Eastman Kodak does not often commission a comprehensive study on one aspect of its operation in a single market. It’s a time-consuming exercise and costs a great deal. Yet earlier this year, the world’s best-known maker of film, camera and film processing equipment enlisted the help of an accounting firm to study all of its transfer pricing practices and procedures in China. The reason? “We felt it was something we needed given the environment we would be operating in,” says David Uhazie, Eastman Kodak’s CFO for greater Asia.

The environment Uhazie refers to is China’s most aggressive tax collection drive in decades. With its high-octane growth slowing on one side and foreign investment pouring in on the other, China is looking at tax with real hunger in its eyes. Specifically, Beijing is eyeing the practice of transfer pricing, or the amount charged on a transaction between subsidiaries or related parties.

These prices can attract the attention of tax authorities if they can’t be shown to reflect a fair value for the goods. And considering the sharp rise in the number of foreign companies and the growth of cross-border sales following China’s admission to the World Trade Organization (WTO), Beijing will no longer tolerate not getting its fair share of the tax dollar.

For foreigners operating in China, this aggressive posture is something new. In the past, China was so eager to attract foreign investors that it provided them with juicy tax incentives. It also operated a fairly loose system of tax rules and enforcement. In recent months, however, the country has been sending armies of tax inspectors to seminars and lectures in Beijing to learn to be better auditors, tax collectors and enforcement officers.

China has also announced that it’s phasing out its preferential tax rates and tax holidays in the country’s five special economic zones and 49 smaller development zones that allow foreign companies to pay a tax rate of 0 to 15 percent instead of the regular 33 percent.

“China is trying to protect its tax base and [wipe out] tax avoidance,” says PricewaterhouseCoopers tax partner Spencer Chong in Hong Kong. “With its entry into the WTO and the concessions it has made to lower tariffs and custom duties, China needs to get revenue from other sources, and tax collection from transfer pricing enforcement will likely be one of these sources,” says Chong. China is focusing on transfer pricing, partly because it believes companies are using it as a technique for tax avoidance.

Tax officials have long suspected some companies create losses in their China operations by buying high from one subsidiary or joint venture and selling low to another in order to reduce their tax bills. With better trained and more knowledgeable tax inspectors, Beijing hopes to rein in such practices by doing more audits. Companies with widely fluctuating profits and losses from year to year, companies with big transactions between related parties or subsidiaries, and companies that continue to expand despite big losses are most likely to attract the auditors’ attention.

“In the past, many companies were able to negotiate their way out of a dispute if they had a good relationship with the Chinese authorities,” says Arthur Andersen tax partner Becky Lai in Hong Kong. “But this will unlikely be the case in the future,” she adds.

Audit Defense

China’s tougher stance on tax audits and collection could mean more work for CFOs. For one, as an audit defense, companies will have to have better reporting procedures and documentation of their sales and purchases, payment receipts, and transactions between subsidiaries and related parties. Second, in the event of a tax adjustment, companies will have to be prepared to argue their case or face the prospect of being double taxed if the extra income China attributes to its subsidiaries has already been taxed elsewhere.

Many companies operating in China are now scrambling to modify or update their tax models. They see it also as a way to meet the new commercial needs and changing market conditions in a China post-WTO.

At Eastman Kodak, Uhazie says he initiated the transfer pricing study in January when he became aware of China’s changing regulatory and business environments, and how they would affect his company’s taxation practices and procedures. “I expect more significant tax reforms in China in the next two to three years,” Uhazie says.

Since 1998, Kodak has been running five factories in China – in Shanghai, Xiamen, Wuxi and Shantou, with each enjoying tax holidays of some sort. The various film, photo chemicals, cameras and film processing equipment that the Kodak factories produce are for both domestic consumption and exports, which means the way the company charges its costs and books its profits will be under close scrutiny in the future.

Uhazie says he hopes the study will help his company better comply with the new rules and regulations, avoid unnecessary risks, and yield a more effective tax strategy. The study will be completed in April.

View to the South

At the Hong Kong-based $2.2 billion-a-year China Resources Enterprises, which has a wholesale and retail operation in Beijing, Shanghai, Guangzhou and Shenzhen, KW Kwok says he is constantly monitoring the tax situation in China.

His company currently pays an effective 15 percent tax rate in China. When the preferential rate expires, Kwok says, the group will try shifting some of its China tax liability to Hong Kong, which enjoys a 16 percent corporate tax rate.

“There are a few other things we are looking at that will help us reduce our tax bill,” says Kwok, financial controller at the group’s retail division. But he, like several other CFOs contacted for this article, declines to be more specific on his tax-saving measures.

Meanwhile, experts predict Asian companies that are not used to dealing with transfer pricing issues and their complexities will have a tough ride in the coming months. U.S. and European multinationals, who are generally more experienced in operating in developing markets with evolving tax rules, could be better off.

But for all foreign companies, the free and easy days of low taxes in China are surely gone for good.

Lotte Chow is a contributing editor at CFO Asia based in Hong Kong.

More Protection Needed

According to tax experts, there are a few methods commonly used by companies operating in China to improve their business efficiency and mitigate their overall tax costs:

• Move some of their profit-drivers such as research and development, brand-building, and marketing units to lower tax entities. These entities often have the physical and intellectual resources that enable the companies to continue to focus on their core competencies. With their proximity and well-developed infrastructure, Hong Kong, at 16 percent, and Macau, at 15 percent, are preferred locations.
• Consider an advanced pricing agreement, or APA. China’s tax authorities use an APA to approve a company’s transfer pricing policies on particular transactions over a period of time, say three years. This eliminates the company’s future transfer pricing risks and make sure that it complies with the new rules.
• Look into a cost sharing arrangement to spread the costs of research and development, and related activities such as building patents and trademarks between the company and its business partners. This enables CFOs to allocate their tax liabilities to different locations.
• Use a holding company if the group has many subsidiaries, allowing for the use of a China profit alignment. This allows finance managers to explore and evaluate strategies that look at all the tax positions – transfer pricing, business tax, income tax, value-added tax and others – and then implement the most effective one. This method is most popular with companies that are reorganizing or restructuring their China operations because that is when they have the most flexibility to adopt new tax structures. —LC