U.S. – China Supply Chain: Revisiting Transfer Pricing and Trade Duties Amid COVID-19

May 2020

China’s National Bureau of Statistics reported in April that China’s GDP shrank 6.8% from the prior year in the first quarter of 2020.  Based on a poll conducted by Reuters, analysts expect China’s economic growth to slow sharply from 6.1% in 2019 to 2.5% for 2020.

As the world is going through an unprecedented novel coronavirus (COVID-19) crisis, multinational corporations (MNCs) with cross-border trade or transactions are facing challenges to maintain cash flow, improve liquidity, control profit decline and mitigate losses caused by demand and/or supply shocks.  
 

Review Current Transfer Pricing Policy

MNCs with operations in China have traditionally employed a classical supply chain model involving a contract manufacturer (CM), toll manufacturer (TM), or limited risk distributor (LRD) in China, depending on the type of their Chinese operations.  

Under such supply chain model, the Chinese CM, TM or LRD normally maintains a fixed (albeit limited) profit level coupled with limited risks.  The offshore principal often reaps greater rewards or bears losses commensurate with the greater economic risks borne. 

Since China started a nationwide shutdown in early February as part of its COVID-19 containment measures, its manufacturing output dropped significantly, as evidenced by the sharp decline in the Purchasing Managers’ Index (PMI) of China in February.  As China’s economic activities have resumed recently, other countries around the world are taking an economic hit, causing a reduction in consumer demand.  MNC’s sales have significantly shrunk in the past months and certainly are at great risk of further decline with the global pandemic. Meanwhile, the effort of Chinese enterprises to resume production has been slow due to continued virus containment requirements and shortages of workers and supplies.

The combined effects of a two-month shutdown, sluggish resumption of production capacity, and suppressed global demand could severely impact the overall profitability of MNCs, which may now need management to review the limited-risk supply chain model for the Chinese CM, CM or LRD.  

For a CM or a TM that is typically guaranteed a fixed cost plus mark-up, the cost plus compensation may no longer be considered reasonable and sustainable, since the arrangement may overburden the principal.  In the current situation, these structures should be reviewed to determine how declines in profit (or losses) should be shared between the CM, TM and principal.

Similarly, for an LRD that is typically guaranteed a fixed profit margin while the principal absorbs the gains and losses from changes in the business or economic climate, it may also be necessary to review the current structures and determine how declines in profit (or losses) could be shared between the LRD and the principal in the current economic environment.

MNCs should consult their transfer pricing advisors to assess whether and how to maintain and adjust their current transfer pricing systems, taking into account the current economic climate, tax consequences, and risks in both countries while balancing the impact on the group’s overall tax liability. In addition, considering that the Chinese tax authorities have required stable profit margins for CM, TM and LRD, which is stipulated in the prevailing China transfer pricing rules, an adjustment to an MNC’s transfer pricing policy to reduce the profit allocated to China faces uncertainty. It is suggested that MNCs seek proactive communications with Chinese tax authorities or engage professional tax advisors to assist with such communications if the MNCs would like to implement transfer pricing policy adjustments.  
 

Review Import and Export Duties and Taxes

Since 2018, the U.S. and China have respectively increased import tariffs on goods imported from the other country.  Most notably, the U.S. has imposed tariffs on more than $360 billion of Chinese goods, and China has retaliated with tariffs on more than $110 billion of U.S. products.  These tariffs have increased the cost for businesses in both countries to engage in cross-border trade. 

On January 15, 2020, the U.S. and China signed the “phase one” trade deal under which the U.S. agreed not to impose tariffs on $160 billion of Chinese imports (including popular consumer items such as cellphones and laptops) and reduced the tariff rate on another $120 billion worth of goods from 15% to 7.5%.  In return, China’s retaliatory tariffs, including a 25% tariff on U.S.-made autos, have also been suspended, among other concessions made by China.  After signing the phase one trade agreement, the trade negotiation of phase two agreement was put on hold under the global outbreak of COVID-19 crisis.

Meanwhile, in response to the COVID-19 pandemic, the U.S. has temporarily exempted a range of Chinese health and medical products, including sanitary wipes, medical gloves, face masks, surgical gowns, and other items from Section 301 duties.  Notably, these medical exclusions are retroactive to the imposition of the tariffs, with the starting date varying based upon the applicable list at issue. This opens up the opportunity of seeking refunds of these Section 301 duties back to the original imposition of the duties, providing a potential source of liquidity for businesses.  Moreover, the U.S. Trade Representative (USTR) likely will continue to grant numerous medical exclusions.   

Businesses in the impacted sectors should regularly monitor the USTR website for potential future exclusion developments.  As the USTR generally issues exclusions on a rolling basis, early submission of requests can result in earlier duty savings and better cash flow.

The Chinese customs and tax authorities have also taken measures to provide certain tax relief in response to COVID-19.  Based on the most recent customs duty relief announced in China, qualified goods imported from the U.S. during the period from February 28, 2020, to February 27, 2021, are added to the exclusion list for the additional retaliatory tariffs against the U.S. Section 301 duties.  In addition, donations used for epidemic prevention and control are exempted from import duties, import VAT, and consumption tax.

Last but not least, U.S. companies that import goods from Chinese related parties should also consider how the aforementioned transfer pricing adjustments to prices may affect the import duties.  It is important to take action before importation to align the income tax and customs approach to mitigate the impact of any transfer pricing adjustment.

U.S. companies with Chinese operations should carefully review the continuing development of COVID-19 relief measures in both countries to identify how it will impact them. Please contact your client service professionals for the latest COVID-19 updates and discuss the appropriate course of action to manage the business impacts of COVID-19.

For more information: Visit the BDO Global COVID-19 Crisis Hub for the latest guidance and advice for businesses and individuals across the globe. Prepare your business for the impacts of COVID-19 by staying up to date on the latest insights and events in the United States.
 

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