China’s General Administration of Customs (GAC) has released an amendment to the Import and Export Declaration Documents Standards. Among many changes, the Amendment now requires Chinese entities with importing and exporting activities to confirm in the customs declaration documents:
- Whether there is an underlying intercompany or other special relationship between the contracting parties (the Special Relationship Confirmation)
- Whether the import/export price is influenced by the special relationship (the Arm's Length Confirmation) and
- Whether any royalty in relation to the goods imported or exported is paid by the buyer to the seller (the Royalty Payment Confirmation).
To comply with these confirmation requests, the Chinese entities with importing and exporting activities should fill in the corresponding columns in the declaration documents with a simple Yes or No. Although such confirmation requests do not mandate a disclosure of details and explanation, it is very clear that the GAC is stepping up its monitoring of cross-border transactions, especially intercompany imports, and royalty payments in relation to imported goods.
For Chinese companies that frequently import from their overseas affiliates, especially those who make royalty payments to overseas affiliates, it becomes more important than ever to make sure that intercompany import prices and royalty payments are carefully and properly planned, based not only on the transfer pricing rules but also relevant customs regulations.
In this article, we share with you our interpretation of the above confirmation requirements, the underlying China customs pricing rules, and relevant planning considerations for multinationals.
The Special Relationship Confirmation
Generally, the Special Relationship Confirmation requires the Chinese company to ascertain whether a special relationship exists between the contracting parties to the underlying import/export activity.
For identification of a Special Relationship (i.e., an intercompany or other relationship that may affect the prices of the imported/exported goods), the customs authority is using a slightly different and broader definition than that of intercompany relationships under the Corporate Income Tax Law (CIT Law). According to the Measures for Assessing Dutiable Prices of Imported and Exported Goods (Assessment Measures), other than kinship, shareholding, sharing of management personnel, control of business operations, or common control by a third party, the following will also be identified as triggering a Special Relationship that may influence the transaction price:
- The two transacting parties directly or indirectly control a third party
- The transacting parties are members of a partnership and
- A transacting party directly or indirectly holds, controls or owns no less than 5 percent of the other party's public voting shares.
The Arm's Length Confirmation
The Arm's Length Confirmation requires the Chinese company to ascertain whether the import/export price in the transaction is affected by an identified Special Relationship.
According to the Assessment Measures, if a particular import/export price can be proved to be close to any of the following benchmark prices, it would be deemed "free from the influence of Special Relationship" − or else should be recognized as of non-arm's length:
- The transaction price of the same or similar goods with an independent party inside China
- The import price calculated based on the Resale Price Method (i.e., calculated based on the resale price inside China minus reasonable profit, expenses and taxes) and
- The import price calculated based on the Computed Method (i.e., calculated based on costs of the products plus average profit and expenses).
As the Amendment indicated, the Chinese company in an import/export transaction shall bear the burden of proving the arm's length nature of the prices used in transactions involving a Special Relationship. If the price is not close to any of the benchmark prices, or if the Chinese company cannot produce relevant support, then when filling out the declaration document the Chinese company shall mark No in the corresponding column for arm's length confirmation.
Apparently, a simple No as the answer to the Arm's Length Confirmation will raise a red flag that potentially invites customs investigation. To ensure a positive Yes as the answer, it would be necessary to identify and document the benchmark prices used in determining the import/export prices.
Royalty Payment Confirmation
The Royalty Payment Confirmation requires the Chinese company to acknowledge whether the buyer pays any royalty to the seller in relation to the goods imported/exported.
This confirmation is more relevant to imports than to exports, because export sales are generally entitled to customs duty exemption. It should be emphasized that, according to the current Customs rules, royalty payment is subject to customs duty unless it is "irrelevant to the imported goods" or it is not "a condition for the resale of the imported goods inside China."
The following are specified in the Assessment Measure:
- Royalty payments meeting any of the following conditions will be considered relevant to the imported goods:
- The royalty is paid for use rights of technologies or patents that have been crafted into the imported goods or used in manufacturing of the imported goods
- The royalty is paid for the trademark attached to the goods, regardless of whether the trademark is attached to the goods before or after the import
- The royalty is paid for copyrights of imported medias, such as tapes and compact discs carrying software, songs, pictures, videos or other similar contents or
- The royalty is paid for the distribution right, sales right or other similar rights related to the imported goods.
- A royalty payment will be considered to be "a condition for the resale of the imported goods inside China" if it is prerequisite or an inseparable condition for the import agreement.
In other words, royalties for trademark, distribution right and patents related to goods imported for resale in China are likely to be identified as dutiable, and, given that the Royalty Payment Confirmation has been introduced into the declaration documents, the practical risk that Customs will challenge against outbound royalty payments has noticeably increased.
While the general customs pricing rules have been in place for years, many multinational companies did not properly include them as part of the considerations for transfer pricing planning. Import prices of products and royalty payments to overseas affiliates are often used for profit repatriation from China, without sufficiently assessing the risks associated with the customs pricing rules. With these new rules, however, the risk that multinationals’ China operations will face oversight from Customs authorities has grown.
To defend the arm's length nature of intercompany prices, it is prudent for multinational companies with a presence in China, especially those with substantial intercompany imports and royalty transactions, to think through the following important questions:
- Whether the current prices would be considered as free from the influence of Special Relationship
- Whether a proper Benchmark Price has been identified and documented to justify the arm's length nature of the price
- Whether there is a frequent fluctuation of prices due to market changes and the transfer pricing arrangement from income tax perspective, and whether such fluctuation would be justifiable based on the selected Benchmark Price
- Whether the current royalty payment would be caught as dutiable under the current customs pricing rules
- Whether it would be possible to reasonably replace royalty payments with an adjustment to the import prices, and what would be the duty/tax implications.
Finally, it should be noted that the pricing rules in China's customs regulations are fairly separate from the transfer pricing rules under the CIT Law. Unfortunately, there has been, so far, no visible synergy or cooperation between the customs and tax authorities to bridge the gap. While it could be very complicated and tricky to balance a pricing arrangement between the diverged tax and customs rules, it is nonetheless important and necessary to do so in view of full compliance and mitigation of the pricing risks, and eventually the control of the overall tax burden.
Find out more by contacting:
Daniel Chan - Partner, Hong Kong
Windson Li - Of Counsel, Hong Kong
Ellen Sun - Tax Consultant, Hong Kong