Circular number 363 issued by the China State Administration of Taxation (SAT) [titled Strengthening the Monitoring and Investigation of Cross-Border Related Party Transactions, Guo Shui Han [2009] number 3637 / 6 / 09] is short (just 441 Chinese characters or about half a page) and fuzzy (the year to which it applies is unspecified), but it has upended traditional approaches to transfer pricing documentation and vastly extended the documentation burden. In circular 363, the SAT has staked out a position that loss-making in limited-function enterprises is transfer pricing manipulation and has shifted the burden of proof to the taxpayer. The issuance of circular 363 places multinationals in a catch 22 situation; loss-making entities must prepare documentation but excuses are not acceptable.

Given this conundrum what can a taxpayer do? Many multinationals do not appreciate the tightness of the net that is being drawn around loss-makers.

A new documentation burden
Having already assessed how many entities need documentation, taxpayers in China got an unpleasant surprise in July when circular 363 was issued requiring limited-function enterprises to prepare documentation even if they fall below the relevant thresholds. Such entities must file documentation for the year in which any loss occurred by June 20 of the following year. Exacerbating the risk, other circulars issued by the SAT (such as circulars 85 and 114) indicate that there will be an increase in nationally coordinated investigations, regionally coordinated investigations and industry-coordinated investigations .

Historical background on loss-makers
In China, loss-makers have always been in the bulls-eye. In 1998, circular 59 specifically identified loss-making entities as the principal targets for audits. In 2001, an unofficial SAT release indicated that approximately 60% of foreign investment entities (FIEs) were in a loss, thus adding fuel to the audit fire. But nothing much happened, because local authorities lacked confidence and contented themselves with collecting value added tax (VAT) and business tax (BT).

SAT boxes in taxpayers
Compounding the problem is that in a number of key areas, the SAT has departed from the OECD guidelines and boxed in the taxpayer with a number of unusual provisions as specified in the landmark circular 2 issued earlier this year [Implementation Measures for Special Tax Adjustments, Guoshuifa [2009] number 2, State Administration of Taxation]. International tax directors need to be away of several specifics, including: