As the year ends, many multinational enterprises would review their year’s operating results and make the necessary transfer pricing adjustments if the actual profitability deviates from the group transfer pricing policy. This is to ensure that the actual result aligns with the group pricing policy. However, the tax risks embedded within the year-end adjustment are often overlooked by taxpayers.
According to our observation, taxpayers would usually adjust the operating result at the end of the year under the following circumstances:
Difference between budget cost and actual cost
Multinational enterprises usually set the following year’s transfer pricing policy at the end of the current year, and determine reasonable selling prices based on their budget analysis. If the budget cost of taxpayer deviates from the actual cost, the actual profitability may be inconsistent with the profitability under the group transfer pricing policy.
For example, if a manufacturer overestimated its production capacity when analysing its budget, its budgeted unit cost would be lower than the actual unit cost. Assuming the manufacturer adopted the cost-plus method in their pricing policy, their selling price would be determined by the budget unit cost plus a mark-up rate.
After applying the mark-up rate, the selling price within the budget would be lower than the actual selling price, which made the actual profitability of the manufacturer lower than the target margin in the group transfer pricing policy. If the deviation between the budget unit cost and the actual unit cost became significant, it might lead to an operating loss for the manufacturer.
The table below shows that a taxpayer initially sets a unit selling price at 1.1 RMB/ton in the budget, however, because the budget overestimates the production capacity, the taxpayer has to set a unit selling price at 2.2. RMB/ton to ensure it receives a 10 per cent profit margin.
| |
Budget |
Actual |
| Total cost (RMB) |
100 |
100 |
| Production capacity (Ton） |
100 |
50 |
| Unit cost (RMB/Ton） |
1 |
2 |
| Target profit margin (%） |
10% |
10% |
| Selling price (RMB/Ton） |
1.1 |
2.2 |
If the actual profit level significantly deviates from the mark up rate in the pricing policy, the operating result of the company may bring attention from the tax bureau.
Under such circumstance, we would suggest the taxpayer not to make any year-end adjustment on his own. The taxpayer should seek for help from professional firms to establish communication with the tax bureau and provide solution for the taxpayer to minimise transfer pricing risk.
In addition, we recommend that taxpayers make annual budgets as close to the actual amount as possible. More importantly, the cost of the annual budget needs to be reviewed regularly during the year and adjusted according to the actual amount. This is to ensure the budget cost is consistent with the actual cost.
Deviation in the implementation of pricing policies
We also observed that some taxpayers failed to strictly comply with the pricing policy in a contract when formulating the pricing policy of related-party transactions, resulting in a big difference between their actual profit level and the profit level under the pricing policy.
For example, a taxpayer implemented the cost plus pricing policy and failed to collect costs in accordance to the full costs specified in the contract. Typically, the full cost should include both direct and indirect costs. Direct costs include salaries, raw materials, etc. Indirect costs include office rents and utilities, as well as costs and expenses incurred by back-end support staff. When calculating the full costs, the taxpayer only considered the direct cost and did not include the indirect cost, which resulted in a low cost base. The actual profit level was, therefore, lower than the profit that should have been obtained under the pricing policy. If the selling, general and administrative expenses were high, the taxpayer might even incur a loss which would draw attention from the tax bureau.
In order to avoid the risk of transfer pricing in China, many multinational enterprises compensate the profits of domestic companies through sales discounts or market penetration fees at the end of the year. These methods, however, seem to avoid the risk of transfer pricing, may cause other problems. For example, the auditor and tax authorities of the overseas related party may inquire about the nature of business. Meanwhile, domestic taxpayers must first ensure the services they provided are within the scope of the business to avoid additional tax burdens, such as VAT and surcharges due to remittance of overseas service fees.
Before implementing the pricing policy, we would recommend taxpayers to identify the cost pool, and choose a reasonable allocation method where necessary, so as to fundamentally solve the deviation in profit level between pricing policy and implementation.
Higher-than-expected profit level
Some multinational enterprises may notice their profit levels in the current year are higher than expected, which they would then transfer (the additional profits) to overseas related parties through year-end adjustment of transfer pricing. On the basis of the arm’s length principle of transfer pricing, when the profit level of a single-function entity with limited risks does not reach the target profit under the arm’s length principle, its overseas affiliated party should compensate the single-function entity its target profit margin, and vice versa. This will reduce the transfer pricing risk of the overseas related parties.
However, in practice, it is very difficult for the Chinese subsidiaries of multinational enterprises to adjust the transfer pricing to reduce their yield in China. The transfer pricing adjustment to reduce the profit level in China involves communication and coordination with Chinese tax authorities, customs, banks, and other institutions. We would suggest taxpayers in China to communicate with professional firms to seek for help rather than adjusting the profit level on their own.
Our Services
If you need to know how to avoid the tax risks associated with transfer pricing adjustments, our team can help you through the following services:
- answer any question related to year-end transfer pricing adjustment;
- assess risk of transfer pricing adjustment, assist taxpayers to identify the reason of the deviation between actual profit level and the target profit level in the pricing policy, and provide suggestions for improvement;
- assist taxpayers to communicate with the tax bureau and other related institutions, and provide a solution to resolve issues in transfer pricing adjustment;
- for the lack of reasonable transfer pricing policy and implementation mechanism, we can assist taxpayers in their tax planning and formulation of pricing policies and implementation of tax plans according to the requirement of the management; and
- for taxpayers under tax inspection, we can assist to communicate with all levels of the tax bureau, develop dispute resolutions for the tax controversy to achieve optimal result.
For more information regarding our services, please contact the
Tax Advisory Service team at SBA Stone Forest.
