After informing our readers in December that China had changed its stance on transfer pricing, we spoke to Martin Richter, international tax and transfer pricing partner at EY, on how to find out  whether your pricing practice in China will land you in hot water.

● Multinationals should assess whether the allocation of the system profit among the related parties within the group is consistent with where value is created and economic substance is located. If a company is performing more functions than a related party it transacts with, it should receive higher returns than the related party. If a company bears more risks than the related party, the more volatile its returns should be.

●  To achieve consistency, corporates need to assess the functions, assets, and risk profiles of a China taxpayer company and compare that to related parties in the group company that the China taxpayer transacts with. For example, if a multinational luxury bag maker manufactures its products in China, but design, material sourcing, marketing and retailing are conducted by other companies outside China, it is reasonable to assume it will earn a lower profit margin overall.

●  After an assessment is made across all related parties, corporates should benchmark a Chinese taxpayer’s profit margins from related party transactions against similar transactions to other companies, especially ones that work with completely independent companies in a supply chain where no transfer pricing is taking place

●  A red flag to a regulator is the treatment of intellectual property (IP). A routine manufacturer would not expect to suffer from persistent losses or continually volatile margins. Similarly, it would not be common for a routine group manufacturer to pay intercompany charges such as IP royalties if it is not the IP owner or licensor, or marketing service charges if it only sells products on an intercompany basis.

●  Another warning sign is consistent loss making. If a company is conducting research and development (R&D) in China, it is reasonable to expect its China profit to be volatile. However, if a China entity is not involved in R&D (or very little), a tax authority is likely to get suspicious.

●  Proper documentation and justification on transfer pricing policy is important. For example if a China company is paying an offshore related company for IP services, the China company should justify the necessity of the IP, actual usage, the benefits of the IP for the China company, and whether the payment size is in line with the importance and benefits from using the IP. Well-documented intercompany agreements on the services should be presented to the tax authority.