Secondary Adjustments and Deemed Dividend Withholding in China Transfer Pricing
Transfer pricing adjustments in China convert unreturned offshore cash into deemed dividends subject to mandatory withholding tax unless repatriated directly.
Transfer Pricing Secondary Adjustment
Meaning
An administrative tax procedure requires a multinational enterprise to align its accounts with a primary transfer pricing adjustment to reflect the arm’s length principle. In Chinese tax administration, the transfer pricing secondary adjustment treats the difference between the adjusted transaction price and the actual payment as a constructive transaction, such as a dividend or a loan. The State Taxation Administration applies this rule to prevent enterprises from shifting profits out of the country through artificial pricing.
This procedure ensures that the enterprise pays the appropriate taxes on the reclassified transaction.
Constructive Recharacterization
When the tax authority makes a primary pricing adjustment, it changes the taxable income of the enterprise. The secondary adjustment then addresses the cash that remains with the foreign affiliate because of the artificial price. Under Chinese regulations, this cash is treated as a constructive dividend paid to the foreign parent company, or as an interest-bearing loan to the affiliate.
This recharacterization allows the tax bureau to levy withholding tax on the dividend or interest.
Financial Impact
The tax on the constructive transaction creates a double tax burden for the multinational company, as the cash has already been taxed in another jurisdiction. For example, if the cash is treated as a dividend, it is subject to a 10 percent withholding tax under the Enterprise Income Tax Law. This additional tax liability can be avoided if the affiliate agrees to repatriate the cash to China within a specified period.
Repatriation returned the funds to the local enterprise, eliminating the need for a secondary adjustment and helping to restore the company’s financial balance without incurring further tax penalties or administrative costs.
Legal Remediation
To resolve the double taxation, the enterprise can seek a Mutual Agreement Procedure under the applicable tax treaty. This procedure involves the tax authorities of China and the partner country negotiating a fair resolution to the pricing dispute. While this process can be lengthy, it remains the most effective way for the company to avoid paying tax twice on the same profits.
The enterprise must present detailed documentation of its pricing policies to both authorities to support its case.