Foreign enterprises concealing related-party transactions are investigated by the tax bureau and are required to pay over CNY 1.2 million in back taxes!
M Company is a Sino-foreign joint venture manufacturing enterprise, jointly funded by Singapore-based H Company and China-based F Company, with F Company holding a 65% equity stake and H Company holding a 35% equity stake. After official production started, sales revenue has been growing steadily year by year. However, in stark contrast, the company's gross margin and sales profit margin have always been at a low level, even incurring losses, which has attracted the attention of the tax authorities.
Ninety percent of the products produced by M Company are sold to the Singapore-related party H Company, which then sells to overseas customers. Tax officials subsequently reviewed the M Company's declaration details and found that it had not declared the "Annual Summary of Related Party Transactions."
The tax department conducted an anti-avoidance investigation into M Company and found that the profit margins of M Company's overseas related-party transactions were generally lower than the profit margins of domestic and foreign non-related party transactions, suspecting profit shifting. The reasonableness of the transfer pricing in the related-party transactions between M Company and H Company became the focus of the investigation team's review.
M Company admitted to the fact of concealing related-party transactions. However, the person in charge of M Company believed that H Company, as its international market agent, bears significant risks and high costs, and it is reasonable to obtain higher profits, with no issues of related party interest transfer.
Nevertheless, after gathering evidence from multiple sources, the tax authorities found that, in terms of functional positioning, M Company integrates research and development, procurement, and production. Although M Company signed an overseas sales contract with H Company, the export sales orders show that the goods are directly shipped by M Company to the destination, with H Company only acting as a middleman. From this, it is judged that H Company only undertakes limited sales functions, while M Company bears most of the risks, and the profits obtained by both parties are clearly not proportional to the functions and risks undertaken.
Ultimately, the tax bureau made a tax adjustment decision according to the law, and M Company paid over CNY 1.2 million in corporate income tax.
Dongjin Reminder: Related-party transactions of multinational enterprises are a key area of supervision for tax authorities. Enterprises should follow the arm's length principle to ensure the reasonableness of transfer pricing in related-party transactions and must not use related-party transactions to shift profits. Otherwise, the tax bureau has the right to make tax adjustments based on the average profit rate of similar enterprises in the market. If the enterprise refuses to cooperate, it will not only need to pay back taxes but may also face severe tax penalties.
If enterprises have any questions, they are welcome to consult Dongjin at any time.
Mike Chang
Partner
mikechang@shanghaiinvest.com