By: Wang Feng and Dai Menghao
Recently, we assisted several clients in communicating with the National Supervision Bureau for Duty Collection (Shanghai) of China’s General Administration of Customs (GAC) regarding the transfer pricing (“TP”) research and documents request initiated by the Bureau in 2020.
Based on our knowledge and experience in similar situations, we hope this article can help you and your companies in the research. Our preliminary view is that China Customs may shift its focus in valuation from royalties to the special relationship between affiliated companies. Although the TP research is a new initiative by Customs, it still focuses on a typical topic in customs valuation – does the special relationship between transaction parties influence the import price of the goods?
This topic has been a concern for numerous multinational corporations since the signing of the “Agreement on Implementation of Article VII of the General Agreement on Tariffs and Trade 1994” of the World Trade Organization (WTO) (“WTO’s Customs Valuation Agreement”). In particular, part of the Agreement overlaps with base erosion and profit shifting concerned by tax authorities, which complicates the structuring and arrangements in specific international transaction of goods. For the investigation on whether the transaction value is influenced by special relationships, the issues of how to determine if there is a special relationship and how to apply specific valuation methods will not be detailed here. Instead, we will share our insights on changes of the way of Customs’ thinking, based on our experience and updates from the World Customs Organization (WCO) on customs valuation.
1 Is it useful to submit a TP report?
TP report has almost become a “standard document” requested by China Customs in valuation investigations concerning whether the transaction value is influenced by special relationships. This is particular the case after the Case Study 14.2 submitted by China Customs was compiled in WCO’s Customs Valuation Compendium in October 2017. In practice, many companies have surely been requested by Customs to adjust the dutiable value of the imports directly according to the interquartile range of the profit margin listed in TP documentation. In this regard, many companies may consider it “useless” to submit TP reports to Customs, or even mistakenly understand that “the regulatory mindset of Customs conflicts with that of tax authorities”. Some companies inquired us of the possibility of issuing a “TP report that is acceptable by both Customs and tax authorities”. According to WTO’s Customs Valuation Agreement as well as WCO’s relevant Commentaries and Case Studies, the regulatory mindset on affiliated transactions indeed differs between Customs and tax authorities, but that is mainly because of different regulatory focuses of the two authorities. Therefore, TP reports can be used theoretically as reference documents for customs valuation, but situations may vary in specific valuation cases.
According to Article 1.2 (a) of WTO’s Customs Valuation Agreement, “[i]n determining whether the transaction value is acceptable…the fact that the buyer and the seller are related…shall not in itself be grounds for regarding the transaction value as unacceptable. In such case the circumstances surrounding the sale shall be examined and the transaction value shall be accepted provided that the relationship did not influence the price.” Clearly, during the valuation investigation of special relationships, Customs focuses on examining the “circumstances of the sale”. Particularly for specific imports, their dutiable value may be determined by analysing the “circumstances surrounding the sale” only, but not by applying the other test values in WTO’s Customs Valuation Agreement. This principle is adopted as the “general commercial practice” in Article 18 of the Measures of the Customs of the People’s Republic of China on Determining the Dutiable Value for Imports and Exports (“Valuation Measures”) .
Meanwhile, according to the Addressing Base Erosion and Profit Shifting and the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations from the Organisation for Economic Co-operation and Development (OECD), tax authorities, from TP supervision perspective, focus on examining whether the affiliated transaction follows the arm’s length principle, to prevent the inconsistency between profit allocation and the economic activities generating the profits. It is also specified in China’s Implementation Measures for Special Tax Adjustment.
In view of above regulatory principles, analysis on the “circumstances surrounding the sale” of specific goods in customs valuation is conducted from a relatively micro perspective, whereas the TP examination by tax authorities is conducted from a broader perspective of TP policy. The “circumstances surrounding the sale” are not only determined by “whether the pricing policy follows the arm’s length principle”, but also influenced by several factors to be duly considered, including the quality of specific products, and the processing work in the exporting country. Whereas the pricing policy requires a summary of a type of business model (e.g. the sale of finished products or intangible assets), it is impossible to be tailored for each product. As such, WCO and OECD called for better coordination and information exchange between Customs and tax authorities, to promote the consistency between TP and customs valuation. In practice, however, it is quite difficult for a TP report prepared per the requirements of tax authorities to fulfil the needs of customs valuation, except for companies with relatively simple business models and product lines.
In fact, the WCO Technical Committee on Customs Valuation (TCCV) elaborates on this issue in the “Examination of the Expression ‘Circumstances Surrounding the Sale’ under Article 1.2 (a) in Relation to the Use of Transfer Pricing Studies” (“Commentary 23.1”) published in October 2010. TCCV specifies in this Commentary that, “the use of a transfer pricing study as a possible basis for examining the circumstances of the sale should be considered on a case by case basis. As a conclusion, any relevant information and documents provided by an importer may be utilized for examining the circumstances of the sale. A transfer pricing study could be one source of such information.” In Case Study 14.2 submitted by China Customs, although WCO concluded that the declared import value was influenced by special relationships based on the TP report, it also stressed that Customs must analyse on a case by case basis when utilizing TP reports for examining the circumstances surrounding the sale, as emphasized in Commentary 23.1. In fact, in Case Study 14.2, besides utilizing the TP report, China Customs conducted comprehensive analysis on the differences of the product, the function of relevant companies, the origin of the product, specific arrangements of business flow, and such. In a valuation case investigated by Tianjin Customs involving the affiliated transactions of a multinational oil corporation, the Customs was convinced of the company’s opinion on the “circumstances surrounding the sale”. However, preparation of many solid documents for the argument is indeed needed.
Therefore, it is necessary for companies to submit TP reports to Customs, as an important factor of determining the circumstances surrounding the sale. Meanwhile, it should be understood that neither companies nor Customs should simply rely on the data in TP reports to determine the transaction value of the goods. In particular, if the business model or the product line subject to the investigation conducted by Customs is unique, companies should explain to Customs the uniqueness of their circumstances surrounding the sale. If necessary, it is advisable to conduct cost analysis on specific product, and prepare a separate benchmark analysis report. For example, if Customs questions the import price of electric kettles, whereas the products in the company’s TP report are household appliances (including microwaves, blenders and electric kettles), a specific test on the circumstances of electric kettle sales can be more effective than simply providing the data in the TP report. Such a test may include the business model, the function and shared liabilities, products of the same type of the electric kettles. In another valuation audit case by Tianjin Customs on a company with the biggest market share in its industry, separate benchmark analysis reports were prepared for different product lines, which was eventually accepted by Customs.
2 Does a pre-ruling on price help customs valuation?
Since the Interim Administrative Measures on Pre-rulings of Customs of the People’s Republic of China (“Pre-Ruling Measures”) became effective on 1 February 2018, many companies surely have been advised to apply for customs pre-rulings to specify tax-related issues and mitigate company’s risk. These pre-rulings include the ones on relevant factors and valuation measures of the dutiable value of the imports. In fact, we have assisted several companies in successfully applying for pre-rulings on price regarding a number of tax-related issues, including a well-known multinational automobile company in obtaining pre-rulings on price in two major Customs in north China. This case was included as the only one of its kind by GAC in its one-year pre-ruling review in 2019.
In terms of the application of price pre-rulings and its influence on customs valuation, we would like to share our following experience:
Firstly, pre-rulings play a significant role in determining the nature of customs valuation, and ensure wide applicability and stableness for customs recognition of relevant matters. According to Article 13 of the Pre-ruling Measures, customs pre-rulings are effective for three years, and applicable nationwide. Although in principle, the pre-rulings have no retrospective effect on the goods already imported or exported before the rulings become effective, as specified in Article 14 of the Pre-ruling Measures, if the business model, relevant goods and transaction arrangements basically remain consistent before and after the pre-rulings become effective, the rulings still have relatively high reference value in terms of determining the tax-related factors of previous imports and exports, considering the consistency of administrative law enforcement. In the abovementioned price pre-ruling of the global-renowned multinational automobile company, the pre-ruling directly influenced the audit work of Customs that audit was pending to be proceeded according to the result of the ruling.
Secondly, since the application of pre-rulings is related to the time of importation or exportation, companies should submit the application three months before importing or exporting the goods. In addition, Customs may request companies to supplement relevant documents after the submission. Failure to supplement the documents within the limited time will be deemed not having submitted an application, all the previous efforts will be wasted. Therefore, companies who plan to apply for pre-rulings on valuation matters need to make plans and prepare documents in advance to secure a successful application.
Furthermore, the results of the current valuation-involved pre-rulings are limited to analysing the nature of the tax-related factors and valuation measures. While given the uniqueness of the valuation cases involving royalties and special relationships, the subsequent quantitative analysis may be more crucial. In this regard, applying for price pre-rulings may well be the first step of customs valuation. Companies should be prepared to discuss the results of the quantitative analysis with tariff department, duty collection bureau or audit department, based on the results of the pre-rulings. Meanwhile, we anticipate China Customs further refining the results of customs valuation by means of communicating with Customs in other countries, making “advance valuation arrangements”, and such.
3 How will companies be prepared for the risk of customs valuation in affiliated transactions?
Disputes concerning customs valuation, regardless of affiliated transactions or royalties, are more complicated than other customs disputes as they involve more customs departments and relevant data. Based on our previous experience, companies may make preparations in the following aspects to mitigate as many compliance risks as possible and effectively cope with the possible questions from Customs.
a Correct way to declare import price, including the following two aspects:
Firstly, the pricing policy of goods for price declaration should be set out of reasonable commercial purposes, but not illegal ones such as deliberate tax evasion. Given the uniqueness of affiliated transactions, if Customs considers that the declared value of the goods following a pricing policy with reasonable commercial purposes does not comply with the transaction value, Customs will adjust the dutiable value and request claw-back taxes, without imposing administrative punishment on the company. However, if a company achieved illegal purposes, such as evading import taxes, by manipulating the business flow and pricing arrangements in a related party transaction, the company will face the risk of administrative punishment, and, where the act constitutes crime of smuggling, even criminal liabilities. For example, in the largest smuggling case of cosmetics in China, we assisted 3 foreign companies in investigation. The defendant company achieved the purpose of evading import taxes by deliberately setting unreasonable price in affiliated transactions. During trial, the company argued the arrangement simply followed the company’s TP policy. The company was eventually fined RMB 200 million, and its main in-charge person was sentenced 13 years in prison.
Secondly, certain price-related information shall be truthfully declared to Customs based on actual circumstances. According to GAC’s Announcement No. 28 in 2016, GAC makes major adjustments to the “Specifications on Filling Customs Declaration Forms”, and added three declaration columns of price-related information, i.e. confirmation of special relationships, price influence and royalty payment. Despite Customs interpreted and modified the detailed requirements on filing these three declaration items, the specifications on filing the confirmation of special relationships basically followed Article 16 of the Valuation Measures. However, the definition of special relationships in Article 16 of the Valuation Measures is based on Article 15.4 of WTO’s Customs Valuation Agreement and differs from the definition of related parties in the Implementation Measures for Special Tax Adjustment. If companies determine the confirmation of special relationships to be declared to Customs simply relying on the definition of related parties in the Implementation Measures for Special Tax Adjustment, the special relationships may very likely be declared incorrectly. If causing a dispute in taxation, the incorrect declaration may incur risk of administrative punishment in addition to claw-back taxes.
b It is crucial for company’s management to consider the whole picture of transaction structure when setting or adjusting a pricing policy.
Due to the diversity of the business models of multinational corporations and their long-term consideration of business arrangements in China, the whole structure of affiliatedtransactions tend to be complicated with multiple factors taken into account, such as the sale of goods, royalty payment, technical services and warranty arrangements. As a result, simply focusing on the pricing policy of the sale of goods may not fully reflect the whole picture of the actual circumstances of the sale of goods. Lacking the knowledge of the whole transaction circumstances yet simply focusing on the pricing policy during communicating with Customs on valuation may very likely impose adverse impact on the company and the negotiation on customs valuation. Likewise, companies should fully consider the whole picture of the circumstances of the sale when adjusting the overall pricing policy or negotiating with Customs on valuation, including the detailed adjustments to the price of specific product lines. It is inadvisable to take a one-size-fits-all approach.
It is worth mentioning that, in the valuation case the imported finished automobiles of a famous German company that we assisted, and the ongoing case of examination of the import price of a well-known pharmaceutical company, Customs engaged third-party accounting firms to assist in the examination to better understand the overall circumstances of the company. It shows the importance for companies to have an overall and comprehensive consideration of the whole transaction structure.
c Thorough communication with overseas affiliated companies on issues related to pricing policy
Most multinational corporations have uniform pricing policies. Hence, Chinese companies need to confirm detailed information of the pricing policies they execute with their overseas parent companies. However, in many cases, the parent companies, due to various reasons, are reluctant to fully cooperating in providing the documents in a valuation investigation initiated by China Customs. It requires the Chinese companies to communicate with the parent companies, explain the potential consequence and risk, and try to obtain relevant documents. If these documents are unavailable, the Chinese companies should also make alternative plan, such as opting applicable test values to cope with customs investigation.
It is yet too soon to tell if the TP research initiated by the duty collection bureau will become a nationwide special action similar to the special audit by Customs on royalties in automobile and electronics industries in 2016. Nevertheless, special relationships remain a long-lasting topic in customs valuation, and an inevitable issue faced by every multinational corporation. In order to minimize the impact of customs valuation investigation and audit on company’s profits and operation, companies need to have an overall understanding of the issue, with proactive coordination among the parties involved and preparations.
“It was recognised that the “test values” option in Article 1.2 (b) and (c) for examining related party transactions was not likely to be useful for MNEs which typically sell unique goods. In other words, it is unlikely that such test values, based on the strict criteria of identical or similar goods provided in the Agreement, will be available. So the focus was on the analysis of the “circumstances surrounding the sale” provision outlined in Chapter 2.” (Chapter 4.3, WCO’s Guide to Customs Valuation and Transfer Pricing)
“Upon examining the circumstances surrounding the sale of goods, if the sale complies with general commercial practice, Customs may determine that the special relationship does not influence the transaction value of the imports.”
“Administration on transfer pricing shall mean the collective reference to work such as examination, evaluation, investigation and adjustment, etc. on whether the business transactions between an enterprise and its related parties…comply with the arm’s length principle carried out by tax authorities pursuant to the relevant provisions of Chapter 6 of the Income Tax Law and Article 36 of the Levying Administration Law.” (Article 3, Implementation Measures for Special Tax Adjustment)