Richard Simmons and Shanshan Shi, Lingnan University, review the results of recent tax research to suggest how manipulative transfer pricing may be curbed in Mainland China.

According to a conservative estimate, the tax revenue lost to the government in Mainland China as a result of tax avoidance and evasion practices is over 100 billion RMB each year. The size of this ‘tax gap’ jeopardises the social equity of the nation’s tax system and disrupts the efficiency and competitiveness of its market economy.

For companies in Mainland China, widespread means of illegally evading tax include the under-reporting or non-reporting of income and the maintenance of alternative sets of accounting records. Companies are also able to legally avoid their taxes through, for example, taking advantage of a wide range of government tax incentives offered to encourage economic development. Central and local governments have long offered a basket of tax incentive policies: enterprises located in specific geographic locations (such as Xinjiang and Tibet), or operating in certain industries (such as software), or qualifying as high-technology or new-technology enterprises, can enjoy tax rates as low as 15% for a specified number of periods. However, the complex tax rate structure provides opportunistic circumstances for enterprises to engage in aggressive tax practices to minimise the group’s overall tax liabilities, both domestically and internationally.

Manipulative transfer pricing involves the use of non-arm’s length prices for the transfer of goods, services and intangibles among affiliated parties within a corporate group, shifting profits from high-tax to low-tax companies or jurisdictions, and thus minimising the total tax liability for the group. As such, it inhabits a grey area between illegal tax evasion and legal tax avoidance, and is commonly classified
today as ‘aggressive tax avoidance’.

Group enterprises in Mainland China are not required to consolidate tax filing under the current tax laws and regulations. Therefore enterprises with subsidiaries in different regions can dodge taxes by shifting profits from profitable subsidiaries to loss-making subsidiaries and from high-tax to low-tax enterprises. Profits can also be shifted between time periods to reduce tax. A study by Lin, Mills and Zhang (which appeared in the Journal of American Taxation Association in 2014) found that in 2007, private firms, anticipating major tax reforms in Mainland China, were able to shift their taxable income to a lower-tax year, saving over 8% of their total tax expenses.

Manipulative transfer pricing results in a substantial loss of tax revenue for the government, reducing trust in the nation’s tax system and seriously distorting the efficiency of the economy, so it has unsurprisingly drawn increasing attention from tax authorities. The Enterprise Income Tax Law (EIT Law), effective since 2008, stipulated a range of measures to combat aggressive tax avoidance practices. The new law authorised the country’s tax bureaus to assess additional taxes plus related fines and penalties if enterprises had engaged in manipulative transfer pricing practices. Since then, transfer pricing regulations in Mainland China have evolved rapidly along with developments in the international arena. In June 2016, the State Administration of Taxation (SAT) issued a public notice requiring firms to report considerably more detail on related-party transactions, whether domestic or international in nature, accompanied by supporting documentation. This enhanced regulation represents Mainland China’s response to the new international tax landscape that is shaping the practice of transfer pricing globally.

This new tax landscape is influenced predominantly by efforts against base erosion and profit shifting (BEPS) led by the Organisation for Economic Co-operation and Development (OECD). In 2015, these efforts resulted in the issuance of 15 BEPS action plans. Today, more than 125 countries and jurisdictions, including Mainland China, have subscribed to these action plans and are collaborating to implement associated measures. The OECD’s action plans 8 to 10 specifically tackle aggressive tax avoidance practices through transfer pricing, and, together with the latest updates on OECD transfer pricing guidelines issued in October 2017, form an internationally agreed consensus for valuing cross-border transactions in today’s increasingly global business environment.

Against this domestic and international background, this article considers current tax developments and recent academic research in order to suggest how three important processes – strengthening Mainland China’s tax administration, improving the country’s corporate governance and changing ethical perceptions in the nation towards aggressive tax avoidance – can help combat the problem of manipulative transfer pricing.

Strengthening tax administration

Strengthening tax enforcement with respect to aggressive transfer pricing practices should encourage firms to conduct their tax affairs in compliance with applicable laws and regulations. A unique aspect of Mainland China’s tax system is the varied interpretation and enforcement of tax laws by tax bureaus according to level of government responsible, geographical region and type of tax. This results in a lack of consistency and uniform application of the law, which partly contributes to widespread tax avoidance practices in the country. Tax revenue is shared between central and local governments. Until June 2018, Mainland China maintained a two-tier tax administration system, consisting of the National Tax Bureau (NTB) and Local Tax Bureaus (LTBs). The scope of tax administration and collection of each bureau was separate but duplicated in certain respects. This, coupled with the fact that the majority of listed companies are government-controlled, led to more tax avoidance activities by local government-controlled firms, as shown in the study by Tang, Mo and Chan (published in The Accounting Review in 2017). However, in June 2018, the two-tier tax administration system was unified. This development should streamline tax administration, provide a more integrated and consistent approach to tax enforcement, and hence encourage greater tax compliance by corporations.

Notwithstanding this development, a problem remains that in some regions tax officials take a tough stance in applying the arm’s length principle to cases of transfer pricing, while in other regions they take a more relaxed approach, applying the laws leniently based on political and social connections and local government interest. In a recent study (published in Contemporary Accounting Research in 2018), Lin, Mills and Zhang found that in Mainland China’s politically controlled economy, board ties with politicians can pose a significant challenge to effective tax enforcement. The resultant inconsistency in enforcement and punishment inevitably sends the wrong signal to taxpayers and ultimately leads to more aggressive tax avoidance behaviour.

On top of this, the current tax administration is based on a variety of taxes, and as a result lacks coordination and appropriate checks and balances. Taxpayers commonly have to deal with several individual officials in a tax bureau according to the kind of taxes concerned. This complicates firms’ tax affairs and potentially encourages them to be less compliant.

Tax laws and regulations on transfer pricing should be clear, concise and practicable for taxpayers, who should not have to take into consideration the discretionary power of particular tax officials or bureaus. The knowledge and technical skills of tax officials are also critical in handling tax avoidance cases involving transfer pricing. Recent technological and economic developments have brought many challenges for tax enforcement and, as a result, tax officials in Mainland China are increasingly required to master foreign-language skills, hone their knowledge of international tax and be tech-savvy, for example by using data analytics in transfer pricing audits. However, wide disparities in the competencies of tax officials currently exist. A continued effort on the part of the tax authorities to improve officials’ tax audit knowledge and skills are clearly more than ever warranted.

Improving corporate governance

Corporate governance, referring to a set of policies and procedures established by a firm’s board of directors to foster the sustainable achievement of corporate goals, is likely to play a vital role in defining a company’s tax reporting behaviour. Undoubtedly, a firm may achieve better short-term tax efficiency through aggressive transfer pricing practices, but in the long run it runs the risk of reputational damage (with perhaps an associated consumer backlash) if it is viewed as a socially irresponsible corporate citizen that is not paying its fair share of taxes. Additionally, such practices may prompt suspicion of other unethical behaviour, including dishonesty in the company’s financial statements. Further, if the firm is audited by the tax authorities, it would have to allocate a significant amount of manpower and other resources to deal with the issue, and may eventually be subject to tax adjustments and additional fines and penalties.

Research has shown that certain aspects of good corporate governance reduce aggressive tax avoidance. A study by Lo, Wang and Firth (appearing in the Journal of Corporate Finance in 2010) found that firms with a higher percentage of independent non-executive directors (INEDs) on the board are less likely to engage in transfer pricing manipulations. INED regulations were introduced in Mainland China in 2001 and the current ‘one-third of the board’ INED requirement was officially included in company law in 2006. However, the current percentage of INEDs on boards in Mainland China is comparatively low internationally. According to the 2018 Spenser Stuart Board Index survey, this percentage is currently somewhere between 30% and 50%, compared to 85%, 61% and 57%, in the US, UK and Singapore, respectively.

Mainland China operates a dual board system, with a supervisory board exercising supervisory power over the board of directors. This, to a certain extent, duplicates the roles of INEDs on the board of directors, since members of the supervisory board and INEDs act as the company’s internal supervision mechanism, providing an independent view of the company, and objectively scrutinising the performance of management and the reporting of company performance.

In Mainland China, however, dominant controlling ownerships, by the state or provincial governments in state-owned enterprises or by the owner/founder in private enterprises, commonly result in a lack of INED independence. The Chairman of the board in a Chinese company is often equivalent to the CEO of a US company, commonly directly or indirectly nominating INEDs from his/her pool of business and social connections. Because of this, INEDs usually are not disposed to disagree with the Chairman. A few years ago a concerned government prohibited many high-ranking government officials from becoming INEDs for fear of collusion and rent-seeking behaviour. Corporates responded by appointing many university professors as INEDs: currently, more than 45% of INEDs in Mainland China’s listed companies are academic professors, a phenomenon that is very distinctive from developed economies where most INEDs have prior experience in top management positions in other companies. In sum, there is clearly still a lot of scope for improving the INED system in Mainland China.

More encouragingly on the corporate governance front, Mainland China recently introduced corporate social responsibility (CSR) reporting requirements, and by 2018 a total of 851 companies listed on the Shanghai and Shenzhen stock exchanges published CSR reports on sustainable growth. Following international trends, this year Mainland China will likely adopt an environmental, social, and governance (ESG) annual reporting framework for all listed issuers (as Hong Kong did in 2016). As its name suggests, an ESG report is more comprehensive than a company’s corporate governance report. Since a company’s ESG performance is connected to its long-term financial health, a strong performance in this regard should send a strong signal to the market that the company is ethically conscious and, as such, will not engage in aggressive tax conduct such as creative transfer pricing arrangements.

Enhancing the perception of transfer pricing as an ethical issue

Manipulative transfer pricing would appear to be deeply rooted in the self-interest of the enterprises and their owners at the expense of their other various stakeholders, including the general public. Public attitudes towards aggressive tax avoidance by corporates have considerably evolved in recent years in developed nations such as the US and UK, where an explosion of civic awareness and public discussion on the issue has taken place. A tide of negative public opinion has created pressure groups such as US Uncut and UK Uncut, who have been involved in demonstrations and sit-down protests in targeted corporate locations, as well as boycotts of popular brands. This public discontent has been acknowledged by governments. In the UK, for example, Members of Parliament (MPs) have been sharply critical of the tax avoidance activities of multinational companies such as Vodafone, Google and Starbucks. In the latter case, pressure from government and the public was so intensely felt by the company that it offered to pay the UK government ‘a significant amount of tax in 2012 and 2013, regardless of whether the company is profitable’. This offer, an unprecedented action for a multinational enterprise, effectively represents a donation to the tax authorities as an act of penitence for admitted tax underpayment.

Greater public concern over unethical tax practices can influence board decision-making through, for example, consumer and shareholder activism. However, in contrast to the case in Western countries, the perception of aggressive tax practice by corporations as essentially an unacceptable ethical issue is generally very low in Mainland China. It is currently difficult to say whether the attitudes of the general public now prevalent in Western nations towards the phenomenon will also emerge in Mainland China as forces for change. Nonetheless, the attitudes of professionals who are particularly prominent in influencing aggressive tax behaviour are likely to grow more critical towards the practice.

For example, professional accountants, who act as company board members or in-house tax advisors, have long been expected to serve the public interest. Indeed, the International Code of Ethics for Professional Accountants of the International Ethics Standards Board for Accountants (IESBA) states at its very beginning, ‘A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the public interest’. The Code of Ethics of the Chinese Institute of CPAs (CICPA) is converging with IESBA’s code, and the CICPA is now dedicated to instilling commitment to the values expressed in its Code amongst its members. This should hopefully impact on the attitudes of professional accountants in Mainland China towards manipulative transfer pricing. In a study published in the Accounting Auditing and Accountability Journal in 2016, Shafer, Simmons and Yip found that tax accountants in Mainland China who possessed higher levels of professional commitment judged manipulative transfer pricing to be more unethical and expressed a lower intention of engaging in this activity.

Enhanced commitment to professional ideals amongst individuals in firms that commonly advise corporations on their tax affairs is likely to lead to a more ethical culture within those firms, especially if those individuals are in a position to ‘lead from the top’. This culture shift can hopefully reduce the promotion of aggressive tax schemes by all within the firm. In a study published in the Accounting Auditing and Accountability Journal in 2011, Shafer and Simmons found that the existence of a strong ethical culture within accounting firms in Mainland China significantly reduced the reported likelihood of individual tax practitioners within those firms supporting manipulative transfer pricing arrangements with their clients.

Finally, the attitudes of budding tax professionals in Mainland China towards aggressive tax avoidance can be enhanced through education and training. One means to this end is through more emphasis on ethics in tax courses offered at universities. A study by Simmons, published in the Journal of Business Ethics Education in 2014, found that undergraduate students at a Hong Kong university became more critical of manipulative transfer pricing after taking a taxation course imbued with a significant ethical component. Another means is through greater effort by professional bodies in Mainland China such as the CICPA to instill ethics more pervasively into the tax component, currently predominantly technical, of their professional qualifying programmes. Revisions to training programmes that stress the fundamental importance of ethics to tax advice, and building it into the heart of tax decision-making frameworks, will go a long way towards the advancement of a new generation of more ethically minded tax specialists in Mainland China.


Improvements in the effectiveness of Mainland China’s tax administration, enhancement of the corporate governance of firms with regard to taxation and a deeper and more widespread perception amongst corporate board members, professionals and the general public of aggressive tax avoidance as an ethical issue can together help create an environment which is increasingly unfriendly to manipulative transfer pricing. If these developments continue to unfold, they can help transform corporate behaviour and reduce the harm manipulative transfer pricing can inflict on government revenues, trust in Mainland China’s tax system and the country’s economy in general.

Richard Simmons, Professor of Teaching, and Shanshan Shi, Postgraduate Diploma Programmes Director
Lingnan University