to implement the collaborative administration of transfer pricing(“TP”) of associated imported goods (“CAM”) to balance and coordinate their supervision on the pricing of associated imported goods.
According to the CAM, SZ Customs and SZ STA, in the form of cross-departmental cooperation, and upon the application of taxpayers, will jointly assess the pricing of the associated imported goods under the existing Customs advance price ruling (“APR”) according to “Interim Measures of the Customs of the People’s Republic of China for the Administration of Advance Ruling” (Order No.236 of the General Administration of Customs, “Order No.236”) and tax advance pricing arrangement (“APA”) according to “Announcement of the State Taxation Administration on the Issues Concerning Improving the Administration of Advance Pricing Arrangement” (Announcement No. 64 [2016] of the State Taxation Administration, “Announcement No.64”). A Memorandum (the “Memorandum”) will be jointly entered into by SZ Customs, SZ STA and the enterprise upon their consensus. The CAM is expected to reduce compliance costs of taxpayers and enhance compliance certainty and management efficiency.
Based on our rich experience in dealing with Customs and TP cases, the following will discuss relevant legal and practical key issues we identified in relation to implementation of the CAM as addressed by Notice No.62.
1. What is the Purpose of Establishing the CAM?
The CAM is a valuable attempt to address the long-standing differences and conflicts between the Customs and tax authority in supervising the pricing of associated imported goods.
The “Guide to Customs Valuation and Transfer Pricing” published by the World Customs Organization (“WCO”) states clearly in the very beginning that “…at this stage any alignment or merger of tax and Customs methodologies is not a realistic proposition given the particulars of the existing legal frameworks upon which they are based.” This is because while the regulatory requirements of Customs valuation and TP appear to be similar to the extent that both of them aim to ensure that transactions between related parties should be priced based on the arm’s length principle, differences or even conflicts always exist between the Customs and tax authority in this regard.
Two major reasons for this. Firstly, taxpayers have different motives in declaring the price of imported goods for Customs vis-a-vis tax purposes. From the perspective of import declaration, lower declared price can reduce tariffs and taxes upon importation[1], but may result in higher profits and higher corporate income tax liabilities for domestic enterprises; on the contrary, higher declared price means more costs and less corporate income tax, but may increase the duty on imports.
Secondly, Customs valuation and TP have different regulatory approach and conception. Customs valuation focuses on price per se, and makes sure all necessary elements are weighed in the price. The focus is on relatively micro factors such as the “circumstances surrounding the sale” and its impact on “import price”, for which the Customs has comprehensive and sufficient data to support its price-based verification.
In comparison, from TP perspective, though there are also price-based methods such as the comparable uncontrolled price (“CUP”) method, its application is difficult due to unavailability of comparable data in most cases. The tax authority usually has to focus on whether the result of TP policy of an enterprise’s overall associated transactions (including import and export of goods, services, intangible assets, capital, loan, etc.) is consistent with the commercial results obtained by independent third parties with similar functions and risks and under similar business circumstances.
Notwithstanding the above differences, Customs’ valuation methods and tax’s TP methods have important referential values to each other. It is important to note that the Customs also has a valuation method to deduce prices from the profits, while tax authority also considers the impact of price under specific circumstances, especially in bulk commodity transactions. In addition, the impact of price will normally be passed to profits. These mean the approaches of the Customs and tax authority still have something in common, which is an important basis for them to strike a balance and collaborate upon.
Extracted From WCO “Guide to Customs Valuation and Transfer Pricing”
It can be seen that tax authority's TP analysis of controlled transactions is an important reference for Customs purposes as the assessment of gross profit level based on the arm's length principle is also a vital part of Customs valuation. Especially, since the Technical Committee on Customs Valuation ("TCCV") under the WCO published the Case Study 14.2 that establishes the important role of TP report in examining the circumstances surrounding the sale for Customs valuation, it has become a common practice to request the TP report for Customs valuation.
However, it's a pity that in China's TP practice, while the APR issued by the Customs can endorse TP arrangement to some extent, it is still not a necessary reference document for tax authority at present. It follows that the Chinese Customs and tax authority often examine the same transaction of the same enterprise yet render conflicting results based on different regulatory concepts. The underlying complementarity of pricing/valuation methods vis-a-vis regulatory independence thus becomes a focal point.
Accordingly, the call for harmonizing the approaches of tax authority and Customs on this issue is growing. For example, the OECD Transfer Pricing Guidelines 2022 and its counterpart United Nations Transfer Pricing Manual 2021 both call for better collaboration and information exchange between the Customs and tax authority, so as to ensure that TP and Customs valuation are in the same direction to preventing the conflicting regulatory results by the two authorities. The new CAM under Notice No.62 is a valuable attempt in response to the above issues. Although the new policy is currently only applicable in SZ Customs District, it is expected that if the CAM proves to be effective in smoothening the differences between the Customs and tax authority on TP and improving the effectiveness of follow-up administration, it is likely to be further replicated and promoted nationwide.
2. What are the Provisions of the CAM?
Notice No.62 mainly introduces the workflow of the CAM from the perspective of procedures, as shown in the following chart:
Workflow Chart of CAM Application
The CAM of SZ Customs and SZ STA is actually based on two existing systems, namely, the APR of the Customs under Order No.236 and the APA of TP under Announcement No.64. Therefore, it is necessary to coordinate the two systems in the implementation process, and it is necessary to pay attention to the procedural differences between the two systems.
3. The Issues Requiring Further Attention under the CAM
3.1 Price or Profit Margin? — It May Depend on Pricing Method
As mentioned above, the core of Customs valuation is dutiable value rather than profit margin. In the circumstances surrounding the sale test to determining the dutiable value, the Customs needs to assess not only whether the TP policy complies with the arm’s length principle but also a series of factors that may affect the sales circumstances and transaction price, such as the quality of a specific product and the process conditions in the exporting country. Even if focusing on profit margin, according to WTO “Customs Valuation Agreement”, the Customs usually pays more attention to gross profit margin.
From TP perspective, the TP methods applicable to goods transactions generally include the CUP method, resale price method, cost plus method and transaction net margin method (“TNMM”). Among them, only the CUP method directly compares prices. With bulk commodity and intangibles (which are often not the focus of the Customs except for royalty valuation) as exceptions, the external comparables are generally not available publicly, and no available internal comparable may exist within the enterprise group as well. Although the CUP method is considered as the most reliable method in theory and applicable to Customs valuation, it is limited in TP practice.
In terms of profit margin, both the resale price method and cost plus method use gross profit margin as profit level indicator. But similar to the CUP method, they also have higher requirements for comparability and lower tolerance for differences in accounting standards adopted by different countries, and the former generally applies only to low value-adding processing or purely buy-sell business. In theory, the resale price method or cost plus method may be selected to align with the Customs valuation when information such as gross profit margin is available. However, their practical application is relatively limited in the same vein as the CUP method.
In contrast, the TNMM, which provides lower comparability requirements and higher tolerance for accounting standard differences, is more commonly used in the TP practice in China, i.e. using net profit margin as profit level indicator to examine the price of cross-border related transactions indirectly. In this scenario, it may be worthwhile to adopt both gross profit margin and net profit margin as profit level indicators to meet the different regulatory requirements of both the Customs and tax authority under the CAM.
It should be noted that the analysis of gross profit margin needs to consider the impact of intangible assets. One of the explanations for the higher gross profit of some PRC enterprises is their participation in the development of intangibles in China. For example, when Chinese trading companies engage in marketing and sales activities to increase market share and acquire more favorable prices, they should also participate in allocation of residual value derived from the sales in China. This is consistent with the position of Chinese tax authority in recent years on market premium and that income should be taxed where value is created. However, such argument requires effective communication and collaboration with both the Customs and tax authority to obtain their dual recognition.
In a more complicated scenario, if a PRC enterprise has other types of associated transactions in addition to importing goods, such as purchasing services from its overseas related parties, in practice TNMM is usually used to examine whether the overall net profit margin of the target enterprise accords with the arm’s length principle. In this scenario, question arises as to whether the enterprise can enter into APA with the tax authority and on this basis to simultaneously apply for the CAM. If the answer is in the affirmative, should a separate examination of gross profit margin be conducted for related transactions or a specific product under the APA, and will this examination entail necessary adjustments of the selected comparables under TNMM? These issues all need to be further explored in practice.
In addition, a more important issue here is that the related royalty transactions are the focus in Customs valuation while the related services are often relatively less addressed. According to the CAM, the Customs would have more chances to put services into regulatory considerations. It also raises concerns if the Customs count the charge of royalties as an important factor determining whether special relationship has affected the price.
3.2 Different Regulatory Perspectives between the Customs and Tax Authority
From TP perspective, TNMM usually applies in a macro way to the overall profit margin level of the enterprise or a business line, while from the perspective of Customs, the import price of specific goods is the focus, which is not completely consistent with the TP perspective. For example, for specific goods, their gross margin may be higher or lower than the comparable’s margin range under Customs valuation due to various affected factors, such as, market competition and characteristics of goods, or the profit margin of specific products with higher tariff rate is lower while the margin level of products with lower tariff rate is higher due to different importation strategy for various products adopted by the enterprise, but under both scenarios the overall profit margin of the enterprise may still be within the comparable’s margin range from TP perspective. This will result in challenges to both the Customs and the tax authority on their administration of the imported goods.
Therefore when applying for the CAM, from TP perspective, in addition to the routine TP analysis, it may be necessary to separate different business/transactions and provide segment financial data in the APA to address the Customs concerns on the import price of specific goods. From the perspective of Customs, the leeway allowed for the pricing of different imported goods under the same business model according to the overall profit level of the enterprise is also a key issue in the application process.
3.3 Coordination of Application Time
In accordance with Order No.236 and Announcement No.64, the Customs requires that the application for advance ruling shall be made three months before the importation of goods, and the APR shall be made within 60 days. However, the APA negotiation with the tax authority often takes long in practice. Even if the simplified procedure is applied, it usually takes 6 months. Under the CAM, enterprises should make sufficient preparation and justification, and arrange informal communication or preliminary meetings with the tax authority in advance, so as to coordinate the time requirement for the APR by the Customs.
3.4 Retroactive Effects
According to Order No.236 and Announcement No.64, the Customs advance ruling does not have retrospective effect, i.e. the results of APR of the Customs cannot be directly applied to the dutiable value of the goods imported before the ruling is issued. In contrast, the tax authority can apply the APA retrospectively to previous years. Once the tax authority has made such decision, it is not yet clear whether the Customs recognizes the relevant results for historical imports or as the basis for ongoing Customs inspection or price review.
3.5 Follow-Up Regulatory Requirements—New Challenges to CAM
Regarding the following-up implementation, the Customs and tax authority may also have different understandings on whether the enterprise complies with the Memorandum.
For example, we note that Article 6 of the Memorandum provides that “the actual financial indicators of the applicant in any year shall be implemented in accordance with the median of the fair trade range determined in Article 5, paragraph 3, the applicant shall make price adjustment according to the median of the financial indicator if the indicator is lower or higher than the median”. Whether there is room for any adjustment leeway for this provision still needs to be further explored in the future. As far as the clause itself is concerned, it is unreasonable to strictly follow the median from the technical standpoint of both the Customs and TP perspectives. However, it can be understood as a balance between the opposite regulatory positions taken by the Customs and the tax authority. For example, if the profit level indicator is higher than the median, the enterprise is exposed to the risk of lower import price from the Customs perspective, while if the rate is lower than the median, TP risk may arise.
Besides, strict reference to median brings greater pressure on enterprise. Assuming a PRC enterprise is a trading enterprise, after determining the target gross profit margin of imported goods, the actual import price needs to be deduced from market price, which can hardly be accurate in practice considering various factors such as market changes, discounts/rebates, etc. If the PRC enterprise is a manufacturer, the affecting factors of the imported price and the deduced calculation will also be more complex and difficult.
In this regard, we suggest enterprises establish effective financial control system and TP management to regularly monitor the historical performance and financial forecast, and make necessary adjustment once profit margin deviations are identified. If the import price fluctuates substantially, it is suggested to have effective communication with the authorities. In addition, if cross-border profit compensation is involved, effective communication with banks is also necessary under the existing administration of foreign exchange system.
3.6 Cross-Border Challenges——Tax Administration of Other Involved Jurisdictions
From the MNC group’s point of view, it is inevitable to consider the position of tax authority of exporting countries on the pricing of the cross-border transaction, while the Customs supervision in the exporting countries usually faces fewer challenges as export transactions are generally duty-free. In case of a unilateral APA, the MNC needs to balance such challenges from the exporting countries and its impacts on the importing country.
In this regard, a bilateral APA can naturally solve the regulatory problem of the tax authorities of the two countries, while the negotiation and communication with both tax authorities of the two countries will be more complicated and full of uncertainty.
Furthermore, if a group implements a global pricing policy and applies for the CAM in China, whether the corresponding pricing policy adopted by the CAM has potential impact on that of other jurisdictions also requires strategic consideration at the group level. It should be noted that the APA should be disclosed in the group’s master file of TP documentation.
4. Our Suggestions
For many MNCs, the CAM means an opportunity to communicate with the Customs and tax authority on the TP issue, and to strike a balance between the two authorities to the greatest extent. Before the formal application, it can make necessary preparations and assessment from the following aspects:
Firstly, assess the completeness and accuracy of application materials in advance. Any documents provided to the government regulatory authority shall be true and accurate. When applying for the CAM, one set of application materials should be submitted to two authorities at the same time, and attention should be paid to the habitual requirements on the documents of the two authorities.
Secondly, when implementing the CAM, fully consider any possible differences between the review results of the two authorities and the enterprise’s expectations. As the Customs and tax authority will review from different perspectives on the same pricing issue of imported goods, the final result should reflect a conclusion fully negotiated with the two authorities. The enterprise should take full account of the possibility that the results may not meet its original expectations.
Moreover, consider the impact of the CAM on other jurisdictions. At present, the new policy is restricted to Shenzhen. It is important for MNCs to consider whether the results achieved under the CAM in Shenzhen can be transplanted to other subsidiaries in China, and in a larger picture, how it may relate to the TP policy of the same MNC group in other jurisdictions.
Finally, when implementing the CAM, if enterprises make subsequent adjustments to the prices of imported goods, they need to deliberate on the requirements of both Customs and tax authority to minimize the risk of violating the regulatory requirements of either authority. As mentioned above, since the Customs and tax authority may have different understandings of the follow-up administration, relevant price adjustment may meet the requirements of one authority, but fall short of the other, or CAM may even be suspended. Therefore, the importance of fully considering the Customs and tax authority’s concerns in the subsequent administration cannot be ignored.
To sum up, Shenzhen’s trial of the CAM still has many issues to be further clarified and discussed in its implementation, but it is a milestone in improving predictability and certainty of TP and Customs administration, as well as promoting trade facilitation. We hope that the trial CAM in Shenzhen can further improve China’s administration on TP of imported goods and strengthen the interaction between the Customs and the tax authority. Once the new system in Shenzhen and the Greater Bay Area becomes full-fledged, hopefully it will spread to the whole country and benefit more enterprises.
Based on the input tax credit mechanism of VAT, the impact of high or low import price is in principle tax neutral for VAT.
