Transfer Pricing in China General Principle and Planning Opportunities Backup slides: Recent Development Consequence of TP audit UTA Presentation Patrick Su at Shell March 13, 2004 © ©

1. Maximize shareholder interest on the investment 2 1. Maximize shareholder interest on the investment 2. Tax effective structure 3. Compliance with law and regulation in the country Is arm’s length principle apply to related party transaction and how to prove it? © ©

Functional and Risk Analysis The purpose of the functional and risk analysis is to establish the functions undertaken, risks assumed, and intangible assets employed by each relevant business entity, and the relative importance of each Functions typically include R&D, procurement, manufacturing, sales and distribution, marketing, and accounting, finance & general and administrative © ©

Functional and Risk Analysis (Cont’d) Business risks typically include market risk, inventory risk, credit risk, and foreign exchange risk Intangibles include Manufacturing intangibles, e.g., patents, technical know-how, and formulae Marketing intangibles, e.g.,trademarks, trade names, brand names, and customer list © ©

Benchmarking Select internal or external comparable prices for a Comparable Uncontrolled Price (“CUP”) method analysis Select internal transactions for an internal Resale Price Method (“RPM”) or Cost Plus (“CP”) Method analysis Search for external comparable transactions or companies for an external RPM or CP analysis © ©

Documentation Record each state of the process to form a defense document in support of future tax filings and investigations/audits Typical transfer pricing documentation includes (i) business overview, (ii) analysis of controlled transactions, (iii) method selected, (iv) identification of comparables, and (v) benchmark analysis © ©

Planning Opportunities How to Lower Effective Tax Rates Through Transfer Pricing Planning © ©

What is Effective Tax Rate? Effective tax rate (“ETR”) is calculated as income tax payment relative to taxable income. ETR can be higher or lower than statutory tax rate. In China, due to (i) different statutory tax rates in different regions, (ii) tax holidays, and (iii) tax loss carry-forwards, a group could have an ETR higher than the statutory rate on a consolidated basis. ©

How to Lower Effective Tax Rate Proactive transfer pricing planning can lower the ETR. Effective transfer pricing planning can create a tax efficient structure that maximizes residual (mobile) income. ©

Transfer Pricing Planning Strategies Transfer pricing planning strategies focus on migrating functions, risks, and/or intangible assets. In practice, the planning strategies are carried out through redefining manufacturing, trading, and services: Distributor Conversions Manufacturer Conversions ©

Distributor Conversions The strategy can be utilized to restructure existing business relationships with sales affiliates by converting distributors into manufacturer representatives, limited distributors/service providers, or vice versa. The strategy helps achieve a lower ETR through reallocation of profit between manufacturing entities and trading companies. ©

Critical Features of Trading Companies Manufacturer Representative Limited Distributor Distributor Does not take title Takes title No credit risk Minimal credit risk Credit risk No inventory risk Minimal inventory risk Inventory risk No marketing Limited marketing responsibilities Limited to full marketing responsibilities ©

Distributor Conversions: What Can Be Transferred? To convert a trading company from a distributor into a manufacturer representative or vice versa, one would typically migrate Inventory, i.e., holding cost of inventory Inventory risk Market risk Credit risk © ©

Distributor Conversions: Example I Basic facts: Trading company (“TradeCo”) is in a tax-loss position and also has loss carry-forwards while Manufacturing company (“MfgCo”) is in a tax-paying position; TradeCo’s loss is due to (i) significant marketing expenses, (ii) fast declining market prices, and (iii) bad debt. Solution: Migrate marketing responsibilities, market risk and credit risk from TradeCo to MfgCo. Result: TradeCo becomes profitable while MfgCo’s taxable income decreases. ©

Distributor Conversions: Example I (Cont’d) Market Risk Marketing Trade Co MFG Co Credit Risk Loss ©

Distributor Conversions: Example II Basic facts: MfgCo is in its first profitable year (and not taxable during tax holiday) while TradeCo is taxable at a 15 percent tax rate; MfgCo is introducing a new product to the market, which requires significant marketing expenses. Solution: Migrate marketing responsibilities for the new product from MfgCo to TradeCo. Result: TradeCo’s taxable income decreases. ©

Distributor Conversions: Example II (Cont’d) Marketing Trade Co MFG Co Expense ©

Manufacturer Conversions The strategy can be utilized to restructure manufacturing entities by reassigning risks, and transferring manufacturing/process engineering intangibles, ownership of raw materials, work in progress and final goods inventories. The technique helps achieve a lower ETR through reallocation of profit between manufacturing entities. ©

Critical Features Distinguishing Contract Manufacturers from Full-fledged Manufacturers Does not own product related technology and/or know-how Possesses little risk Potentially receives inventory on consignment Has little control in production planning and scheduling Defers quality control to customers Usually manufactures high volume, mature products Full-fledged Manufacturer Owns or licenses technology Possesses entrepreneurial risk Purchases own materials Controls production planning and scheduling Possesses direct control over quality Manufactures products at all stages of product line cycle ©

Manufacturer Conversions: What Can Be Transferred? To convert a full-fledged manufacturer into a contract manufacturer or vice versa, one would typically migrate Production planning and scheduling Sales and marketing Inventory, i.e., holding cost of inventory, through consignment Entrepreneurial risk including, but not limited to, inventory risk, credit risk, and market risk ©

Manufacturer Conversions: Example Basic facts: MfgCo1 is taxed at 30% and MfgCo2 is taxable at 15%, respectively. Both MfgCo1 and MfgCo2 have excess capacities. Solution: Migrate production from MfgCo1 to MfgCo2. Inventory can be consigned. Result: Profit is shifted from MfgCo1 to MfgCo2. ©

Manufacturer Conversions: Example (Cont’d) Production MAG Co1 MFG Co2 Income ©

Transfer Pricing Planning: Documenting the Changes Changes in transfer pricing policies due to planning should be based on economic substance. Quantification is key. Proper documentation of pricing policy and changes to it are important parts of planning. It is also important to document the economic substance of the planning so that it is clear to the relevant tax authorities that the change produces an arm’s-length result. If benefits are sufficiently large, one may want to secure such benefits through an APA A unilateral APA usually takes 3-6 months to complete ©

Backup Slides: Current Environment © ©

Transfer Pricing Enforcement In Practice: 1996-2001 Audit Cases Income Adjustment Additional Tax 1996-2000 3,829 RMB9.3B (US$1.1B) RMB750M (US$90M) 2001 1,230 RMB4B (US$482M) RMB348M (US$42M) ©

Consequence of Transfer Pricing Audits and Adjustments Audits generally last 6 months to one year Follow-up supervision of three years Likely resulting in investigations of affiliates Appeal or lawsuit is practically difficult Adjustment is likely treated as deemed dividend Loss of dividend reinvestment tax refund ©

Consequence of Transfer Pricing Adjustments (Cont’d) No tax refund of withholding tax if royalty or interest payment is disallowed Double taxation relief is theoretically possible but difficult to obtain due to under-developed competent authority process Other tax consequences Acceleration of first profitable year for tax holiday purpose Other related tax issues, e.g., VAT, business tax (“BT”), and consumption tax ©

Recent Development © ©

Transfer Pricing & Customs Enforcement The tax authorities stepped up enforcement efforts on service and inter-company loans Circular 128 Recent audit of inter-company loans Advance Pricing Agreements Customs enforcement Price adjustment Inter-company royalties PRC Customs Audit programme ©