A five-year case involving China’s first use of information exchange to confirm related-party transactions and succeed in tax adjustments has recently been finalised in Xiamen. The anti-avoidance investigation adjusted the taxpayer’s taxable income by 28.07 million yuan, and back taxes 2.93 million yuan. http://www.chinataxblog.com/?p=28

This is a very significant tax case that has just recently been concluded. It is first case where the State Administration of Taxation has used information exchange (in this case with the US) in respect of related party transactions. The case took over 5 years to conclude and demonstrates the patience of the SAT to get their man. Given the importance I have decided to give a little case summary (I feel like Im back in Law school).

Xiamen Case

The name of the company has not been revealed by the tax authorities. However, the structure was a very common one. A foreign invested enterprise (“China Co”) was set up in Xiamen almost 20 years ago for the purpose producing leather and polyurethane (a rubber like material) shoes. The enterprise was basically established as an original equipment manufacturer (OEM) and did not retail the shoes it produced. Overtime the business developed a stable level of production and profitability. However, China Co’s reported profits remained low. This was despite the fact that the scale of the operations expanded from an initial 4 production lines to 14 production lines, that annual production capacity increased from 4 million pairs of shoes to 10 million pairs and that the capital of the company was increased from $400,000 to $9,000,000.

The tax authorities looked cynically on such low profits and in 2004 began investigations into the company’s affairs. Through these investigations it became clear that China Co had one principal client, an American company (“US Co”). There was also some other dodgy stuff going on. China Co had a poor tax record generally, having previously been subject to tax adjustments. At some stage, the ownership of the equity was transferred to a nominated individual (the SAT formed the view that this was done to avoid an appearance of a related party transaction).

However, it was incumbent upon the SAT (in order to invoke the transfer pricing rules) to establish that China Co and US Co were related parties. In response to the tax authorities enquiries, China Co argued that there was neither an investment relationship (US Co was not a shareholder in China Co) nor any common senior management between the two companies. Accordingly, China Co argued that this was an ordinary commercial relationship (note that this case was determined pursuant to the old transfer pricing rules). Despite the obvious concerns arising out of the inherent nature that the business was run, the authorities had difficulties in acquiring sufficient evidence to establish a related party nexus.

In around 2007-2008, the authorities determined to proceed with an information exchange with their US counterparts in relation to the companies. This information exchange included information in relation to the two companies bank accounts. The information provided established a critical clue – that the controller of US Co’s bank account was the individual shareholder of China Co. This therefore established a requisite related party nexus.

It should be noted that the current transfer pricing rules provide that parties will be related where one party largely controls the purchase and sales activities of the other party. Its likely that proving that US Co controlled China Co would no longer be necessary. The fact that China Co’s whole business was, in essence, for the purpose of supply China Co would likely be sufficient.

This is a good little case for several reasons. Firstly, it provides a good example of how tax authorities use information exchange to investigate avoidance practices. Secondly, it provides a good example of a structure that was once quite common in China (and is still not uncommon) that will be particularly targeted by the SAT over the coming years. Finally, it provides a good example of the crude use of transfer pricing to reallocate profits.