On 1 November 2013, China Taxation News reported that the Beijing State Tax Bureau (BSTB) made a transfer pricing adjustment and collected RMB110 million (US$18 million) in taxes from a pharmaceutical company.
When performing a functional analysis of the company, the tax authorities discovered that the company had both domestic and export sales businesses. The company performed a single function (manufacturing) for the export sales business, whereas it performed all functions (except research and development) for the domestic sales business.
Despite the greater volume of work associated with its domestic sales business, which would normally be expected to generate greater profit levels, the tax authorities discovered that the company’s profit levels for its domestic sales were much lower than the industry average. The tax authorities also found that about 70% to 80% of the company’s major raw materials were supplied by its foreign-related parties and asserted that related-party transactions were the main cause of the company’s low profit level for domestic sales.
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The company argued that the low profit rate resulted from other special factors rather than from transfer pricing, for example, an increase in business expenses. The company further argued that the gross profit method should be used instead of the net profit method to determine the arm’s length transfer price.
According to the report, the tax authorities referred to the principles established by the Organisation for Economic Co-operation and Development’s transfer pricing guidelines and rejected the company’s argument that the gross profit method should be used. In addition, when selecting comparables, the tax authorities only accepted pharmaceutical companies that were publicly traded on China’s stock exchanges because the Chinese pharmaceutical industry is subject to special regulation by the government. In the end, the company accepted the transfer pricing adjustment and paid the taxes.
This case demonstrates that Chinese authorities are becoming increasingly sophisticated in transfer pricing audits. It also shows that Chinese authorities prefer domestic comparables and believe special circumstances in China should be taken into account when making transfer pricing adjustments. Multinational companies doing business in China may have to assess their transfer pricing risk more carefully in light of this case.
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