The importance of year-end adjustments for foreign companies operating in China

Transfer pricing adjustments are designed to ensure that intercompany transactions between related parties comply with the arm’s length principle. However, when these adjustments affect the value of imported goods, they also have a direct impact on the customs duties that are calculated based on the goods' value. This creates a major challenge for foreign companies importing into China via local entities, where customs and tax authorities operate independently and retroactive adjustments often require revisiting customs valuations​.

Customs value adjustments in China are fraught with regulatory nuances. Upwards adjustments require pre-disclosure to customs authorities, while downwards adjustments, although not subject to mandatory reporting, still require careful consideration. The lack of clear guidance on transfer pricing adjustments means that each case requires individual negotiations and discussions with local customs officials. This variability across different regions in China complicates the process further.

For local companies, it is imperative to engage in pre-communication with customs authorities to understand local practices and requirements. This proactive approach can help mitigate risks and ensure a smoother implementation of TP adjustments.

Coordination with financial institutions is also essential. For inbound TP adjustments, banks require specific documentation to process foreign exchange transactions. Ensuring compliance with these requirements can help avoid delays or complications. It is also necessary to follow the guidelines issued by the State Administration of Foreign Exchange (SAFE) for processing TP adjustments involving cash inflows and outflows.

In practice, customs authorities are particularly concerned with upwards adjustments to declared import values, which can result in higher customs duties and VAT. While tax authorities focus on profits and arm’s length pricing, customs officials scrutinise these adjustments to ensure they align with the declared values for goods at the time of import. Any discrepancies can result in fines, delays and increased administrative burdens.

Retroactive upwards adjustments in import prices necessitate voluntary disclosure and declaration to China Customs due to foreign exchange controls. This process is not only time-consuming, often taking at least six months, but also subject to case-by-case feasibility assessments by the authorities.

Conversely, retroactive downwards adjustments do not generally need to be declared to China Customs, and obtaining a refund of customs duties is practically impossible.

From a general standpoint, the concept of transfer pricing adjustments made purely for profit or loss allocation purposes, which typically should not have VAT implications, does not apply in China. In China, there is no recognition of TP adjustments made solely for tax purposes as being "outside the scope of VAT", and the Chinese tax authorities have implemented strict controls regarding the nature of the payments made as a result of the transfer pricing adjustments.

Specifically, any payment arising from TP adjustments invoices issued between the parties must be classified as relating to either goods or services, which leads to VAT obligations.

Given the specific context in China, arranging transfer pricing adjustment payments may not be as straightforward as in other countries, and can present additional complexities. Such payments need to be carefully categorised according to the relevant foreign exchange administration regulations. To ensure compliance, it is advisable to coordinate in advance with the Chinese banking partner of the entity operating in China, clarifying any necessary procedures and any supporting documentation.

When a TP adjustment and related payment is linked to an underlying supply of goods and/or services, the adjustment is considered as consideration for the supply of goods or services performed, which essentially changes the value of the transaction itself.

In the context of foreign companies operating in China, year-end TP adjustments can be categorised into two main types: retrospective profitability adjustments, which can either increase (upwards adjustments) or decrease (downwards adjustments) the value of intercompany transactions performed, and prospective profitability adjustments, which directly impact the sales price of future supplies and can lead to either an increase or decrease of the transactions value based on the adjustments.

An upwards retrospective adjustment increases the value of intercompany transactions performed, subsequently raising the customs value of imported goods. As VAT is directly linked to the customs value (since VAT for the import of goods is calculated based on this value), such an increase means a higher VAT taxable base, which ultimately leads to an increase in the VAT payable amount.

For foreign companies operating in China, the increased VAT payable from upwards adjustments can strain cash flow, particularly if the adjustments are substantial. However, the voluntary disclosure of the upwards adjustments should not in principle lead to late payment interest and penalties, provided that the revised transaction value was agreed after the import of goods. Nevertheless, such adjustments may lead to the need for a correction of VAT compliance obligations in China.

In contrast, a downwards retrospective adjustment reduces the value of intercompany transactions and, consequently, the customs value. Generally, there is no reclaim for customs duties available, and as a general rule customs declarations might not be amended. Recovering the overpaid VAT from previous periods is nearly impossible under current Chinese regulations. Where companies have a full right of recovery, this should not trigger any additional VAT consequences.

On one hand, for the retrospective profitability adjustments (both upwards and downwards adjustments) made to the supply of services performed, these should follow the same VAT treatment as applied on the original supply, and the place of supply rules should be followed.

On the other hand, the VAT treatment of prospective adjustments should align with the VAT treatment of the future supplies, since there is no immediate VAT impact when the TP adjustment is calculated. However, substantial fluctuations in the sales price for future supplies of goods and/or services may attract scrutiny from the Chinese tax authorities, potentially leading to future inquires and controls.

In conclusion, foreign companies operating in China should approach year-end transfer pricing adjustments with a comprehensive understanding of how these adjustments impact their VAT position. Whether facing retrospective or prospective profitability adjustments, maintaining comprehensive documentation for all transactions affected by profitability adjustments and ensuring that these changes are reported accurately is essential in order to prevent compliance issues and minimise tax risks. By adopting a proactive strategy and with thorough preparation, foreign companies can navigate the complexities of VAT compliance more effectively, thereby optimising their financial outcomes and avoiding any unnecessary administrative burdens.

Once a group falls under Pillar Two, a multinational enterprise might benefit from a reduced compliance burden (due to an exemption from the detailed top-up tax calculation) if it can demonstrate, based on its qualifying County-by-Country Report (CbCR) and financial accounting data, that the jurisdiction passes at least one of the three tests defined under the Transitional CbCR Safe Harbour (TSH).

The OECD's Administrative Guidance, published in December 2023, clarified that for the TSH, year-end transfer pricing adjustments would generally not be considered unless they are already accounted for in the financial accounts of the respective year they relate to.

In contrast, when required to do a detailed calculation of top-up taxes, the Pillar Two model rules provide for adjustments to GloBE income or loss due to TP adjustments. The treatment of these adjustments depends on whether they are bilateral or unilateral, the direction of the TP adjustment and the tax rates in each jurisdiction involved. According to the Pillar Two model rules, GloBE income or loss must be adjusted in the case of bilateral TP adjustments where the taxable income of at least one group member involved in the transaction uses a different transfer price for the determination of its taxable income than the ones reflected in its financial accounts. On the other hand, the Pillar Two model rules do not permit an adjustment to GloBE income or loss for unilateral transfer pricing adjustments that increase or decrease taxable income in a country with either a nominal tax rate below 15% or a GloBE effective tax rate of less than 15% in the previous two years. This is to avoid double taxation or double non-taxation in such cases.

Regarding the covered taxes, the model rules currently seem to imply that an alignment between GloBE income or loss and covered taxes is only foreseen when the GloBE income or loss is reduced as a result of the TP adjustment. Consequently, the GloBE effective tax rate for the party experiencing an increase in GloBE income or loss could potentially be distorted, which might lead to (additional) top-up taxes.

While the approach under the CbCR Safe Harbour regarding year-end transfer pricing adjustments seems relatively clear, the treatment under the detailed calculation of top-up taxes is still a bit ambiguous. Therefore, careful consideration should be given to further guidance regarding year-end transfer pricing adjustments and their impact for Pillar Two purposes.