Chapter Thirty-Eight

China–Taiwan Trade

Once Forbidden, trade between Taiwan and mainland China (PRC) is becoming increasingly important for both countries, particularly for the smaller power, Taiwan. Multinational enterprises from either side of the Taiwan Strait face increasing risks of double taxation because both sides lack the administrative mechanisms that would otherwise preclude such anti–double taxation. More and more, transfer pricing is becoming a conflict mechanism between these two sides.

TAIWAN AND CHINA: A HISTORY LESSON

Sixty years have passed since the end of the Chinese Civil War and the promulgation of the Cross-Straits Economic Cooperation Framework Agreement (ECFA or Framework Agreement; governmental delegates signed that pact at the end of June 2010). The ECFA or framework agreement is a preferential trade agreement between the governments of the People’s Republic of China (PRC) and the Republic of China (Taiwan). The ECFA curtails tariffs and commercial barriers between both sides. Multinational enterprises are increasing cross-straits trade as both sides implement the ECFA.

Many businesses that engage in cross-straits trade are related enterprises (i.e., businesses that have facilities in both the PRC and Taiwan). As such, transfer pricing is a frequent issue between parties on both sides of the strait. For historical reasons, there remains a strong well of opposition to cross-strait trade. All too often, economic nationalism affects the positions of the parties. Nevertheless, the ECFA fails to address transfer pricing issues that enterprises on both sides of the strait are facing. The ultimate objective that remains from a conflict resolution standpoint is for the two taxing jurisdictions to establish viable mechanisms that would enable the governments to allocate the combined profits of entities that are doing business in both jurisdictions.

Over the past 60 years, conflicts between the PRC and Taiwan lurked between impending war and combined economic growth. Limited military conflicts, tensions, and the instability of the cross-strait relationship was often the norm. The PRC and Taiwan, as nation-states, do not provide official recognition to each other. This lack of recognition makes agreements between these governments circuitous and convoluted.

ECONOMIC CONSIDERATIONS

Many international business executives view Taiwan as being the world’s electronics powerhouse. Taiwan is known for many facets of electronics, including integrated circuits, broadband, personal computers, notebooks, motherboards, graphics cards, semiconductor foundry processes, mobile phones, cellphones, opto-electronics, LCD panels, and photovoltaic processes that convert solar energy into electricity. In addition, Taiwan manufactures biotechnology and nanotechnology products and, quite separately, manufactures bicycles and other products.

Trade with the PRC is a much greater percentage of Taiwanese sales than is the percentage of Chinese sales. As the growth continues between Taiwan and the PRC, trade with China provides a major favorable input to the Taiwanese economy. Nationalists in Taiwan view this trade with alarm, suggesting that this trade would make Taiwan more economically dependent on China. In contrast, trade with Taiwan remains relatively insignificant to China from a policy perspective. Data from the 2011 CIA World Factbook illustrates the parameters:

ONE-CHINA POLICY

Both the PRC and Taiwan have adopted a one-China policy. Either or both countries have insisted on this one-China policy from time to time. As a result of this one-China policy, both governments compete to have the world view them as being the one and only legitimate government of China. Each government objects to the use of terms such as “China–Taiwan relations” or to “PRC–ROC relations,” as these terms imply the existence of a two-state solution.

Since each government does not recognize the other, the governments on both sides of the strait relate to each other only through unofficial nongovernmental, semiofficial exchanges. At the present time, the PRC seeks to integrate Taiwan within its operations. It is our view that the PRC might be looking forward to there being a Taiwan Special Administrative Region (SAR) analogous to the current structure in Hong Kong and in Macao.

As part of this one-China policy, the government of the PRC has been using its influence on neighboring countries to prevent these neighbors from signing free trade agreements with Taiwan. However, to a large extent, the PRC has permitted Taiwan to piggyback its trading relationships with the PRC as East Asia moves toward economic integration. An important input to this economic integration process is the Association of South East Asian Nations (ASEAN) agreement. ASEAN members include Indonesia, Singapore, Malaysia, Brunei, the Philippines, Thailand, Burma, Vietnam, Cambodia, and Laos.

The ASEAN group plans to extend this economic integration to include China at a later date. As a result of this expansion, the ASEAN–China agreement would exclude Taiwan unless Taiwan wants to receive and accept piggyback status from China. The Taiwanese government acknowledges that the one-China policy would put Taiwan in a deleterious position with the ASEAN–China agreement but for the signing of the ECFA.

ECONOMIC COOPERATION FRAMEWORK AGREEMENT

The parties to the Cross-Straits Economic Cooperation Framework Agreement are:

• The Straits Exchange Foundation (SEF), representing the government of Taiwan.
• The Association for Relations Across the Taiwan Straits (ARATS) representing mainland China.

The détente between the PRC and Taiwan began in 2008. Since that time, SEF and ARATS have signed 15 agreements on behalf of their respective governments. The most recent of these agreements is the Cross-Strait Agreement on Intellectual Property Rights Protection and Cooperation. The PRC and Taiwan are planning more arrangements following the implementation of the ECFA. SEF and ARATS are planning to reach an arrangement for cross-strait medical cooperation, for pharmaceutical cooperation, and for health cooperation. In addition, SEF and ARATS are planning to implement an investment protection agreement.

The ECFA, after establishing its objectives and cooperation measures, addresses trade and investment issues, including trade in goods, trade in services, and investment activities. The ECFA establishes the facets of economic cooperation, including economic cooperation itself. The ECFA addresses the “early harvest” program for trade in goods and trade in services, which benefit small and medium-size providers in particular. The program enables accounting firms and financial institutions to set up operations cross-border. Both countries reduce tariffs applicable to the other country.

A number of important groups in Taiwan have opposed the ECFA. The opposition asserts that the ECFA would cause deleterious changes in Taiwan and would:

• Reduce manufacturing jobs in Taiwan
• Reduce the average salary in Taiwan
• Create a brain drain for Taiwan’s management and technology expertise

Further, the ECFA opponents argue that the ECFA would lead to an influx of mainland Chinese white-collar workers and professionals in Taiwan, and that influx could adversely impact job security for the Taiwanese.

The current détente between the PRC and Taiwan has brought about extensive trade, flows of tourists, and cross-investment. Nevertheless, cross-state businesses are taking advantage of labor-rate differentials and market availability. Wage rates are substantially higher in Taiwan than in China. Taiwanese businesses are seeking a larger share of the Chinese market.

TAX CONSIDERATIONS

The Taiwanese government views cross-straits businesses as having three dynamics:

The Taiwanese government, aware of these transfer pricing issues, asked us to develop transfer pricing parameters that would allocate more profit to the multinational enterprise located in Taiwan and, by extension, would allocate more profit to the Taiwanese. In the interest of fair disclosure, Robert Feinschreiber met with Chinese officials initially in December 1992, at various cities in China at the request of China and the United Nations, to facilitate China’s economic growth.

• The Taiwanese government asked us to examine both developmental activities and manufacturing activities.
• We were to focus on the transactional profit split method, which we had suggested to the Taiwanese government as a viable transfer pricing method 14 months earlier.
• The Taiwanese government asked us to ignore distribution functions of businesses. The Taiwanese government took the approach that existing applications of transactional net margin method (TNMM) are sufficient as to these distribution activities.
• The Taiwanese government asked us to focus on transfer pricing issues facing the electronics industry.

During the current détente, which began in 2008, trade with the PRC has become an increasing share of Taiwan’s international trade activities. The PRC is now Taiwan’s most significant trading partner. In light of these facts, the Taiwanese government asked us to specifically address trade with the PRC and production activities when we addressed these transfer pricing concerns.

Both the PRC and Taiwan accept the Organisation of Economic Co-operation and Development (OECD) transfer pricing principles. It is our view that, while lurking transfer pricing issues will remain, the fact that each government is willing to abide by OECD transfer pricing principles will go a long way in conflict resolution.

In a larger sense, both the PRC and Taiwan want to make sure that they receive their “fair share” of the operating profits that the cross-strait company receives. The issue is, then, to determine each country’s fair share of these profits. We will demonstrate that both the PRC and Taiwan can achieve many of these fair share objectives by applying the OECD’s transfer pricing provisions, but we caution that the transfer pricing provisions are not always a cure-all. Nevertheless, transfer pricing mechanisms provide a range of disputes between these two governments. These transfer pricing mechanisms, even without the advance pricing arrangement (APA) process and the mutual agreement procedures (MAPs), might provide a narrower area of dispute than the countries would otherwise expect.

This conflict resolution process is not perfect—the cross-straits company might be subject to some degree of double taxation or might find itself with a tax gap. This conflict resolution approach is limited because the two governments do not recognize each other. As we shall see, intended tax-oriented remedies, such as bilateral APAs and MAPs, do not present a viable solution given the nature of the governmental institutions.

CHOICE OF TRANSFER PRICING METHOD

The OECD guidelines would have the multinational enterprise or the tax administration, when viewing transfer pricing methods, rely on one-sided transfer pricing methods or, alternatively, on two-sided transfer pricing methods. The choice between these transfer pricing methods depends on the applicable facts and circumstances.

• A one-sided transfer pricing method looks to one party as being the tested party.
• A two-sided transfer pricing method looks to testing both parties together.

Given these facts, it might be appropriate for Taiwanese multinational enterprises to consider applying a two-sided transfer pricing method, such as the transactional profit split method, to limit the exposure to double taxation.

FUNCTIONAL ANALYSIS

Taiwanese electronics manufacturers, for the most part, are highly developed, sophisticated, and highly integrated operations. These electronics manufacturers are part of a production chain that ultimately brings the electronic goods to market. Nevertheless, each such manufacturer produces items or parts that, for the most part, have no established market. In essence, such a manufacturer is producing work-in-process inventory items.

The production process for these Taiwanese manufacturers is often this:

• The Taiwanese manufacturer develops product technology that will ultimately lead to the ultimate sale of the electronic product to the ultimate consumer.
• The Taiwanese manufacturer purchases electronic parts for its manufacturing process from other unrelated electronics manufacturers in the production chain.
• The Taiwanese manufacturer adds value to the product.
• The Taiwanese manufacturer exercises quality control over the manufacturing process.
• The Taiwanese manufacturer completes its production activities before these products ultimately reach the consumer.

The production process for a Taiwanese manufacturer having PRC operations is often this:

• The Taiwanese manufacturer develops product technology that will ultimately lead to the ultimate sale of the electronic product to the ultimate consumer.
• The Taiwanese manufacturer, having this product technology, hires its related party in the PRC to produce the product en masse to the marketplace.
• The Chinese manufacturer adds value to the product.
• The Taiwanese exercise quality control over the manufacturing process in the PRC.
• The Chinese manufacturer completes the production activities before these products ultimately reach the consumer.

ANALYSIS OF THE PRODUCTION ACTIVITIES

A one-sided transfer pricing method would not be appropriate1 to these production activities as the electronics production is part of the integrated production of highly specialized goods.2 As such, the multinational enterprise or the tax administration would determine that a two-sided transfer pricing method (i.e., the transactional profit split method, would be the enterprise’s “most appropriate” transfer pricing method).3

The Taiwanese manufacturer might sell its work-in-process inventories to more than one manufacturer, where one of these parties is not a related party. The presence of such an in-house comparable could provide a ready comparable. Although the ROC Tax Agency is acutely aware of such transactions taking place, our fact pattern is otherwise.

The multinational enterprise would apply a different approach to the distribution function. Once the manufacturer completed its production function, the enterprise can better address the distribution function in terms of the resale transfer pricing method, or by applying the TNMM method in lieu of the resale transfer pricing method, as analysis of the distribution now takes precedence.

Our analysis presupposes that the contract between the Taiwanese party and the PRC manufacturer does not constitute contract manufacturing or contract service activities, or otherwise create simple functions that would cause the multinational enterprise or the tax administration to apply a one-sided transfer pricing method.4

FACT PATTERN

The next example illustrates an operation of a long-standing Taiwanese electronics enterprise that shifts its manufacturing operations to the PRC. The Taiwanese enterprise made this shift because of the comparatively high cost of manufacturing labor in Taiwan, as it had found that it no longer was economical for the business to undertake its basic electronics manufacturing operations in Taiwan. The enterprise has retained its high-value research operations in Taiwan.

The Taiwanese operation has personnel that evaluates the company’s market strategy and orders raw materials and components for further manufacturing. The Taiwanese operation directs order processing operations. In contrast, the Chinese operations develop the production flow and handle the specific manufacturing operations.

The Chinese operation sends the finished electronic products to the offshore distributors. Some of the distributors are related parties. The Chinese operation takes title to the electronic products freight on board (f.o.b.) Taipei. The distributors sell to ultimate customers located in various locations throughout the world. The Taiwanese–Chinese multinational enterprise does not advertise; the distributors handle the marketing efforts. The Chinese operation, by selling in bulk, then bills, insures, and arranges for transportation of the products. The Taiwanese operation takes on the responsibility for damaged goods and for risk of loss.

The Taiwanese operation had established initial customer relationships with the distributors, and the Taiwanese operations continue this relationship. The customers obtain their own credit lines to purchase the electronic products. The Taiwanese operation and the Chinese operation are independent of the customers’ financial activities. The Chinese operation sells the electronic products f.o.b. plant.

ACCOUNTING AND TAX OPERATIONS

Both the Taiwanese operations and the Chinese operations provide extensive comparable data to each other. Taiwan and the PRC have different accounting systems, but the enterprise expects that both governments will ultimately be able to harmonize the two accounting systems.5 The Chinese operations reflect the Chinese documentation forms,6 and the Chinese operations provide this information to the Taiwanese operations. The Taiwanese operations provide to the Chinese operations the transfer pricing report that it had furnished to the ROC’s Tax Agency.7

Taiwanese operations and the PRC operations have effectuated a perpetual goods-until-canceled cost plus contract. The multinational enterprise and the tax administration are in the process of evaluating the transfer pricing arrangement.

PERMANENT ESTABLISHMENT

The Taiwan operation and the Chinese operation satisfy themselves that their cross-strait activities do not constitute a permanent establishment:

• The Taiwanese operation sends different personnel on occasion to the Chinese operations.
• The Chinese operation sends engineers to Taiwan periodically to review technological updates.

TAIWANESE–CHINESE ELECTRONICS COMPANY

The next example illustrates the Taiwanese activities and the Chinese activities from a comparative standpoint.

TRANSACTIONAL PROFIT SPLIT METHOD CRITERIA

The OECD guidelines would apply the transactional profit split method in situations in which a multinational enterprise meets one of these five criteria:

In the context of the trade of electronics between Taiwan and China, the first category, the creation of the integrated production of highly specialized goods, would provide the rationale for applying the transactional profit split method.

MOST APPROPRIATE TRANSFER PRICING METHOD

The guidelines would have the multinational enterprise or the tax administration apply the “most appropriate” transfer pricing method.13 Following the concept of the “most appropriate” transfer pricing method, it appears that the multinational enterprise or the tax administration would select an allocation key that is the most appropriate allocation key. The guidelines, however, are silent in addressing the appropriateness of a selected allocation key within the transactional profit split method.

ALLOCATION KEY SYSTEM

The OECD guidelines provide that the multinational enterprise or the tax administrations can put forth four types of allocation keys:14

Based on the facts presented, the multinational enterprise and the tax administration should be in the process of developing allocation keys pertaining to the creation of the integrated production of highly specialized goods.

STRONG CORRELATION STANDARD

The OECD guidelines impose a “strong correlation” standard to the multinational enterprise and to the tax administration in selecting the allocation key.15 We have covered this issue elsewhere. The guidelines fail to define the “strong correlation” standard itself.

• The guidelines apply the strong correlation standard between the tangible assets, the intangible assets, or the capital employed as to these assets or capital and the “creation of value”16 in the asset-based allocation key context.
• The guidelines apply the strong correlation standard to relative expenses and to relative value added in the cost-based allocation key context.17

We anticipate that vagaries in applying the allocation key analysis will continue because the OECD guidelines fail to define the terms “strong correlation,” “creation of value,” and “relative value added.”

SELECTING AMONG ALLOCATION KEYS

The database provides these allocation keys:

In this instance, it is our view that none of these allocation keys meets the strong correlation standard: the machinery allocation key, the building allocation key, the land allocation key, nor the other asset allocation key. The presence or absence of a portion of the machinery, building, land, other assets, or total assets, standing alone, appears to not affect the “creation of value” to the enterprise. As such, the asset base in China and asset base in Taiwan would then not play a role in developing the allocation key.

Now we consider the possibility of incurring employee costs as an allocation key:

In this instance, the presence of employee costs correlates the relative value of these expenditures to relative added costs of these activities. The multinational enterprise would allocate these amounts based on cost-based allocation activities. Nevertheless, it appears that the multinational enterprise or the tax administration would not have a sufficient basis to exclude some employee personnel costs in favor of other employee personnel costs. We conclude that the total employee allocation key appears to be a strong correlation based on the facts at hand. That allocation would allocate 37% of the total combined income to Taiwan and would allocate 63% of the combined income to the PRC.

Now we turn our attention to applying the personnel count as an allocation key:

In this instance, personnel counts appear to be a potentially valid “other allocation” key. The OECD guidelines specifically enumerate headcounts (i.e., the number of individuals involved in the “key functions that generate value” to the transaction as an allocation key). The key functions in this instance would be R&D, engineering, and production and possibly might include other activities as well. As a result, the total number of employees in the enterprise could well serve as an allocation key, allocating 10% of the total combined income to Taiwan and allocating 90% of the combined income to China.

The multinational enterprise in the PRC and in Taiwan, together with the tax administrations in both jurisdictions, could potentially view the allocation of the combined income as being:

The Taiwanese tax authorities in this instance are likely to insist on taking 37% of the enterprise’s taxable income. The enterprise in this circumstance would face extensive double taxation (37% of the combined income from Taiwan plus 90% of the combined income from China, or 127% of the combined income from both Taiwan and China) if China forces its tax position based on headcount or on applying a similar transfer pricing approach.

Most multinational enterprises, whether China based or Taiwan based, view China as being the more forceful of the two trading partners. The Taiwanese tax authorities face a dilemma: acceding to China’s allocation key approach or subjecting multinational enterprises within its purview to double taxation. As this issue unfolds, we can expect pushback by the Taiwanese tax authorities, putting the onus of double taxation on the multinational enterprises themselves. As we shall see, the bilateral APA process is a much less than ideal solution.

APA PROCESS

The APA process presupposes that the contracting party has a mutual tax agreement with the contracting party’s treaty partner. Thus, the OECD guidelines would apply Article 25 of the OECD Model Tax Convention for this purpose.18 The question then becomes how Taiwanese companies and, to a lesser extent, Chinese companies cope with double taxation risks in light of the fact that China and Taiwan do not have a mutual tax agreement and, for that matter, do not recognize each other diplomatically.

The bilateral APA process requires a minimum of four stakeholders: both tax administrations and each associated multinational enterprise. The APA process might well become confrontive between a tax administration and its multinational enterprise, but the confrontive nature between two nation-states in the APA process is a different matter entirely. The multinational enterprise in such a situation is well advised to have separate tax counsel from its counterpart.

WantChinaTimes.com (Knowing China through Taiwan) reported on September 8, 2011, that Procter & Gamble (P&G) signed on September 8 a trilateral APA with Taiwan’s Ministry of Finance and with Singapore’s tax authority. Similar to other APAs, the purpose of this APA is for P&G to avoid paying cross-border taxes twice. The author of this piece, Wang Shin-Ren, reports that the conclusion of the APA may lead to “other international companies doing business with Taiwan and negotiating similar pacts.” Whether this approach will see the end of Taiwan’s diplomatic isolation remains to be seen.

SEF and ARATS are not now well positioned to represent specific multinational enterprises in the APA process. Nevertheless, as Taiwanese–China relations continue to improve, SEF and ARATS are likely to attune themselves to tax considerations.

NOTES

1. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (July 22, 2010), 2.109.

2. Guideline 1.9.

3. Guideline 2.2.

4. Guideline 2.109.

5. Guideline 2.126.

6. R. Feinschreiber and M. Kent, “Reporting Related-Party Transactions in China,” Corporate Business Taxation Monthly (July 2009): 37.

7. R. Feinschreiber and M. Kent, “Taiwan’s Transfer Pricing System,” Corporate Business Taxation Monthly (July 2009): 33.

8. Guideline 1.9.

9. Guideline 2.109.

10. Guideline 1.9; Guideline 2.109.

11. Guideline 1.9.

12. Guideline 2.10.9

13. Guideline 2.2.

14. Guideline 2.135.

15. Guideline 2.135.

16. Guideline 2.136.

17. Guideline 2.138.

18. Guideline 4.139.