The growing sophistication of the international tax environment, driven by OECD standards and reinforced by the actions of the BEPS (Base Erosion and Profit Shifting) project, has led Chinese tax authorities to adopt a more proactive and thorough stance on related-party transactions. In this case, proper Transfer Pricing documentation is a regulatory requirement and fundamental for tax management and risk mitigation.
The State Taxation Administration (STA) of China has intensified audits and requirements, demanding more detailed, consistent, and supporting documentation. This situation requires companies—especially those with multinational structures—to understand local expectations, adopt appropriate methodologies, and document their internal policies according to the Arm’s Length Principle.
This article discusses best practices for preparing Transfer Pricing documentation in China, offering specific technical guidance for companies aiming to enhance their compliance and transparency with the Chinese tax authorities.
1. Regulatory Framework and Formal Obligations
The Transfer Pricing documentation system in China is based on a three-tier approach, inspired by the OECD’s Action Plan 13 recommendations but adapted to local conditions.
Types of Documentation Required:
Master File
It is required when the multinational group to which the Chinese entity belongs has consolidated global revenues exceeding RMB 1,000 million in the previous fiscal year.
Local File
Required if the taxpayer’s related-party transactions in China exceed:
- RMB 200 million in the purchase/sale of goods,
- RMB 40 million in the provision of services, or
- RMB 100 million in financial transactions.
Special Issue File:
Mandatory when there are special agreements such as Cost Sharing Arrangements (CSA), corporate restructurings, or intra-group financing. These situations must be thoroughly analyzed due to their high risk of audit.
Failure to comply with these requirements may lead to tax adjustments, financial penalties, interest surcharges, and increased scrutiny in subsequent years.
2. Main Failures Detected
Chinese tax authorities have identified frequent errors in the preparation of documentation:
- Inconsistent information between files: It occurs when the data recorded in the Master File, Local File, and tax returns do not match. This lack of consistency erodes the tax authority’s trust and increases the risk of an audit.
- Use of outdated documentation: Many companies reuse files from previous years without considering significant economic changes, internal functions, or related party relationships. This practice is dangerous in an environment as dynamic as China’s.
- Superficial functional analysis: A usual error is to describe functions, assets, and risks in general terms without clearly attributing value. Omitting this information may invalidate the defense against a tax adjustment.
- Lack of required formalities: In China, documentation must comply with formal requirements, including signatures, official seals, the local language (simplified Chinese), and verifiable documentary support. Failure of these elements may be a direct breach.
3. Technical Recommendations for Preparing the Local File
A) Corporate Structure and Organization
The Local File must clearly demonstrate the organization of an entity in China within the group, which includes:
- Functional organizational 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 demonstrate to the tax administration how information flows and the local generation value.
B) Business Analysis negocio
It should include a comprehensive description of the operating model:
- Details of the products or services offered.
- Target markets.
- Key factors of competitiveness and growth.
- Relevant regulatory amendments and their effects.
- Financial performance of the company in the period analyzed.
This analysis contextualizes transactions and supports margins obtained before comparables.
C) Related Party Information
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 during the year (new relationships, terminations, or restructuring).
It is relevant 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 among related entities, the company must detail how it generates and distributes value within the multinational group. Hence:
- The functions, assets used, and risks of each related party are clearly and quantifiably recognized.
- The principles used to allocate the group’s profits throughout the global value chain are explained, along with the results obtained.
Particularly, tax authorities require an explanation of whether the allocation of profits follows functional and risk profiles or on comparable Arm’s Length margins. Both cases must support the following:
- The logic used to quantify the contribution of each company.
- The methodology for determining the margins or benchmarks applied.
- The data sources used and how these translate into the final profit distribution.
The analysis must show that the profit allocation properly reflects the actual contributions of each participant in the chain.
E) Comparability and Methods
The Transfer Pricing method selected must follow:
- Functional comparability with companies in the same sector.
- Market conditions in China (competition, regulation, demand).
- Necessary adjustments to improve comparability.
- Choice of data sources (bases such as Wind, Osiris, or local).
Solid support avoids subsequent adjustments by the tax administration.
F) Financial Analysis and Margins
- File financial results for the taxpayer and comparables.
- Support margins using indicators such as ROA (Return on Assets), 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, shareholders, roles, and expected benefits.
- Methodology for determining each entity’s contributions.
- Support of the reasonably expected profit for each shareholder.
- Periodic performance evaluation and necessary adjustments.
- Evidence Arm’s Length conditions in the agreement.
Additionally, there must be evidence of the agreement’s effectiveness, whether the economic result correlates with the value generated by each participant. Documentation should prevent contributions from being perceived as a transfer of value not adequately offset by the beneficiary.
B) Intra-Group Financing and Thin Capitalization
China applies strict indebtedness level rules with related parties:
- Each loan or line of credit must be documented with the following clear conditions: Amount, deadline, interest rates, collateral, and prepayment clauses.
- Market comparisons must be filed to support the agreed interest rate.
- Assess whether the debt level agrees with market practices (debt/equity ratios) and whether the entity has the actual financial capacity to take on and repay the loan.
Conclusion
The correct preparation of Transfer Pricing documentation in China is a complex and detailed process beyond a simple tax obligation. It involves a deep 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 tax stability of the organization.
Need Transfer Pricing Advice?
At TPC Group, we have an experienced team in Transfer Pricing and International Taxation at your disposal to advise you on business restructuring processes, ensuring regulatory compliance, and optimizing your tax position.
Source: China Briefing / Kunda TP