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The enforcement of transfer pricing in China

May 2018


Professor Kenny Lin on the effectiveness of enforcing transfer pricing regulation in the Mainland



The new transfer pricing regulation 

The transfer pricing regime in Mainland China has evolved over the years since the 2008 transfer pricing regulation first authorized the tax authorities to initiate an investigation into enterprises with abusive use of transfer pricing for tax purposes. One major post-2008 change to this regime is the heightened documentation requirements. Particularly, in June 2016 the State Administration of Taxation (SAT) issued the public notice requiring both domestic and foreign enterprises to submit 22 (instead of nine in the past) related party transaction forms along with their annual income tax filing. Failure to do so is subject to heavy penalties. Additionally, 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. 

Benefits and costs of more paperwork 

The new transfer pricing documentation requirements serve two purposes in the government’s fight against transfer pricing manipulation. Firstly, they help tax inspectors allocate available resources to areas in need of extra attention. Secondly, the high ex-ante threat of a tax audit, heavy penalties, and ex-post incidence of closer monitoring, act as a powerful deterrent to transfer pricing manipulation. 

However, by requiring enterprises to report in a non-English language, details of related party transactions and to maintain contemporaneous transaction documents, the new requirements create substantial administrative costs for compliant taxpayers and hence, may deter some foreign investment. They also pose significant challenges to local tax offices’ ability to efficiently process a large volume of new information when deciding on audit targets. 

Will the benefits of the new transfer pricing requirements outweigh the costs of compliance? In my opinion, it is questionable, because increased documentation does not necessarily translate into increased deterrence of tax avoidance, especially if a country’s infrastructure supporting effective enforcement is weak. To raise the marginal benefits, the government should shift its focus from ex-ante documentation requirements to ex-post enforcement practices. This shift is necessary for governments in transitional economies where market-supporting infrastructure is typically too weak to enforce regulations. 

Tax enforcement of transfer pricing regulation 

So, is current tax enforcement in Mainland China effective in deterring enterprises from overt pricing manipulation practices? Anecdotal evidence casts doubt on the ability and willingness of local tax offices to constrain tax avoidance. As a result of decentralization of decision rights, local governments acquired more autonomy in economic matters and consequently had goal incongruence with the central government. For example, they are reluctant to collect taxes belonging to the central administration. The decentralization also created a wide disparity in economic and institutional development between regions. As a result, there are regional differences in the level of professional competence among business intermediaries and of economic development and government quality. Research suggests that tax offices in some regions have more financial resources than others to attract and retain talented people, enforce tax laws, improve tax administration, and promote voluntary tax compliance. In some areas, tax officials apply the “arm’s length principle” more strictly and take a tougher stance against tax avoidance, while in other areas, they selectively enforce tax laws and are more lenient in imposing penalties and surcharges. 

Recommendations for improvement 

The current level of detail required in the annual filings of related party transactions is sufficient, if not excessive. Now is the time for the government to direct its available resources to enforce existing transfer pricing regulation. Although tax authorities have taken steps to address ex-post enforcement concerns, their enforcement capacity remains hampered by several weaknesses within the system. From a policy perspective, the following are recommendations for improvements in the transfer pricing arena. 

Firstly, SAT should increase the audit workforce across the country, especially in western regions. According to the China Tax Audits Yearbook, national and local tax bureaus employed a total of 81,000 tax inspectors in 2015. This figure is far from sufficient, given the number of corporate taxpayers registered and related party transactions involved in the country. The relatively low probability of being detected may encourage enterprises to be aggressive in arranging related party transactions. Furthermore, there is a geographic variation in workforce deployment and auditor quality. For example, there are about 11,000 tax auditors (of which 5 percent are professionally qualified) working in Northwest China compared to 18,000 (11 percent qualified) in Southeast provinces. Due to the lack of skilled human capital, tax authorities in northwestern regions may not focus on enforcing transfer pricing rules as strictly as those in eastern regions. 

Secondly, SAT should offer more transfer pricing educational programs to enhance the competency of local tax officials. These programs would also create national uniformity in handling transfer pricing issues. While local tax officials can gain exposure to transfer pricing manipulation through their practices, it would be more efficient to train them at the inception on the proper practices to ensure that they are alert to transfer pricing issues during the initial desktop review. A related problem facing the tax administration is the lack of qualified employees to implement the existing transfer pricing rules. According to the government statistics, only about 8 percent of tax auditors are CPAs or certified tax agents. The lack of rigorous accounting and tax education likely affects the quality of initial desktop reviews and subsequent field audits. 

Thirdly, given limited resources and time, the tax authorities should modify their audit strategies. For example, they should focus on the quality, and not the quantity of audits and also concentrate on sizable enterprises or one industry at a time. They should also direct their efforts to the transfer of intangible assets which are frequently prone to mispricing, and target complicated income transfers that potentially yield more tax revenue. Research shows that enterprises with the following characteristics are associated with a higher likelihood of engaging in tax-induced transfer pricing in Mainland China:

1) Private, non-state enterprises; 

2) Intangible-intensive enterprises; 

3) Poorly governed enterprises; 

4) Subsidiary enterprises with theirtransfer pricing decisions dictated by the parent enterprise; and 

5) Enterprises in regions with weak tax enforcement. 

For example, in their article published in the 2010 issue of Journal of Accounting and Economics, Chan, Lin, and Mo call on countries that decoupled their financial and tax reporting systems to increase tax audits on enterprise reporting large differences between accounting profits and taxable income. Studies by Lin, Mills, and Zhang (appeared in Journal of the American Tax Association 2014) and Wong, Lo, and Firth (Journal of International Financial Management and Accounting 2015) find that in anticipation of a tax rate change, enterprises (non- SOEs in particular) transfer their profits across member firms and years in a way consistent with tax avoidance. 

Fourthly, the government needs to develop “comparable enterprises” to facilitate application of the “arm’s length principle.” Currently, domestic listed enterprises must disclose details of related party transactions, but their unlisted counterparts are exempt from making such disclosures. As such, it is difficult to find comparable figures for publicly traded enterprises in Mainland China. The China Securities Regulatory Commission required public enterprises to disclose gross profit ratios from related-party sales only in the 2004 annual reports. The recently imposed requirement for segmented financial reports to provide a comparison of profitability between related parties and non-related parties is a step in the right direction in identifying a sample of enterprisesas more likely suspects of avoiding tax through transfer pricing. 

Finally, SAT should recognize that tax officials are susceptible to political influence. The proposed merger of state and local taxation authorities at the province level and below – thereby creating a system which is jointly led by the SAT and local governments – places local tax agencies at risk of interference by politicians in the region. For example, a local government can affect the operation of tax bureaus under its jurisdiction via local finance bureaus that control resource allocation to all bureaucratic agencies. Similar to other civil servants, local tax officials and their families face welfare and social issues such as housing, schooling, education, healthcare, and employment – the resolution of which depends, to a large extent, on their ability to cultivate relationships with corporate managers. Therefore, they may subject the tax positions of politically-connected enterprises to less scrutiny or selectively enforce tax regulations. According to a report, titled “Do political connections weaken tax enforcement effectiveness?” and published in Contemporary Accounting Research, corporate political ties significantly undermine the deterrent effect of tax audit intensity and penalty magnitude, suggesting political influence is a significant challenge to the effective enforcement of tax compliance in China. Therefore, successful tax reform to increase government revenue should not be limited to the strengthening of a country’s tax administration alone, but should also take the political economy of tax enforcers into consideration. 


Professor Kenny Lin is Head of Accounting at Lingnan University.