Meaning
Resultant tax correction following a primary transfer pricing adjustment ensures that the financial accounts of the related parties reflect the tax authorities’ revised pricing. The secondary adjustments address the fact that even after more tax is paid, the actual cash remains with the wrong entity according to the arm’s length principle. This process treats the excess funds that were not transferred at the correct price as a different type of transaction, such as a dividend or a loan.
The goal is to bring the commercial reality of the parties’ balance sheets into alignment with the tax reality established by the audit. In China, these adjustments are a mandatory part of the special tax adjustment process and can have significant implications for withholding tax and capital management. They ensure that the tax authorities’ intervention is reflected in the actual cash positions of the companies involved.
Deemed Distribution
Distribution of profits to a foreign parent company is the most common way that these corrections are handled in China. When a primary adjustment increases the taxable income of a local subsidiary, the excess cash that was previously paid out is often treated as a secondary adjustments deemed dividend. This means that the amount is subject to withholding tax at the standard rate or the reduced treaty rate.
The company must then pay this tax to the state, even though it has already paid out the money to its parent. This can lead to a significant unexpected tax bill. The treatment of the excess funds as a dividend also affects the subsidiary’s retained earnings and its ability to pay future dividends.
This mechanism ensures that the state collects the withholding tax that would have been due if the profits had been distributed correctly in the first place.
Capital Treatment
Treatment of the excess funds as an injection of capital is another option that may be applied in certain circumstances. Instead of being treated as a dividend, the secondary adjustments can be viewed as an additional investment by the parent company into the subsidiary. This avoids the immediate withholding tax liability but requires a formal change to the subsidiary’s registered capital.
This process involves approvals from the Ministry of Commerce and the State Administration of Foreign Exchange, which can be complex and time-consuming. The choice between dividend and capital treatment depends on the specific facts of the case and the tax laws of both countries. The goal is to find a way to reconcile the accounts that is legally acceptable and minimizes the risk of double taxation.
This capital treatment is often preferred if the company intends to keep the funds in China for future expansion.
Repatriation Protocol
Protocol for the actual return of the funds to the correct entity is the final step in the adjustment process. To avoid the negative tax consequences of a deemed dividend, the secondary adjustments rules allow the taxpayer to physically move the excess cash back to the subsidiary. This is known as repatriation.
The funds must be transferred within a specific timeframe, usually ninety days after the primary adjustment is finalized. If the money is returned in full, the tax authorities may waive the withholding tax on the deemed dividend. This requires coordination between the banks, the foreign exchange authorities and the tax bureau to ensure that the transfer is recorded correctly.
The repatriation protocol provides a way for companies to correct their financial position and avoid some of the more punitive effects of a transfer pricing audit. It requires careful management to ensure that all legal and regulatory requirements are met in both jurisdictions.
