China is now emerging as the epicentre of the global automotive industry, with growth being fuelled by rapid upskilling and development of its abundant workforce, as well as growing demand from an increasingly affluent middle class. It is a dynamic market with a solid domestic base, and one that provides plentiful opportunities for foreign car makers to succeed. However, China’s auto industry is not without challenges for foreign players and taxation is among the major concerns.
Close scrutiny by the authorities
With efforts to increase China’s tax base, tax authorities tend to apply a market premium to the profits of the Chinese subsidiaries of foreign automakers, using transfer pricing rules as justification.
The argument goes like this: China has unique barriers to entry not commonly found in other international auto markets that effectively impose an implicit quota on the number of participants in the Chinese market. For foreign automakers already in the Chinese market, this reduced competition means that they are able to capture higher than average profits than in a market with fewer regulatory, administrative or operational constraints. Thus, a market premium is deemed necessary in order to reflect the larger market share these companies are perceived to have in comparison with other international markets.
Nonetheless, the emergence of domestic Chinese manufacturers producing similar products at lower prices has shifted some of the consumer demand to domestic cars over imported/foreign-branded cars. Therefore this weakening of market concentration provides a potential basis for defending against any increase in market premiums.
Regardless of the merits of the market premium argument, foreign auto manufacturers in China should acknowledge that it is a key argument that could be raised in the event of a transfer pricing investigation while they can do well to proactively address this issue. Taxpayers may self-impose a market premium of their own choice. A comparable company benchmarking analysis may also be conducted using only comparable Chinese companies, since the profit levels of these companies should have already captured any market premium associated with the Chinese market.
Proper transfer pricing documentation and studies are also important in the event of a Customs audit, since the auto sector, as a high duty industry, has been subject to close scrutiny by China Customs as well. This is especially pertinent for multinationals with subsidiaries in China conducting importation transactions with overseas related parties. In such cases, a benchmarking study can be used to support the assertion that the pricing adopted is consistent with the respective companies’ functions and risks and that the price is set on an arm’s-length basis and settled within industry pricing norms. For non-trade payments (such as royalties), a detailed analysis on the nature of the payments and the characteristics of the associated arrangements should be documented in order to demonstrate to Customs why such payments should not be dutiable.
Tariff classification is another area to come under the scrutiny of Customs officials. In addition to customs duties, tariff classification also determines the applicable Valued Added Tax (VAT) refund rates. This issue is especially important for the importation and exportation of auto parts, where detailed studies need to be carried out by Customs and technical specialists. The adoption of an incorrect tariff classification may lead to underpayment of duties and taxes, excessive VAT refunds, or the failure to hold the appropriate licenses/certificates.
International carmakers also need to keep in mind the role that their local parts manufacturers play in their value chain. In many cases, a local parts manufacturer may be characterised as a contract manufacturer, performing limited functions and assuming limited risks. However, the Chinese subsidiaries of multinational auto companies are playing an increasingly high value role as foreign car makers target Chinese middle class consumers. No longer is China important to foreign car companies merely as a source of labour, but it is also an important source of consumers as well.
Given this, Chinese tax officials have called into question the actual characterisation of Chinese subsidiaries where they undertake certain marketing or relationship-building activities. In such cases, where the local manufacturer’s networking efforts and client relationships are contributing to the market penetration of the foreign-owned automotive brand, taxpayers need to reconsider the arm’s length compensation for the local parts manufacturer.
Promulgation of rules not catching up with the development of industry business model
The current foreign exchange control regime in China poses issues for auto manufacturers in China to remit compensation to suppliers located in other jurisdictions. In particular, problems arise when OEMs or higher tier auto parts manufacturers need to remit compensation to overseas suppliers for the cost of developing or purchasing moulds where there is no actual physical importation of the moulds.
One solution that has been employed to circumvent these foreign exchange restrictions is for overseas suppliers to incorporate the cost of the moulds into unit price of their products. However, this can cause the unit price of the products to fluctuate substantially, particularly where suppliers seek to recover the costs earlier rather than evenly over a period of time, which increases the parts manufacturer exposure from transfer pricing and Customs perspectives. Therefore, careful planning is required and taxpayers may need to consider other alternatives.
Planning for tax incentives
Planners in China are nevertheless also keen to help the Chinese automotive industry evolve into a globally competitive one. As such, authorities across different levels, functions and locations are offering incentives and special tax benefits to encourage investment and improve operations. The automotive organisations that understand how these policies work will gain a competitive advantage in the Chinese market.
A popular incentive accessed by auto parts manufacturing companies in China is the “High and New Technology Enterprise” (HNTE) qualification. Qualifying for HNTE status allows companies to enjoy a 15 percent preferential corporate income tax rate. However, expanding business activities coupled with stricter implementation the relevant regulations have made it more difficult for certain companies to continue to satisfy HNTE qualification criteria.
For example, qualifying for HNTE status requires that at least 30 percent of a company’s personnel to hold tertiary or higher degrees, among which no less than 10 percent of the company’s personnel must be engaged in R&D activities. To satisfy this requirement, HTNE enterprises have often arranged staff loans with labour agents in the past. Under this arrangement, the enterprises argue that the loaned workers should not be considered as employees of the enterprises, and therefore should be excluded from total headcount.
However, new PRC Labour Contract Law provides that the employment of labour forces by way of staff loan arrangement should only be for temporary or auxiliary positions, and should not last for more than 6 months. Thus, workers currently loaned for more than 6 months may need to be employed by the company as its own employees going forward, resulting in increased total headcount. Companies with current HNTE status will need to rearrange their staffing in light of this development.
Companies seeking to qualify as an HNTE must also ensure that their ratio of R&D expenditure to total sales is no less than 3 percent to 6 percent. For expanding businesses with growing sales, keeping R&D expenditure at the requisite levels may be challenging. In such cases, a company may need to consider possible ways to reduce total sales, such as selling products to a related party trading company at a price lower than the price it would ordinarily sell to third party customers at. Although under such arrangements, the portion of the profit transferred to the trading company would be subject to the higher standard CIT rate of 25 percent, the majority of the profit will still remain with the HNTE, subject to the preferential CIT rate of 15 percent. This is still preferable to the situation where the company losses its HNTE status completely so that all its profits are subject to CIT at 25 percent.
Again, in implementing such an arrangement, companies need to ensure that sales are conducted on an arm’s length basis and supported by a detailed transfer pricing study.
The road ahead for foreign auto companies in China offers challenges and regulations are becoming tougher, but they are by no means insurmountable. All multinationals understand the importance that proper tax planning and a robust tax risk management framework plans in the success of an organisation in other jurisdictions, and China is no different.
But more importantly, China also offers opportunities that multinational auto companies can incorporate into their strategy for the future. With most auto companies pinning their success on new products and technologies over the next 5 years, friendly R&D tax policies in China offer it as an alternative destination for R&D growth.