The growing sophistication of the international tax environment, driven by OECD standards and reinforced by the BEPS (Base Erosion and Profit Shifting) project, has led Chinese tax authorities to adopt a more proactive and rigorous stance on related-party transactions. In this context, proper transfer pricing documentation becomes not only a regulatory requirement, but also a fundamental tool for tax management and risk mitigation.
The State Taxation Administration (STA) has intensified its audits and requirements, requesting more detailed, consistent, and justified documentation. This situation requires companies—especially those with multinational structures—to understand local expectations, adopt appropriate methodologies, and document their internal policies in accordance with the arm’s length principle.
This article analyzes best practices in preparing transfer pricing documentation in China in accordance with current requirements, providing specific technical guidance for companies seeking to strengthen their compliance and transparency with the Chinese tax authority.
1. Regulatory Framework and Formal Obligations
The transfer pricing documentation system in China is based on a three-tier approach, inspired by the recommendations of the OECD’s Action Plan 13, but adapted to local conditions.
Types of documentation required:
- Master File
Required when the multinational group to which the Chinese entity belongs has consolidated global revenues exceeding RMB 1 billion in the previous fiscal year.
- Local File
Required if the taxpayer’s related-party transactions in China exceed:
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- RMB 200 million in the purchase/sale of goods,
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- RMB 40 million in the provision of services, or
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- RMB 100 million in financial transactions.
- Special Issue File
Mandatory when there are special agreements such as Cost Sharing Arrangements (CSA), corporate restructurings, or intragroup financing. You should thoroughly analyze these situations due to their high risk of audit.
Failure to comply with these requirements may result in tax adjustments, financial penalties, interest surcharges, and increased scrutiny in subsequent years.
2. Main Failures Detected
The Chinese tax authorities have identified frequent errors in the preparation of documentation:
- Inconsistent information between files: This occurs when the data presented in the Master File, Local File, and tax returns do not match. This lack of consistency creates mistrust in the tax authority and increases the risk of an audit.
- Use of outdated documentation: Many companies reuse files from previous years without considering significant changes in the economic environment, internal functions, or relationships with related parties. This practice is dangerous in an environment as dynamic as China’s.
- Superficial functional analysis: A common error is to describe functions, assets, and risks in a generic way without clearly attributing value. Omitting this information can invalidate the defense against a tax adjustment.
- Lack of required formalities: In China, documentation must comply with formal requirements such as signatures, official seals, local language (simplified Chinese), and verifiable documentary support. The absence of these elements may be considered a direct breach.
3. Technical Recommendations for Preparing the Local File
a) Corporate Structure and Organization
The Local File must clearly present how the entity is organized in China within the group. This includes:
- Functional organization charts.
- Number of employees per area.
- Description of business units, their responsibilities, and hierarchies.
- Information on the reporting and decision-making system.
The objective is to show the tax authorities how information flows and how value is generated locally.
b) Business Analysis
This should include a comprehensive description of the operating model:
- Details of the products or services offered.
- Target markets.
- Key factors for competitiveness and growth.
- Relevant regulatory changes and their impact.
- Financial performance of the company during the period analyzed.
This analysis contextualizes transactions and helps justify margins obtained compared to comparables.
c) Information on Related Parties
All related parties must be clearly identified, specifying:
- Name, country of tax residence, and nature of the relationship.
- Type of transactions carried out (sales, services, loans, royalties).
- Changes that occurred during the year (new relationships, terminations, or restructurings).
It is important to document any developments that may have tax or functional implications.
d) Value Chain Analysis
In addition to describing the operational, logistical, and financial flows between related entities, the company must detail how value is generated and distributed within the multinational group. It is expected that:
- The key functions, assets used, and risks assumed by each related party are identified in a clear and quantifiable manner.
- The principles used to allocate the group’s profits throughout the global value chain, as well as the results obtained, are disclosed.
In particular, tax authorities require an explanation of whether the allocation of profits is based on functional and risk profiles or on comparable arm’s length margins. In both cases, the following must be justified:
- The logic used to quantify the contribution of each entity.
- The methodology used to determine the margins or benchmarks applied.
- The data sources used and how they are translated into the final distribution of profits.
The analysis must demonstrate that the allocation of profits adequately reflects the actual contributions of each participant in the chain.
e) Comparability and Methods
The transfer pricing method selected must be justified based on:
- Functional comparability with companies in the same sector.
- Market conditions in China (competition, regulation, demand).
- Adjustments necessary to improve comparability.
- Choice of data sources (bases such as Wind, Osiris, or local).
A solid justification helps avoid subsequent adjustments by the tax administration.
f) Financial Analysis and Margins
- Submit financial results for the taxpayer and comparables.
- Justify margins using indicators such as ROA, markup on costs, or gross margins.
- Document adjustments applied for accounting, geographical, or functional differences.
4. Special Issue File: Special Cases
a) Cost Sharing Agreements (CSA)
China requires detailed documentation of any structure involving the sharing of costs for the development of intangibles, R&D, or other assets. This file must include:
- Description of the agreement, participants, roles, and expected benefits.
- Methodology for determining each entity’s contributions.
- Justification of the reasonably expected benefit for each participant.
- Periodic performance evaluation and necessary adjustments.
- Evidence that the agreement reflects arm’s length conditions.
In addition, objective evidence of the effectiveness of the agreement must be provided: whether the economic result corresponds to the value generated by each participant. The documentation must prevent the contributions from being perceived as a transfer of value not adequately compensated by the beneficiary.
b) Intra-Group Financing and Thin Capitalization
China applies strict rules on the level of indebtedness with related parties:
- Each loan or credit line must be documented with clear conditions: amount, term, interest rates, collateral, and early repayment clauses.
- Market comparisons must be provided to support the agreed interest rate.
- Assess whether the level of debt is in line with market practices (debt/equity ratios) and whether the entity has the actual financial capacity to take on and repay the loan.
Conclusion
The proper preparation of transfer pricing documentation in China is a complex and detailed process that goes beyond a simple tax obligation. It involves a thorough understanding of business functions, a well-applied technical methodology, and a robust compliance strategy. Given the increase in audits and the constant evolution of regulations, having specialized advice and maintaining up-to-date documentation is essential to reduce contingencies and ensure the organization’s tax stability.
Do you need advice on Transfer Pricing?
At TPC Group, we have a team of experts in Transfer Pricing and International Taxation who can advise you on business restructuring processes, ensuring regulatory compliance and optimizing your tax position.
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