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back to index backASIAtalk November,  2005

Asian Tax Updates: China, Japan, Korea and Singapore

World Tax Advisor

China - see below
Japan - click here
Korea - click here
Singapore - click here

China - SAT Issues Ruling on Capital Adjustments for Transfer Pricing Purposes

The State Administration of Taxation (SAT) recently issued a Circular addressing the taxation of capital adjustments for transfer pricing purposes (Circular [2005] 745).

Capital adjustments are made to adjust for differences in working capital, i.e. to improve the reliability of profitability comparisons if the entity under analysis (the tested party”) differs from comparable companies with respect to levels of accounts payable, accounts receivable or inventory.

The purpose of these adjustments is to remove the interest income or expense embedded in each company's reported sales revenue or cost of goods sold. Because the rationale underlying capital adjustments is economically sound, the tax authorities in many countries accept the concept and usually require - or at least recommend - that taxpayers make such adjustments while defending a transfer pricing audit or preparing an advance pricing agreement (APA).

The Chinese tax authorities, however, have yet to formally accept or endorse the concept of capital adjustments, even though such adjustments are made in practice, and some local Chinese tax authorities have, on occasion, accepted capital adjusted results if they viewed them to be reasonable within the context of a transfer pricing audit or APA.

The SAT has gained considerable practical experience on capital adjustments since it completed its first bilateral APA several months ago. The SAT accepts the concept and the economic rationale underlying capital adjustments but it continues to hold the view that such adjustments should not have a material impact on operating profit margins of a company.

The SAT believes that only if both the tested party and the comparable companies were to efficiently manage their operations would their respective accounts receivables, accounts payables and inventory levels accurately reflect the credit terms granted to customers, received from suppliers and demanded from the operational (e.g. manufacturing and distribution) and sales needs of their companies, respectively.

If either the tested party or the comparable companies fail to efficiently manage their operations, capital adjustments would lead to distortions in the comparables analysis.

Most publicly listed companies in China tend to have high levels of working capital; for example, a typical Chinese public company may have more than 180 days of receivables or inventory. According to the SAT, many Chinese public companies carry significant accounts receivables because their customers often fail to pay on time. The SAT also believes that typical Chinese public companies hold significant inventory because they are not efficiently managed. As a result, lengthy accounts receivable terms often significantly overstate the actual terms given to customers and the high levels of inventory do not accurately convey the timely service provided to customers. As a result, capital adjustments made to Chinese comparable companies often distort the results of the economic analysis because most foreign invested enterprises have fewer days of receivables, or inventory, due to higher levels of operational efficiency and the fact that, with respect to inter-company transactions, they do not deal with third-party customers that may not pay on time.

Circular 745 comes at a time when many taxpayers expect the SAT to issue contemporaneous documentation rules in the foreseeable future. The SAT has made enormous strides in standardizing its transfer pricing practices to bring them more in line with international standards.

For instance, the SAT has indicated on numerous occasions this year that APA submissions should include well-prepared functional, risk and economic analyses, including the comparables analysis.

In the anticipated contemporaneous documentation rules, the SAT likely will require taxpayers to include functional, risk and economic analyses as part of their documentation package. Capital adjustments would thus become one of the technical issues that local tax authorities will have to address.

Transfer pricing knowledge and experience varies at the level of the local Chinese tax authorities, so one purpose of the new Circular is to take advantage of the practical experience of the SAT, with a view to improving the quality and effectiveness of the analysis of comparables. The Circular recognizes that, when comparing the profit level of the investigated enterprise and the comparable companies, capital adjustments will increase operating profit reliability from an economic perspective and improve profit level comparability.” However, the Circular also acknowledges the relative lack of sophistication of (publicly) listed companies in China, and, because of the low comparability of such companies, capital adjustments should not be made when conducting a comparables analysis.

The SAT recognizes that many tax authorities accept, and in many cases encourage, capital adjustments and that there is a strong economic rationale for such adjustments. Consequently, the SAT grants some flexibility by allowing capital adjustments if the local tax authorities confirm that the selection of comparable companies is accurate and the comparability is high. Before the local tax authorities can accept the adjustments, however, they must first obtain approval from the SAT.

Circular 745 indicates that, over the past few years, the SAT has become much more sophisticated in the transfer pricing arena. The Circular is a signal to taxpayers that they should prepare a sound economic analysis, including a comparables analysis, to substantiate the reasonableness of inter-company pricing arrangements. The Circular also reveals the SAT's desire to exert more control over transfer pricing issues at a time when it is making tremendous efforts to bring its transfer pricing practices in line with international standards. Given the SAT's knowledge, increasing experience and desire to control transfer pricing issues, it will become more difficult for taxpayers (and practitioners) to prevail in arguments without having well-prepared economic analyses.

Japan - New Schedule Includes Transfer Pricing Disclosures

For fiscal years ending on or after 31 March 2004, Japanese taxpayers are required to submit the new Schedule 17(3), Detailed Statement Concerning Foreign Affiliated Persons,” with their annual corporation tax return. The information that taxpayers are required to provide on this form includes factual information, which was previously required to be disclosed on Schedule 16-4, and the information on the transfer pricing methodology used to determine the amounts paid or received in transactions with all foreign related parties (a new disclosure requirement).

There are no penalties associated with a failure to complete Schedule 17(3). However, taxpayers that neglect to submit the schedule or that do not provide all required information (such as information on financial performance of the foreign related parties, which many taxpayers are reluctant to disclose) are customarily requested to submit the delinquent form(s) and/or complete the missing information at the beginning of a transfer pricing audit.

Taxpayers should treat this new transfer pricing reporting requirement as more than a simple tax return compliance matter. Specifically, taxpayers should give considered thought to both the information reported and the potential tax audit consequences that may result from the tax authorities' assessment of this information.

Implications of Disclosing Transfer Pricing Methodology

The requirement to disclose the transfer pricing method(s) used sends a clear signal that the Japanese National Tax Agency (NTA) expects taxpayers to establish clearly defined transfer pricing policies supported by appropriate documentation and analysis prior to a transfer pricing audit.

In completing Schedule 17(3), taxpayers should assume that the document will be used by the NTA and the regional and local tax bureaus as a screening tool for identifying the transfer pricing aspects of international transactions to select candidates for transfer pricing audits. Once a transfer pricing audit begins, taxpayers should be aware that the information initially disclosed on Schedule 17(3) should be consistent with what is communicated to the tax auditor.

Identifying and Assessing Audit Risk Exposure

Although the NTA does not make public the criteria for selecting audit targets, experience indicates that taxpayers in the following situations, which will be obvious to the tax authorities from the information disclosed on Schedule 17(3), are at a greater risk of being selected for a transfer pricing investigation:

• Transactions with related parties in non-treaty countries or low-tax jurisdictions;

• Transactions involving intangible property;

• Fluctuation of the profit level (especially the reduction of profit) in Japan;

• Persistent losses in Japan;

• High profits in Japan and/or abroad;

• Changes in transfer pricing methodology;

• Failure to submit or complete Schedule 17(3); and

• Use of the residual profit split method.

Recommended Actions

The NTA's continuing focus on transfer pricing enforcement means that taxpayers involved in cross-border related party transactions must seriously assess their transfer pricing exposure and consider ways to best manage their position. The information provided on Schedule 17(3), particularly the transfer pricing method used by the taxpayer, should be viewed strategically as the basis for a successful audit defense strategy.

In light of the above, taxpayers should immediately revisit their inter-company transfer pricing policies for current and future periods and the documentation available to support such policies to ensure that information disclosed on Schedule 17(3) is fully documented and supported. Being proactive in recognizing and addressing potential problem areas before an audit is initiated has proven to be the best audit strategy in Japan.

Korea - NTS Guidelines for Selecting 2005 Tax Audit Targets

On 26 October 2005, the National Tax Service issued guidelines for the selection of 2005 tax audit target companies. The selection is based on the analysis of tax returns for fiscal year 2003. Large companies (i.e. those with turnover of more than 500 billion won) that have not been audited for an extended period of time (i.e. four years) and companies that are suspected of filing incorrect tax returns are likely to be subject to an examination. Approximately 1.2% of corporate taxpayers will be selected for audit – a slight decrease from last year.

Singapore - Carryback Relief System Proposed

Singapore's 2005 Budget includes the introduction of carryback relief for losses arising from trade.

Current rules only allow for loss carryforward - the relief would allow a one-year carryback of current year unabsorbed capital allowances and unabsorbed trade losses of up to SD 100,000. This relief, which was recently tabled in Parliament, would have effect from Year of Assessment (YA) 2006.


The loss carryback relief is available to a person carrying on a trade, business, profession or vocation. The person can carry back current year unabsorbed capital allowances and unabsorbed trade losses for setoff against assessable income of the immediately preceding YA.

Only current year unabsorbed capital allowances and unabsorbed trade losses qualify for the carryback relief. Current year unabsorbed donations and investment allowances may not be carried back. The amount of current year unabsorbed capital allowances and unabsorbed trade losses that can be carried back to the immediately preceding YA is the lower of:

• The actual amount of current year unabsorbed capital allowances and unabsorbed trade losses (capped at SD 100,000); or

• The assessable income of the immediately preceding YA.

Any unabsorbed capital allowances and/or unabsorbed trade losses not carried back may be carried forward for setoff against assessable income of the subsequent YA.

The current order of setoff for capital allowances and trade losses for any person carrying on a trade, business, profession or vocation will similarly apply in effecting the carryback relief. That is, current year unabsorbed capital allowances will first be utilized against the assessable income of the immediately preceding YA before the current year unabsorbed trade losses.

Where the amount available for carryback exceeds SD 100,000, and that amount arose from more than one trade, business, profession or vocation, the amount to be carried back will be determined on a proportionate basis from each trade, business, profession or vocation.

Conditions for Carryback Relief

The granting of carryback relief is subject to the following conditions:

• For the carryback of current year unabsorbed capital allowances, the same business” test must be met. The same business test requires that the person carries on the same trade, business or profession in the basis period for the current and immediately preceding YA.

Thus, a person cannot carry back YA 2006 unabsorbed capital allowances to YA 2005 if he had not commenced his trade, business or profession during the basis period for YA 2005 (i.e. financial year that ended in 2004).

• Where a company wishes to carry back its current year unabsorbed capital allowances or unabsorbed trade losses, it must meet both the same business test and a shareholding” test. Under the shareholding test, the shareholders of the company on the first day of the year in which the capital allowances arose must be substantially (i.e. 50% or more) the same as the shareholders of the company on the last day of the immediately preceding YA.

• Where there is a substantial change in the shareholders of the company, and the change is not for the purpose of deriving tax benefits or obtaining a tax advantage, the company can request a waiver of the shareholding test. If a waiver is granted, the company should be able to carry back the capital allowances and trade losses, but only may deduct them from profits from the same trade or business in respect of which the capital allowances were made or the trade losses were incurred.

Specific Exclusions/Restrictions

The carryback relief is not applicable, or is restricted, in a number of cases, as follows:

• Current year unabsorbed capital allowances and unabsorbed trade losses arising from a trade or business whose income is wholly exempt from tax (e.g. due to a pioneer incentive) may be deducted only from exempt income of the same trade or business in the immediately preceding YA if the company elects carryback relief. That is, such current year unabsorbed capital allowances and unabsorbed trade losses will not be allowed to be set off against other exempt or nonexempt income in the immediately preceding YA.

• The carryback relief is not available to a company or trustee of a property trust carrying on the business of making investments and subject to tax under section 10E of the Income Tax Act.

• Current year unabsorbed trade losses incurred by an eligible investor from the divestment of his qualifying shares in start-up companies or liquidation of approved start-up companies under the Enterprise Investment Incentive Scheme do not qualify for the carryback relief.

• Restrictions are imposed on the deduction of current year unabsorbed capital allowances and unabsorbed trade losses arising in respect of a person deriving income from finance leases and from the business of hiring out automobiles.

Source: Deloitte Touche World Tax Advisor Newsletter - GAI

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