According to a survey in 2003, China has taken the place of Japan and become the second biggest energy consuming country. Oil is one of the most important energy in China. Since 1990s, China began to import millions of tons of oil to meet the sharply increasing domestic oil consumption. Nowadays, the annual oil output in China is around 160 million tons, but the annual oil need exceeds 240 million tons. Propelled by a surging economy, China's oil imports soared by 17.6 percent in the first half of this year. It is forecasted that the oil needed in 2010 in China is going to be 350 million tons, but the oil output then will be only 200 million tons (see Figure 1). China is really facing an oil crisis. In the early 1990s, the government and the oil companies realized that the best way was to go abroad to find more oil. To remove the risks, China must rely on increasing domestic oil and natural gas supply as well as develop overseas sources. Starting from winning the tender in Peru in 1993, Chinese oil companies began their international investment and operation.
Figure 1— the oil output, import forecast.
Unit: 10,000 tons.
(red line – import, dark blue line – annual oil consume, azury line – domestic oil output. )
During the following 10 years, Chinese oil enterprises expanded their business to more 30 countries including Sudan, Canada, Venezuela, Thailand. China has got an oil share of 10 million tons from foreign areas until 2005.
During the last 20 years, China had been always trying to get more foreign investments, but today China has to be concerned about his own company going abroad as well. In this process, China has to learn how to deal with the phenomenon of transfer pricing of multinationals, with which China is still not so familiar.
Transfer pricing refers to prices charged in related party transactions including the intercompany transfer of tangible goods and intangibles as well as loans, services and leases.
The oil company’s Transfer Pricing practice is not so different with others. The result of Transfer Pricing can be illustrated by the following figure.
Figure 2 -- Transfer Pricing
Subsidiary Parent Company
Host Country Home Country
Buying Price
（Cost） Transfer Price Selling Price Totals
Case 1 100 150 200
Profit Before Tax 50 50 100
Tax Rate（%） 20 60
Tax Paid 10 30 40
Profit After Tax 40 20 60
Case 2 100 180 200
Profit Before Tax 80 20 100
Tax Rate（%） 20 60
Tax Paid 16 12 28
Profit After Tax 64 8 72
Case 3 100 200 200
Profit Before Tax 100 0 100
Tax Rate（%） 20 60
Tax Paid 20 0 20
Profit After Tax 80 0 80
Case 4 100 250 200
Profit Before Tax 150 -50 100
Tax Rate（%） 20 60
Tax Paid 30 -30 0
Profit After Tax 120 -20 100
Case 5 100 300 200
Profit Before Tax 200 -100 100
Tax Rate（%） 20 60
Tax Paid 40 -60 -20
Profit After Tax 160 -40 120
Assuming that the parent company, are located in the “home country” (China). The subsidiary company is located in another country, namely in the “host country”.
The numbers given by Case 1 (Figure 2) show the ordinary price between the unrelated companies in the market. In this case, the overall profit is thus 50 in the subsidiary company's host country and another 50 in the multinational's home country, totally 100 (before tax). Considering the tax these companies have to pay on their profits, the subsidiary has to pay corporation tax of 20% of the 50 profit and so the tax amounts to 10, while the home-country corporation tax is 60% of the 50 profit, and so our tax amounts to 30, overall, tax paid is 10+30=40 and this reduces the before-tax profit of 100 to an after-tax profit of 100-40=60.
Among this 60 after-tax profit, the subsidiary contributed 40, while the parent company contributed 20. The after-tax profit created by the parent company in the home country is smaller because he pays corporation tax of 60% comparing with the subsidiary's 20%.
Naturally and obviously, it will easily increase the total after-tax profit as long as the transfer price is changed, which can be easily controlled by the parent company itself. The transfer price is arbitrary, depending only on the agreements between the parent company and its subsidiary, and parent company can tell the subsidiary what to charge and can make the transfer price whatever is likes.
Case 2 (Figure 2) gives us the example. The transfer price is now 180 (compared with the previous 150). This has the effect of shifting before-tax profits from the parent company's home country (corporation tax 60%) to the subsidiary's host country (corporation tax 20%). In the end, the companies totally pay less tax (16+12=28) and as the before-tax profit is unchanged (100), the after-tax profit becomes100-28=72 and that is obviously more than the corresponding profit of 60 we made with a transfer price of 150. This time, the subsidiary contributes 64 to this while the parent company’s contribution is 8, the overall after-tax profit is now 72% of the selling price comparing the 60% in Case 1.
It shows that merely by changing the transfer price to an arbitrary higher figure, the overall after-tax profit can be increased greatly, a deal with huge profit but no cost. Why does not a multinational company make the best of this easy but profitable idea?
That is not the end. Case 3 is similar to Case 2, but the transfer price is changed to 200, which means the company buys and sells at the same price of 200. In this case, the overall tax paid is 20 and the after-tax profit becomes 80. It appears that the parent company contributes nothing to the whole after-tax profit, but he does not need to pay tax in the home country by just shifting all the profits to the subsidiary.
We can go further. What will happen if the parent company shifts even more of its profits to the subsidiary? This is illustrated in Case 4. If the transfer price is increased to 250, the subsidiary makes a profit of 150 and the parent company make a loss of 50. The overall result is that the two companies pay no tax at all on this transaction and the total after-tax profit becomes 100.
In Case 5, the subsidiary now makes a profit of 200 and the parent company make a loss of 100. The overall result is that the parent company gets a tax rebate of 60 in the home country, pay 40 corporation tax in the host country, and is thus left with a tax rebate of 20 on this transaction. Adding this to the profit increases the after-tax profit from £200 to 120. Incredible but it is true.
So by merely changing book entries, thus the transfer price, the parent company can get more, even double, profits.
The additional profits arise from tax avoidance. That is to say, this multinational company minimizes its liability for corporation tax by transfer pricing.
It is legal until governments legislate to prevent this practice. For the government, the transfer price may cause favorable or unfavorable result. In the cases we discussed, the tax paid to the host-country government increased, while the tax paid to the home-country government decreased. In other words, one government's loss is the other government's gain. So one government can be expected to legislate against unfair transfer pricing practices, while the other government can be expected to object to, and to resist, such legislation. Transfer pricing can deprive governments of their fair share of taxes from global corporations. No country – poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing.
During the past several decades, China has been attached little importance to transfer pricing and even less to those Chinese companies who has invested abroad, such as oil companies. There are reasons for this. Firstly, it is from the 1980s, China began to open up to the outside. Comparing with many countries, it is a short time to take part in the international trade and investment, so we need time to catch up with the world standard. Secondly, the government has focused on how to attracted more foreign investment, and supplied more tax incentives to foreign capitals, but care less on how to regulate tax avoidance. In the end, the capital involving investing abroad is so small comparing with that of foreign investment to China that the problems of transfer pricing of Chinese companies have been ignored.
Even the simplest oil operation involves hundreds of millions of dollars; in addition, the parent company has to supply technical, human resource support. All these business may be related to tangible, in tangible property. So it is very convenient for a international oil company to make more profit by all kind of available methods, such as transfer pricing.
The tax of those areas where Chinese oil companies invest and operate might lower than that of China. In order to get every possible profit, Chinese oil companies will use every possibility, including transfer pricing policy. Oil investment often involves hundreds of millions or even billions of dollars, it is easier and more possible for them to make use of transfer pricing if there is no relevant regulation.
But the fact is that there are only regulations but no laws in China on Transfer Pricing. The disadvantages of present regulations on Transfer Pricing including:
I. Among those regulations, the main purpose was to regulate foreign companies or joint ventures in China.
II. The definition of related enterprise is not so clear, the standard is not specific either.
III. The obligation of taxpayer to provide the tax administration with needed documents relating to the business with related enterprise is somewhat ambiguous.
IV. The penalty is not substantial if the taxpayer fails to provide the requisite documentation. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations support the dual strategy of requiring contemporaneous documentation and penalizing taxpayers for failure to comply with the documentation requirements.
It is impossible to solve completely the transfer pricing problem, but the government can control transfer pricing abuse through cooperation with their tax treaty partners, particularly their close neighbours. The developed countries have begun to find the way to solve the newest challenges, such as global trading and electronic commerce, but we have not yet dealt with the old problems. The best way may be to study the existing technical assistance to establish, implement and administer transfer pricing rules on the basis of reflecting China’s particular situation.
