Transfer Pricing Enforcement in China- the IRS Should Be Paying Attention!

On my long list of statements from tax officials that strike me as incredibly short sighted comes this:

The China's State Administration of Taxation, emboldened by the Internal Revenue Service's result in the GlaxoSmithKline case, is directing its auditors in appropriate marketing intangibles cases to apply the residual profit split method to recompute royalty income.

The IRS was indeed very successful in arguing that some of the profits that British based Glaxo made on US sales of Zantac were attributable to the marketing efforts of Glaxo’s US subsidiary. But mind you that the tax planners for US based pharmaceutical companies with foreign marketing subsidiaries took notice of the IRS theory to successfully argue that some of the profits from US created drugs belonged offshore under arm’s length pricing. So if the Chinese are about to argue that distribution subsidiaries deserve a large share of the profits – wouldn’t this hold for US entities distributing products manufactured in China. Last year – the US exported only $55 billion of goods and services to China, while China sold almost $288 billion in goods in services to the US. Unless there existed no intangible profits from Chinese exports to the US and there were substantial intangible profits when US manufacturers sold goods to the Chinese, something tells me that China's State Administration of Taxation could come up with the short end of this stick.

It would seem that the Indian tax authorities successfully made a similar argument in a tax dispute with Rolls Royce. If this argument is turned on US based companies selling into India, let’s keep in mind that the India exports twice as much to the US as we export to them. With the US as a net importer of goods, any argument that the local distributor deserves a large slice of the profits is something the IRS should look forward to making in a bilateral way!