Meaning
International tax standards dictate that transactions between related parties must be priced as if they occurred between independent entities. Under the arm length principle article 7 article 9, tax authorities evaluate whether the profits reported by a multinational enterprise in a specific jurisdiction align with the economic value created there. This prevents the artificial shifting of profits to low-tax jurisdictions through manipulated pricing of goods or services.
The State Taxation Administration in China applies these standards to ensure that cross-border dealings between a parent company and its local subsidiary reflect market realities.
Statutory Basis
Bilateral tax treaties incorporate specific provisions to regulate the profit attribution of permanent establishments and associated enterprises. Within the framework of the arm length principle article 7 article 9, the first component governs the allocation of business profits to a fixed place of business. It ensures that a branch is treated as a distinct entity for tax purposes.
The second component addresses transactions between separate but related legal entities, allowing for adjustments when prices deviate from market norms.
Operational Test
Tax auditors employ various methods to determine if a transaction satisfies the requirements of the arm length principle article 7 article 9 during a transfer pricing review. They may use the comparable uncontrolled price method or the transactional net margin method to benchmark the profitability of a Chinese factory against independent manufacturers. Documentation must demonstrate that the chosen pricing strategy reflects the functions performed and risks assumed by the local entity.
Failure to provide sufficient evidence often leads to significant tax adjustments and late payment surcharges.
Pricing Adjustment
Local tax bureaus exercise the power to unilaterally adjust taxable income when a taxpayer cannot justify its intercompany charges. The application of the arm length principle article 7 article 9 allows authorities to restate profits based on data from similar companies in the same industry. Such adjustments impact the corporate income tax liability and can trigger double taxation if the corresponding jurisdiction does not grant a relief credit.
Companies often seek an advance pricing arrangement to secure certainty over their future tax positions.
