China’s Move Into the Auto Industry: Challenges and Opportunities From a Transfer Pricing Perspective

China has been expending considerable resources to market its developing auto industry. China, to a large extent, has been known more for exporting their labour intensive products such as clothing and textiles, rather than capital-intensive products such as automobiles. However, economic development has been good for China. According to the The Economist, China's Gross Domestic Product for 2005 was 1.78 trillion dollars, with economic growth pegged at 8.1 percent. Increases in Chinese exports have resulted in government and private sectors increasing the amount that is being spent in the economy, and in the absolute level of savings.

Savings are required to transform any economy from one that exports labour intensive goods, to one that exports more capital-intensive goods. Savings allows businesses to invest more in technology, which is a necessity for economic development. Increasing exports, coupled with low population growth, translates into high real growth rates for China. This process of economic development is a natural phenomenon that has been followed by many countries in the developed world. (Examples include Japan.)

China has often relied upon foreign joint ventures to produce cars, but this seems to be changing. China has embarked on a path of buying the technology necessary for car production from foreign companies, directly bypassing restrictive joint venture arrangements that they traditionally had with foreign companies. This new approach has been met with recent successes. One of these success stories includes China's Beijing-based Beiqi Foton Motor Co Ltd.¹ The Chinese move into the automotive industry is significant, and will no doubt result in exciting opportunities for owners of the automobile companies and their workers. The evolution of the Chinese automotive industry may eventually require China to set up a significant network of related parties in other parts of the globe to market and sell their products. However, tax authorities around the world will need to take note of the transfer pricing implications such developments create.

What is transfer pricing and why should it be of concern

Transfer pricing investigates the price charged by one member of a multinational firm to related parties for the transfer of goods, services and intangibles. International auditors around the world are increasing their audit and inspection activity of international transactions, which may lead to significant tax exposure for multinational companies operating over multiple tax jurisdictions. The increase in audit activity has resulted in more transfer pricing adjustments being raised and assessed, putting organizations at risk of double taxation - a situation where a firm pays tax in two tax jurisdictions with respect to the same income.

The transfer pricing issues and their tax implications will become more pronounced as China finds ways to export their products across international borders. Chinese automakers should be aware of the many transfer pricing issues and consequences that will follow from their business decisions. For instance, China will eventually need to set up distribution networks that transfer goods, services and intangibles between Chinese-based multinationals and related parties. Determining what related parties earn on both their manufacturing and distribution activities will be scrutinized. Understanding this scrutiny requires that Chinese multinationals apply pricing policies that will result in arm's length prices being implemented between related parties. More contentious transfer pricing problems will surround such issues as royalties. Particularly, the building up of name recognition, and who will benefit from this branding growth. If Chinese-based members of a multinational organization build an international awareness and significant brand recognition, then determining royalty payments from other members in different tax jurisdictions that use this name will be important.

Chinese automakers can benefit from successfully applying transfer-pricing strategies by placing the key assets, functions and risks in tax jurisdictions where they want the profits to flow.² Given that China is relatively new at producing and promoting its cars, the Chinese auto industry has an advantage over existing car companies in that they can take a proactive approach to locating these intangible assets and processes in such a way that allows Chinese auto companies to minimize after tax profits. For instance, if China wanted to ensure that profits are migrated back to China from tax jurisdictions that have higher tax rates, it would be important to ensure that many of the value-added functions related to building and marketing of cars be performed in China. If China allows subsidiaries in other tax jurisdictions to pay for and undertake valuable marketing functions for instance, this would entitle foreign tax jurisdictions to a significant share of the profits, and therefore taxes collected. Waiting to migrate intangibles when they are older and valuable is difficult and more complex than strategically locating the functions, assets and risks when they are in the early stages of development and under less scrutiny from tax authorities.

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¹Irina Aervitz, June 2006, "China's auto makers spurn foreign suitors", Asian Times Online.

² For an article that explains the process needed to migrate intangibles, please refer to TaxationLaw@Gowlings, Newsletter #83.