Meaning
Compliance records maintained by Chinese taxpayers provide detailed analysis of their intra-group transactions, functional profiles and the selection of pricing methods to support their tax positions. This transfer pricing documentation local file is a statutory requirement for companies with related party transactions that exceed the thresholds set by the state taxation administration. It contains a comprehensive description of the local entity’s business operations, its management structure and the competitive environment in which it sits.
The document must explain how the prices for goods, services or intangibles were determined and why they are considered to be at arm’s length. Preparation of this file is a key part of the annual tax compliance cycle for multinational corporations with a presence in china.
Functional Analysis
Description of the activities performed by the local company forms the core of the transfer pricing documentation local file. This analysis identifies the specific functions carried out by the chinese entity such as manufacturing, distribution, research or marketing. It also describes the assets used in these processes and the risks assumed by the company including market risk, credit risk and inventory risk.
The goal is to show how much value the local operation adds to the global supply chain compared to the other members of the corporate group. This information allows the tax authorities to determine whether the reported profits are commensurate with the level of activity and risk in china. If the company is performing complex functions but reporting low profits, the bureau may target it for a transfer pricing audit.
Economic Analysis
Verification of the pricing policy requires a benchmarking study that compares the financial performance of the taxpayer with similar independent companies. Within the transfer pricing documentation local file, the economist or tax advisor must search for comparable firms that operate in the same industry and geographic market. Several financial ratios like the operating margin or the return on assets are used to measure the profitability of these peers.
The study establishes a range of acceptable returns and demonstrates that the chinese entity’s results fall within this range. If the company’s profits are below the median of the comparables, the documentation must provide a logical explanation for the variance. This economic defense is essential for justifying the allocation of profits to the chinese jurisdiction and avoiding a tax adjustment.
Compliance Requirement
Deadline for the completion of the transfer pricing documentation local file is the end of june in the year following the tax year. While the file is not submitted with the annual tax return, it must be available for inspection within thirty days if requested by the tax bureau. The documentation must be written in chinese and should follow the specific structure mandated by the national regulations.
Failure to maintain a contemporaneous file can lead to the loss of certain tax benefits and a higher interest rate on any eventual tax adjustments. It also shifts the burden of proof to the taxpayer during an audit and makes it more difficult to defend the pricing policy. Regular updates to the file are necessary to reflect changes in the business model or the market conditions.
By maintaining a high quality local file, companies can demonstrate their commitment to transparency and reduce the likelihood of a disruptive and costly tax investigation.
