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Doing Business in China Inter-Company Transactions

Conducting intercompany transactions with a subsidiary in China is more complicated than performing the same transactions in many other countries. Understanding the rules and regulations and then following them consistently will result in a relatively smooth flow of your accounting transactions, and very importantly, your products.

Unrelated corporations experience significantly reduced issues as they can contract and invoice at published rates for parts, components, assets and service. The fact that they are unrelated entities, removes many concerns of the PRC.

Transactions with your PRC subsidiary should be treated as "Arms Length Transactions". An Arms Length Transaction means you establish your pricing as if the subsidiary is unrelated to you. Invoicing of goods are made at established rates, and services are performed at published charge rates that will return an acceptable profit. Short of having established rates for goods and services to your subsidiary, you will need to collect significant documentation.

Marketing, distribution and manufacturing subsidiaries will all have intercompany transaction issues. Manufacturing will often experience the broadest and most complex of issues, especially if you are importing assets at startup or a significant number of parts and components in the manufacturing process.

No Charge Transactions:

Sending goods or services at "no charge" should be avoided if at all possible. This causes incorrect accounting in both the sending and receiving unit . More importantly, it can result in shipments being held up in customs.

The desire to send no charge often originates  in the most innocent of manners. Individuals of the parent corporation often attempt this for one of the following reasons:

• Speed up the shipment of the item, by bypassing the invoicing process.

• Desire not to invoice and overburden the fledgling new subsidiary.

• Unaware of the potential problems.

• The cost of the item is small or incidental.

What can go no charge? Listed below are a couple examples of the types of items which can go at No Charge to your Chinese subsidiary:

• Sales brochures and pamphlets

• Pre-production test models(not in large quantities)

• sample parts(small quantities)

• Computer software

Note, even in these instances, you may experience difficulties. For example, if you ship twenty pre-production parts, the customs inspector may see them as having value and hold the items up in customs. This is obviously not worth risking your new product launch schedule. You may be better served to assign a nominal value to the items for customs purposes, even though you may then pay a small incoming duty.

Here are a few of the major reasons why inter-company transactions are more difficult:

• The PRC is very concerned that international corporations will extract profits from China by means over significant Technical Services charges by the parent corporation or a subsidiary of the parent corporation.

• While transactions should be treated as arms length, it can be difficult for parent company personnel to understand why.

• Payment of invoices requires the use of Foreign Currency(use of U.S. funds) which the PRC covets.

• These are legal transactions between to separate legal entities in two separate countries. Therefore, two taxing jurisdictions are looking to receive fair and appropriate income tax revenues.

Any company doing business internationally should establish and document their intercompany transfer pricing policy. These policies should be consistent worldwide for all transactions to and from parent and subsidiary or subsidiary to subsidiary companies. This is especially important if the subsidiary is located in another country and therefore affect two taxing jurisdictions. The taxing jurisdictions will look to be sure that over time they are receiving and appropriate amount of tax revenue for the business.

Establishing a consistent policy worldwide will make the task of proving fairness in pricing to local tax authorities a little bit easier. But even this may not fully satisfy all concerns.

Importantly, the transfer price policy must satisfy the local tax authorities, else they will dictate transfer prices to you.

There are three basic transfer pricing methods:

1. Competitive Pricing- This is generally the preferred method from a tax and legal standpoint. The transfer price is set at or in relation to a competitors' published price for a similar product. This works well as long as the selling units' actual cost is comparable to the cost structure of your competitor. It may not work well for a new manufacturing company in the PRC who is still up the learning curve and could be left cash poor. The opposite can occur as the entity goes down the learning curve and is now significantly cost advantaged to the competitor. The parent entered manufacturing in the PRC to drive lower cost and will want it reflected in the unit cost from the subsidiary.

2. Market Back pricing- This is commonly used as the "Competitive Pricing" method above requires that the competitors price is known. This method takes the final selling price to the customer or distribution channel and subtracts the actual costs. The resulting profit is then shared across the supply chain.  

3. Cost Plus- This method simply takes product cost and marks it up by a pre-established rate to result in profit. In this calculation, the markup is applied to whatever the cost is. This guarantees tax revenue to the tax jurisdiction of the seller.

The transfer price calculation should include all costs incurred and related to the transaction.

A marketing company should include the Unit Manufacturing Cost(UMC), R&D and associated SG&A as well as a profit markup. A royalty cost associated with goodwill, company brand, etc. is also appropriate.

A manufacturing company should include all costs of the manufacturing entity: UMC, transportation, Special Items of Cost and administrative expense.

Technical Services Agreements(TSA's)

Technical Services Agreements are legal transactions between two intercompany legal entities documenting the agreement on technical, engineering and other support services between the legal entities. TSA's often also cover allocations of administrative support.

TSAs contain a basic legal agreement, ideally coupled with a detailed description of the tasks to be completed, along with sound cost estimates. These agreements should be written annually. Corporations who have established manufacturing subsidiaries in another country, should already have documented procedures for TSAs.

Technical Services Billings(TSBs):

Technical Services Billings are the actual invoicing of technical support to another intercompany organization.

It is desirable for all parties involved to perform these billings at actual. There are limitations to this statement(I.e.. You will not want to send actual individual labor cost if it can be avoided).

TSBs should be billed monthly. Billings should be performed at actual cost. Recognizing the sensitive nature of actual individual labor information, if you use department charge out rates, those rates should ideally be published. Inclusion of those rates in the TSA are also recommended.

Coordination of invoicing, billing accruals as need be and remittance  should be documented in advance and followed as closely as possible.

Correctly Booking Revenue and Cost:

Matching revenue and cost in the same reporting period correctly in both companies is a very important task that is not given enough attention. It requires communications and coordination between financial staffs in both companies on the either side of the planet.

Imagine the reaction when the parent company sells $1m (USD) in assets to the subsidiary  in December and the selling department fails to record the COGS until January . In this scenario, the parent books $1m in revenue in year1 with no cost. Great earnings and great bonus. In year2 however, there is no revenue and $1m of cost, there goes your bonus. Complicate this with the subsidiary not making the appropriate accrual into their books in December! It happens. It also happens in reverse.

Rules and procedures will help with this. Communications, diligent efforts towards proper accounting will not completely eliminate it, but it will minimize these occurrences.