Beware of Transfer Pricing Audit Risks in China

June 07, 2019

Chinese customs authorities have stepped up transfer pricing enforcement in recent years. Here are some of the steps multinational companies should take to address the enforcement risks.

Since March 2016, the General Administration of Customs (GAC) of the People’s Republic of China (PRC) has amended its Import and Export Declaration Form template by requiring importers to disclose all related-party transactions and state whether the transaction values of imported goods have been affected by relationships between the parties. The updated disclosure requirement highlights the increasing focus of GAC and its local counterparts (China Customs) on imports between related parties, and the stepped-up transfer pricing enforcement by China Customs over the past few years, especially after the consolidation of the GAC and the PRC Administration of Quality Supervision, Inspection and Quarantine (AQSIQ) since early 2018.

Given the routine transaction and licensing arrangements between the headquarters of multinational companies and their China subsidiaries or affiliates, multinationals have long been perceived as major enforcement targets in transfer pricing audit by both China Customs and local tax authorities. While many multinationals have established practice in preparing transfer pricing documentation required by tax authorities given the longer enforcement history, they may have less experience in handling transfer pricing audits by China Customs.

This LawFlash discusses the rationale employed by China Customs in conducting transfer pricing audits, examine the circumstances where royalties and other nontrading payments should be included in the dutiable values of imported goods, and provide some practical recommendations to address enforcement risks.

Transfer Pricing Audits in Customs Valuation

Under the Chinese customs valuation regulations, mainly including Circular 213 that came into effect in February 2014, China Customs is empowered to review the dutiable values of imported goods to determine whether adjustments are necessary, and it can collect additional duties if dutiable values of imported goods are underreported. The underlying criteria adopted by China Customs in transfer pricing assessment, similar to that used by local tax authorities, is whether transactions between related parties are conducted on an arm’s length basis. However, these two authorities have different focuses in transfer pricing enforcement. China Customs primarily assesses dutiable values of individual shipments and products, while local tax authorities mainly focus on profits of companies for the enterprise income tax collection purpose.

Pursuant to Circular 213, the dutiable value of imported goods is generally determined by the importer’s declared transaction value, which should include freight, insurance premiums, and other relevant costs. If China Customs questions the accuracy of a reported transaction value, it generally employs one or more of the following valuation methods to determine the dutiable value, in order of preference: (1) comparison with the transaction values of identical goods; (2) comparison with the transaction values of similar goods; (3) the resale price method; (4) the “cost-plus” method; or (5) other reasonable methods, dependent on the circumstances.

Although the transaction values of identical or similar goods are two prioritized criteria, customs authorities had found it difficult in the past to track such data because there was no centralized database of transaction records. However, China established such databases in July 2017, which has enabled customs authorities to access a wide range of data in assessing importers’ declared transaction values.

Another method frequently employed by China Customs is the resale price method. Under this approach, the authorities will assess the importer’s gross profit margin to determine whether it is significantly higher than the median profits earned by comparable companies. The underlying rationale of the approach is that a higher profit margin arises from an artificially low reported transaction value, which in turn results in the underpayment of customs duties. This approach was dubbed the “China solution” in Case Study 14.2, released by the World Customs Organization in October 2017, and this method was frequently used in the past before the broad availability of historical transaction data.

Royalties and Other Nontrading Payments

Transfer pricing arrangements between importers and their overseas affiliates often include royalty and licensing arrangements concerning intellectual property, knowhow and resale rights. The outbound payment of royalties and license fees is subject to Chinese withholding taxes and value added taxes (VAT) and as such are separately regulated by the tax authorities. However, these payments may also incur customs duties and import VAT under certain circumstances.

Under Circular 213, royalties and licensing fees should be factored into the dutiable values of imported goods if the payments (1) are made in connection with the imported goods, and (2) constitute conditions of sale to China. Although Circular 213 sets forth specific provisions regarding these conditions, the provisions are general in nature, and in practice China Customs has significant discretion to determine whether the conditions are met. Furthermore, goods sold to importers by their overseas affiliates are often nongeneric goods, and IP licenses often come into play in such transactions. Under these conditions, it is difficult for importers to avoid the assessment of such royalties or licensing fees in transfer pricing audits.

It is also common for local importers to retain their overseas affiliates to provide technical or administrative services. Although there is no specific provision in Circular 213 or any other PRC statute on the role of service fees in assessing dutiable value, in practice, China Customs often approaches these arrangements in a similar manner. For example, if China Customs determines that service fees are connected with the processing or sale, or are otherwise related to, imported goods, it may elect to include the service fees in their dutiable value assessment.

Transfer Pricing Audits in Dawn Raids

China Customs often pursues transfer pricing enforcement in the form of dawn raids in an attempt to seize as much evidence as possible before it is tampered with or destroyed and to prevent target companies from colluding with stakeholders. Dawn raids are conducted with no prior notifications, and therefore they can be disruptive to companies, especially if the companies lack the necessary experience to respond to them effectively. Dawn raids can quickly escalate into a crisis for the company if they are not duly handled. As such, it is imperative for companies to have protocols in place that encompass each phase of a dawn raid, and all affected employees at all levels of the company should be well versed in them.

It should be noted that companies in China have little option to resist a dawn raid, and must cooperate with the authorities provided that due process are observed in dawn raids. Nevertheless, companies may take these actions to preserve their rights and minimize the impact of the raid on their operations:

  1. Informing management and legal counsel, both internal and external, immediately upon the arrival of customs officials, and cordially verifying and copying the officials’ licenses and inspection notices (if available)
  2. Discussing the reasons for the raid with the officers, as well as the scope, and withholding consent to expand the scope without first seeking legal advice
  3. Documenting the officers’ actions, including any documents they review, persons they interview, questions they ask, and documents they request to take with them
  4. Assigning separate employees to copy written documents or electronic data as requested by customs officials, provided that the requested data is within the specified investigation scope
  5. Marking as “confidential information” certain documents concerning transfer pricing that may contain confidential information or business secrets, and requesting that customs officials maintain their confidentiality
  6. Managing internal and external communications after the dawn raids, and reporting to management and seeking legal advice when appropriate

Planning Considerations

In light of intensified transfer pricing enforcement risks, we set out below some strategic considerations for multinational companies that routinely transact with their overseas affiliates, from both legal and practical perspectives.

First, companies should attach greater importance to customs-specific transfer pricing compliance. Many companies have transfer pricing materials requested by tax authorities in place, including annual audit reports, contemporaneous documentation, and group transfer pricing policies, and may provide these materials to China Customs in the latter’s transfer pricing audits. However, these tax-related materials are primarily prepared at the entity level and in intervals of one fiscal year, and do not address the individual goods or shipments that are of special interest to China Customs. Therefore, we recommend that importers also prepare separate explanations of their China-specific pricing mechanisms, including supporting documentation. These should be prepared in writing with Chinese versions made available, and should include an analysis of all determinative pricing factors.

Second, considering the weight given to the transaction values of identical or similar goods in transfer pricing audits, we recommend that multinationals regularly track and document the transaction values of comparable companies, and examine whether their own transaction values deviate from the reasonable range. Where such data is not available, multinationals can evaluate their profit margins with respect to imported goods, and prepare supporting documentation in advance.

Third, multinationals should closely monitor the development of the customs valuation regime and enforcement trends in China, and establish robust internal compliance systems. Key elements of an effective customs compliance system include, but are not limited to, the following:

  1. Formulation of a responsible team to handle customs-related inquires or investigations, with personnel from logistics, legal, compliance, finance, and business functions
  2. Established policies and procedures for responding to inquiries and inspections by customs authorities
  3. Regular trainings for persons in the responsible team, and specific trainings on dawn raids for all employees
  4. Periodic compliance audits of third parties engaged to handle the customs clearance process
  5. Retention of outside professionals to evaluate the dutiable values of imported goods and any royalty or licensing arrangements and, when needed, to prepare documentation of pricing mechanisms in advance

Finally, multinationals should also consider proactively consulting with customs authorities regarding customs valuation, which is provided for under the PRC Interim Administrative Measures on Customs Advanced Ruling, effective February 2018. Advanced rulings are binding, and this mechanism can help mitigate uncertainty, especially when importers anticipate enforcement action but are concerned they do not have sufficient data to support their declared transaction values.


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact the author, Todd Liao, in our Shanghai office.