Nowadays a large share of world trade consists of transfers of goods, intangibles, services and financial instruments within multinational enterprises(MNEs). Transfer prices —payments from one part of a multinational enterprise for goods or services provided by another —may diverge from market prices for reasons of marketing or financial policy, or to minimize tax, or all of these reasons. Together with avoiding double taxation and the impediment to world trade, transfer pricing become a more complicated issue of the international lax law. As many foreign-funded and foreign enterprises have been established in China, the detailed transfer pricing regulations have been issued in 1998 and China is the second country in Asia (after Japan) to do this. With the accession to the WTO, China has been progressively liberalizing its market and has offered tremendous business opportunities for MNEs. More and more business functions such as marketing and R&D services are moving into China. As a result, the volume of intra-group transactions (both cross-border and within China) grows rapidly, and their nature becomes more complicated. On the other hand, Chinese enterprises (both state-owned and private) are looking forward to invest outside China. All these require China’s transfer pricing regulations to be more detailed and sophisticated.

　　1. Transfer Pricing and Transfer Pricing Methods

　　Transfer pricing means to decide the amount charged by one segment of an organization for a product or service that it supplies to another segment of the same organization, that is, the act of pricing on the transaction between the related parties.[1] The amount charged is called transfer price. Transfer pricing can be conducted within a state or cross-border, the latter, which is between the departments of a MEN, can be called international transfer pricing. The MEN we talked is referred to as entity in economics rather than in laws, so it is a group which consisted of all kinds of affiliated enterprises. For the factors of laws or of economics, these individual group members are associated closely and able to move the profits within them therefore maximize the profit of the group. So the MENs can evade tax by transfer pricing, besides, there are also other nontax purposes such as reducing the custom duties to the exportation of the affiliated enterprise or acquiring more, even entire profit of the joint venture. In 2001, Ernst & Young International arranged for an independent survey on transfer-pricing issues of 638 multinational companies and 176 subsidiaries operating in 22 countries. The survey indicated that the primary factor to be taken into account is the operating and management factor rather than tax considerations when the MENs setting the transfer pricing. In the survey 29% of parent companies and 35% of subsidiaries said they considered the strategy of operating to a great extent when setting a TPM, while the figure in 1997 was 28％ and 22％. In addition, only 23% of parent companies and subsidiaries considered the optimization of taxation to be the most important impulse in setting TPMs in the survey.

　　All these tell us that transfer pricing is neutral and we should not always connected it with tax evade. The motivation or aim of MENs may be multiplex while setting transfer pricing. To some extend, the MENs are free to set transfer pricing and the tax authority can make an adjustment rather than punishment unless the transfer pricing is quite preposterous and the substantial result equates that of deliberate tax evade. This can be deduced from I.R.C.§6662（e）and U.S. Regs.§1.6662-6.[2]

　　From a business perspective, there are many reasons to deciding what to charge for the related-party exchange of goods or services. Compensation and performance measurement may push in one direction; the demand for simplicity may push in another; and tax considerations may push in a third. Then the price decided accordingly would diverge from the arm’s length price. The transfer price can be determined by different standard, correspondingly, the TPMs consisted of comparable uncontrolled price method，resale-price method, cost-plus method and other reasonable methods including comparable profit method, profit split method and transactional net margin method.

　　There is general agreement among governments, often by way of bilateral tax treaties, that transfer pricing between related parties should adhere to an arm’s-length standard[3] ; that is, that related companies should carry out their transactions between themselves on the same basis as would have applied had they been dealing at arm’s-length. Otherwise, the tax authority can choose the appropriate TPM which is defined by the law to price at arm’s length , adjust the amount of income and levy accordingly. So, in this process, the tax authority also takes the action of deciding the transfer price and can be the other subject of transfer pricing except MENs.

　　2. Legislation on TPMs

　　The first legislation governing the transfer pricing issue across the country was The Law of the People's Republic of China on the Foreign-funded and Foreign Enterprise Income Tax, which was passed at the 4th session of the Seventh NPC on April 9,1991(hereafter, “FEIT Law ”). Article 13 of the FEIT Law provides: The payment or receipt of charges or fees in business transactions between a foreign-funded enterprise, or an establishment or a place set up in China by a foreign enterprise to engage in production or business operations, and its associated enterprises, shall be made in the same manner as the payment or receipt of charges or fees in business transactions between independent enterprises. Otherwise the tax authority may make an adjustment. This provided a legislative authority controlling the transfer pricing abuse. The Detailed rules for the Implementation of this law provides in Article 54: If the buying and selling between an enterprise is not priced at arm’s length, the tax authority may make an adjustment by selecting an appropriate method as arranged below in descending order of precedence:（1）According to the pricing of the same or similar business activities amongst unassociated enterprises;（2）According to the profit level obtainable from resale to unassociated third parity;（3）According to the costs plus reasonable expenses and profit margin; （4）According to any other appropriate methods. This article introduced the transfer pricing methods and prescribe the order of precedence, furthermore, established the “Arm’s Length Principle”. But the prescription is quite abstract and lack of workability. The transfer pricing audits in China were mainly conducted by local tax authorities in an uncoordinated manner. There was seldom communication amongst the local authorities. Therefore, on 1998, the State Administration of Taxation (the “SAT”) issued the Administration of Tax on Business Transactions between Affiliated Enterprises Rules (Guoshuifa [1998] No. 59, hereafter, “Rules”). This Rules provided a comprehensive and consistent practical guideline for transfer pricing administration.

　　The Rules presented a detailed prescription on the TPMs at Chapter 7 which is named “Selecting of the Adjustment Methods” and contains six articles, among which Article 27 provides the adjustment principle; Article 28 refers to the preferred transfer-pricing adjustment methods which tax authorities should apply as the comparable uncontrolled price, resale price and cost-plus methods. If the first three methods are inappropriate, other reasonable methods such as the profit comparison method, profit-split method and net profit method could be used. Article 29 to 32 provides separately the transfer pricing methods on financing service, labor service, and lease on tangible asserts, alienation of intangible asserts.

　　The TPMs provided by the Rules is generally follow international practice and methodologies and is widely used in practice. On 22 October 2004, based on the past experiences, the SAT issued the Circular on emending the Administration of Tax on Business Transactions Between Affiliated Enterprises Rules (Guoshuifa [2004] No. 143) , by which, the SAT has further standardized the transfer pricing administration procedures and elaborated on certain articles contained in the first detailed Rules.

　　Article 28 of the Rules had been emended as :“(4) Other reasonable methods. If the first three methods are inappropriate, other reasonable methods such as the profit comparison method, profit-split method and net profit method could be used. What should be highlight is the comparability, justification and operating conditions as using this methods”.

　　Two paragraphs had been added to Article 28 as: “（5）According to Article 53 of The Implementation Rules on the Administration Law of the People's Republic of China on the Tax Revenue Collection（hereafter , “the Tax Implementation Rules”）, if a taxpayer’s application on APA has been confirmed by the tax authority an APA could be set out for the future transactions between related parties. （6）Under the circumstances where a taxpayer, unable to provide required information on their related-party transactions, provides false information or is unwilling to provide the information, the tax authority can now adjust a taxpayer's revenue or profits based on the methods stipulated in article 47 of the Tax Implementation Rules .”

　　3. The Deficiencies in TPMs and the Improvements

　　1) The concept of transfer-pricing adjustment methods

　　On the definition of the methods of transfer pricing, the Rules uses the options of the adjustment methods as the title of this chapter. But this definition is not accurate. There is not a specific object concerning about the word “adjustment”, if look at Article 54 of The Detailed rules for the Implementation of FEIT, the object of the “adjustment” is still not obvious, it can be defined as either the taxable incomes or the transaction prices. But the object of transfer pricing and TPMs is price. There are great differences between the two definitions, the former one embodies and follows the arm’s length principle but the latter one did not. Article 55 of the Tax Implementation Rules specifically regulates the object is the income or the tax revenue, not including the determination and regulation on prices, as far as the Rules are concerned, the meaning is ambiguous. There are no strict measurements about adjusting methods, and if look further on the content, it seems to be rather an adjustment on prices, so the so called “adjustment methods” should be reworded as the transfer pricing methods in order to keep the accuracy and the symmetry of the law.[4]

　　From another angle, the subject of TPMs can be MENs and tax authorities, it shows that these methods can be used not only by the tax authorities, but also for those transnational corporations, which is good for eliminating crashes and conflicts.

　　2）The application order of TPMs

　　Presently most countries and regions have basically established the best method approach on the application order of the TPMs. There was no strict hierarchy of methods before 1994 in U.S.A., but the regulation was changed in the rule of 1994: “The arm's length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result. Thus, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others.”[5] The essence of OECD guide keeps the same with U.S.A.’s basically, just stipulating such other methods as profit method, etc still as the last means, OECD guide stipulates: “No one method is suitable in every possible situation and the applicability of any particular method need not be disproved”, “Choose a method that is apt to provide the best estimation of an arm's length price and that enjoys the preference for higher degrees of comparability and a more direct and closer relationship to the business practice.”[6]

　　According to Article 54 of The Detailed rules for the Implementation of FEIT, which provides: "the detailed rules for implementation of income tax law of the foreign-investment enterprise and the foreign enterprise " , the legal order should be applied while choosing the method of transfer pricing; Article 55 of the Tax Implementation Rules of 2002 have not stipulated the application order of the method of transfer pricing ; article 27 of Rules stipulated that “Tax authorities should according to type, nature and audit result of transactions between associated enterprises, consider relevant factors, select the corresponding adjustment method”. It seems that our country adopts best method approach too, but according to the stipulations of Legislative Law to seem like this, Rules issued by SAT is lower than the Implementation of FEIT issued by the State Council, at the same time the Tax Implementation Rules that the State Council issued have not made the clear regulation on the order of precedence too, so the provisions on the application order is effectual in the Implementation of FEIT.

　　So we should make administrative regulations on transfer pricing, elevate the legislative level, and make the definite regulation on the best method approach as soon as possible.

　　3）Operability of the concrete method

　　According to the Rules, the transfer pricing methods of our country consist of comparable uncontrolled price, resale price and cost-plus methods and other reasonable methods, including profit comparison method, profit-split method, net profit method, as well as the method of appraised and specified rate of profit, which is “adjust a taxpayer's revenue or profits based on the methods stipulated in Article 47 of the Tax Implementation Rules”. According to the standard of OECD Guidelines, our country’s regulations on adjustment methods of various kinds of transfer pricing are too simple, only enumerating these methods out and lacking of the regulations to practically apply the methods, and especially the most important international comparative problems are seldom mentioned. There is only the comparability of comparable uncontrolled price method stipulated in the Rules in which the comparability of others is not mentioned, so great difficulty and uncertainty is brought to the application of the adjustment methods of transfer pricing.

　　So, we should make the clear regulations on the comparability of all the application methods, such as comparable environment, factors and adjustment of difference, and at the same time design the concrete application example, pointing out the application prerequisite of all methods and emphasis of comparability analysis. U.S.A.'s Regulations and OECD Guidelines have both enumerated similar comparability factors, which can be regarded as reference. The comparability factors enumerated in OECD Guidelines include: Characteristics of property or service; Function; Contractual terms; Economic environment; Business strategy.[7] The comparability factors that U.S.A.'s Regulations enumerates include: The function; Contractual terms; Risk; Economic conditions; Property or service.[8] And to other rational methods, the concepts are not given definitely clearly either, such as net profit method, which is different from the international transactional net profit method. There are no objects that can be used for reference to the concrete meaning and operating of this method, which has brought very great difficulty for practice. Certainly there are no clarified comparable factors, operating methods and main points of other methods that we should give clear to.

　　On the choice in comparable uncontrolled transaction, in Rules the comparable uncontrolled price method adopts the transaction between the associated enterprises; resale price method adopts the transaction that the buyer of associated enterprise sells to the third person the similar items (products) which brought from the related party as the comparable transaction. The choice is too narrow like this, and is different from the international current operation. Although generally speaking the transactions with the same enterprise are more comparable than those between other enterprises, but if we make the rigid regulation like this, while there is no comparable uncontrolled price with the same enterprise, the method cannot be applied, and under some specific situations the comparable uncontrolled prices between other enterprises are more useful.

　　The other methods are abstract and there is no concrete standard for people to choose in application. For instance, only such a few countries as U.S.A. and New Zealand, etc. adopt comparable profit method, and reject transactional net profit method. OECD and other countries adopt transactional net profit method and object to comparable profit method. Because these two kinds of methods have different foundations, it is extremely difficult to choose the rational method, and the problem will cause more contradictions in practice. And to checking and ratifying the profit method, it is a peculiar method that tax authorities of our country often used in early days, with the core of checking and ratifying. It does not put emphasis on comparability and adopt many principles of the other methods, such as contrasting market standard, cost standard, etc. This method can not give people convincingness in practical application, often with some arbitrariness, so now we should cancel this method as the system of transfer pricing has already basically been formed.