Abstract: In recent years, the Customs has frequently conducted price inspections on whether enterprises make omissions in the report of taxable royalties and whether the special relationship between multinational companies affects the transaction price of imported goods. Due to the characteristics of the organizational structure of multinational companies, they may face price inspection on royalties and special relationships (hereinafter called “two specials” in this note) conducted by the Customs at the same time. If it is not handled properly, the enterprise will pay a heavy price. Based on this, this note briefly introduces the status of Customs “two specials” price inspection, sorts out common misunderstandings, compliance risks and legal liabilities in practice, and puts forward suggestions on how enterprises should effectively handle the issues.

Keywords: Customs price inspection, royalties, special relationship, compliance response

In recent years, royalties and special relationships have been a focus area for Customs price inspection. Based on the professionalism and complexity of the “two specials”, in the process of price inspection, Customs often carries out both the general investigation in the early stage, and the special inspection in allusion to the target industry, enterprise or key products by grasping the preliminary evidence of tax evasion. What makes it more difficult for enterprises to respond to compliance is, based on the particularity of multinational companies themselves, the Customs will likely not only investigate whether they make omissions in the report of taxable royalties, but also dig deeper into whether the special relationship and transaction price policies between affiliated enterprises affect transaction price. Thus, how should enterprises respond to the “two specials” Customs price inspection?

(I) The meaning of royalties and special relationships in Customs determination of dutiable value

1. Royalties

Royalties shall mean fees paid by the buyer of imports to an intellectual property rights holder or persons duly authorized by the rights holder for licensing or transfer of patent rights, trademark rights, proprietary technologies, copyrights, distribution rights, or selling rights.

2. Special relationship

In addition, where the buyer and the seller are related in business or one party is the sole agent, sole distributor, or sole transferee of the other party and satisfy the provisions of the preceding paragraph(s), they shall be deemed to have a special relationship.

(II) Status Quo of “two Specials” Customs Price Inspection

1. In recent years, the Customs has continuously increased the voluntary declaration obligation of enterprises with price declaration elements by improving the system and regulations.

In March 2016, the Customs revised the specifications on Completion of the PRC Customs Declaration Form for Imports and Exports, added the filling specifications for items such as “confirmation of special relationship”, “confirmation of price impact” and confirmation of payment of royalties. Since then, the Customs has issued a lot of interpretation and guidance on how to fill in the price information such as special relationship and royalties.

Based on the past information, we can conclude that, in addition to improving the system, increasing the interpretation of normative documents, and guiding corporate conducts, the Customs continues to increase the intensity of general research and special price inspections which focus on whether the enterprise declares the “two specials” information truthfully, accurately, and comprehensively or whether there is false price declaration, tax omission, etc.

2. For enterprises, increasing voluntary declaration obligations means more compliance risks and legal liabilities.

The revision of the specifications on Completion of Customs Declaration Form emphasizes the obligation of enterprises to actively declare price information including “two specials” to the Customs in a truthful, accurate and comprehensive manner in the Customs clearance process. It also provides reference evidence for the Customs to clarify facts and define liabilities in stage such as inspection, administrative investigation, and criminal investigation.

For example, during the inspection, the Customs found that an enterprise paid taxable royalties to the overseas parent company, but when checking the import declaration form of the goods involved, it found that the item “Confirmation of payment of royalties” was filled in as “No”. This information proves that the enterprise has made a declaration error, and more seriously, it will provide evidence reference for the subjective intention of the Customs to determine that the enterprise has deceived the price.

3. Once the Customs starts a “two specials” special inspection on an enterprise, it is usually not whether to pay the tax, but how much tax to pay, or even whether to transfer cases to Customs anti-smuggling department for case handling.

The reason for the above situation is:

First, the special inspection is different from regular inspection. A special inspection is an inspection initiated by the Customs on the target industry, enterprise or key products after the Customs has obtained preliminary evidence through conducting peripheral investigations.

Second, with the long-term implementation of the “two specials” price auditing matters, the Customs has accumulated abundant price data, risk parameters and successful inspection experience in both theory and practice. For example, the Customs has successively conducted special inspections on target industries or products such as automobile parts, machineries, medicines, and medical apparatus and instruments. These inspections have further enriched the Customs price database and risk parameters, thereby facilitating deeper and broader investigations. Furthermore, with the improvement of information technology and big data applications capabilities, Customs can more accurately determine targets and launch raids.

(I) Common misunderstandings and brief comments

Misunderstanding 1: Customs inspections for royalties and special relationships do not happen at the same time.

Some enterprises managers subjectively believe that the Customs inspection of royalties and special relationship are two distinct issues. When the Customs inspects one, they will not inspect the other, especially in the same inspection process.

Comment:

The Customs’ “two specials” inspection is essentially a price inspection. The core is to examine and verify the authenticity and legitimacy of the price declarations by the enterprise. Maybe the Customs started the price inspection to find out whether the enterprise has underreported taxable royalties, but it does not rule out the possibility that the Customs suspected that the special relationship affected the transaction price during the investigation process. Thus, whether the special relationship affected the transaction price is also included in the price inspection.

Misunderstanding 2: Handle royalties and special relationship separately.

This is a logical continuation of misunderstanding 1 since enterprise operators subjectively believe that the Customs will not conduct inspection on royalties and special relationships at the same time. Thereby when the Customs conducts a price inspection on one of them, it will deal with the issue separately and adopt a single response strategy one by one.

For example, a Chinese subsidiary of a multinational companies was notified by China Customs to conduct a royalty price inspection. The company used the inter-affiliate transaction price policy to explain the legitimacy of not reporting taxable royalties for strategic reasons. The logic behind this approach may be A and B are independent of each other, and Customs inspect of A means that B will not be inspected. If the enterprise uses B which is more complex as the reason to explain A, then the Customs may not inspect B again. Guess whether Customs will stop there?

Comment:

Based on the above situation, in a high probability, the Customs believes that since B is the cause of A, it needs to explain B in detail and provide evidence to prove it. All in all, for affiliated enterprise, it is not impossible to use transaction price to explain that royalties should not be included in the dutiable price. Rather, if this is the case, then enterprises need to provide detailed transaction price information to justify their claims. More importantly, the transaction price material itself is scrutinized.

Misunderstanding 3: Risk assessment and compliance response are only carried out from the perspective of various departments within the enterprise, resulting in different stages of external responses and submitted evidence and materials that hinder each other.

A common situation is that, in the initial interpretation, legal affairs, taxation, compliance, finance departments of the enterprise explain the “two specials” issue to the Customs according to the conventional thinking of dealing with tax authorities. With the advancement of the Customs investigation, the compliance and audit departments of the enterprise have stepped in one after another, and the external responses and submitted evidence materials at different stages are constrained by each other, making it more difficult for the enterprise to respond to the Customs inspection. In the investigation process, the enterprise emphasizes the form over the content. Either the audit report submitted to the tax authority is submitted to the Customs as it is, or although a third-party agency is entrusted to issue a special audit report on royalties or transfer pricing, the report has reservations about Customs and sidesteps the concerns of the Customs. This obviously will not be accepted by Customs.

Comment:

Tax authorities and Customs have different starting points and supervisory points for reviewing transaction price. On the surface, some of them are contradictory, which requires enterprises to start from the overall interests of the group, consider the regulatory requirements of all parties and formulate strategies. In the process of responding, legal affairs, taxation, compliance, finance, and other departments within the enterprise should pay attention to communication, cooperation, and coordination to avoid constraints and internal frictions caused by poor communication and personnel changes.

In addition, it is specially reminded not to use the audit reports of third-party institutions that avoid answering key questions as “urgent hedging”, hoping to “endorsement” the compliance of royalties or transfer pricing. Usually, the possibility of such reserved audit reports being accepted by the Customs is very low, and it may also become evidence for further in-depth inspections by the Customs.

Misunderstanding 4. Some companies have the gambling mentality of “I don't provide transfer pricing information and you can do nothing about it”.

Back to the previous example. Enterprise use transaction price material to justify royalties for strategic reasons. The reason behind this may be that the enterprise believes that since the transaction price is an internal price between multinational companies, if the enterprise does not provide documents, the Customs cannot find the test price, and the inspect may stop there.

Comment:

The transaction price system embodies the conflict game between multinational companies’ pursuit of overall tax minimization and state agencies’ tax interests. In layman’s terms, transaction price is the internal transaction price used to transfer goods, intangible property or provide services between affiliated enterprises of a multinational group, and it needs to comply with the principle of fair trade and Customs price review regulations.

With the Customs risk control capability, price information, and inspection experience becoming more and more abundant, confronting Customs price inspection on the grounds that relevant information cannot be submitted will lead to great compliance risks and bear corresponding legal liabilities. Therefore, do not take legal liabilities as a bet, and enterprise can’t afford to lose on compliance issues.

(II) Legal liabilities

Previously, in “Customs Notes 3: Those Things About Customs Price Inspection”, we gave a detailed introduction to the possible legal liabilities of Customs price inspection. Here we only briefly summarize the content related to this issue.

1. Recover tax. If the Customs do not recognize the transaction price declared by the enterprise, it will use other valuation methods to evaluate the value and make up the tax; or the Customs will determine the amount of tax to be repaid according to the taxable royalties determined by itself.

2. If the Customs believes that the enterprise is suspected of illegal or even smuggling, it will be transferred to the anti-smuggling department for further investigation and handling. If it is determined through investigation that it constitutes a violation of Customs supervision regulations or smuggling, administrative punishment will be imposed in accordance with the Implementation Regulations of Customs on Administrative Penalties. If a crime is constituted, criminal liabilities shall be investigated according to law.

3. If the enterprise refuses to provide transaction price information, etc., it may also be identified as not cooperating with the Customs inspection and thus bear relevant legal liabilities. In light cases, they will be ordered to correct within a time limit and imposed a fine; in serious cases, the Customs shall revoke the declaration registration of the inspected person; the direct accountable person(s)-in-charge and other directly accountable personnel shall be subject to a fine ranging from CNY 5,000 to CNY 50,000; where the case constitutes a criminal offence, criminal liability shall be pursued in accordance with the law.

(I) The basis is overall planning and ex-ante prevention system.

When it comes to “two specials” issues, when an enterprise signs an intangible asset agreement with its parent company, it should try to clarify the type and scope of intellectual property rights involved, and clearly agree on the scope of goods related to intellectual property rights, preferably in the form of a list. The composition and basis of the accrual ratio of royalties should also be clarified. This can provide evidentiary support for the apportionment of subsequent taxable royalties. At the same time, transaction price guidance documents should also be properly prepared, with particular attention to the selection of transfer pricing methods should be reasonable and mutually corroborated by evidence from all parties.

In addition, pay attention to complying with Customs regulations during the import declaration of goods. Enterprises should truthfully, comprehensively, and accurately declare information on royalties and special relationship prices. Especially because the royalties often have the characteristics of deferred payment, it is necessary to pay attention to the consistency of the declaration information.

(II) When a problem is found, the emergency plan should be activated immediately, and the coordination between various departments should be carried out.

When an enterprise finds that there may be the risk of “two specials” Customs price inspection, on the one hand, internally, the enterprise should initiate risk assessment and emergency plan as soon as possible, and the legal affairs, taxation, compliance, finance, and other departments should communicate, cooperate and coordinate, and give full play to the work independence of the compliance department (position) in the process of emergency response and error correction. and priority principle. On the other hand, externally, enterprises must consider Customs, taxation, and compliance requirements of domestic and foreign jurisdictions.

(III) Once inquired or inspected by the Customs, consult or invite professionals to assist with handling issues as soon as possible.

Businesses should be sensitive to Customs inquiries or inspections. Once it occurs, immediately consult or request professional lawyers to intervene, so as to accurately determine the problem and the current risk point and take countermeasures in a focused manner to prevent the problem from escalating due to untimely response or delay the best stop loss timing.

In addition, if an enterprise uses an audit report issued by a third-party agency to support its own arguments, it is not appropriate to submit the report to the tax authority directly to the Customs. Instead, it is necessary to organize and provide information from the perspective of Customs price inspection, and fully demonstrate and respond to the issues concerned by the Customs, and provide strong evidence support at the same time.

(IV) Ensure that information is retained and archived and pay attention to consistency when accepting investigations or submitting evidence.

In practice, due to corporate mergers and acquisitions, position adjustment, employee resignation and other reasons, important materials or information on matters are missing, and companies must bear the adverse consequences of proof. Therefore, although data retention and archiving are common issues, enterprises should pay attention to them.

In addition, when enterprises accept Customs inquiries or inspection and submit evidence materials to Customs, they must ensure that the information and materials can confirm and support each other.

1. Due to the particularity of their organizational structure and business operations, multinational companies may be involved in special relationships and Customs pricing of royalties. In practice, cases where the Customs conducts price audits of “two specials” against multinational companies at the same time also occur from time to time. Sometimes the Customs conducts inspection with one of the objectives as the goal, and as the inspection progresses, it leads to the inspection of another issue.

2. In the stage of the Customs’ evaluation of the “two special” price declarations, it is particularly important whether the enterprise can respond in a timely and proper manner and dispel the Customs’ doubts. Once the response is not timely or inappropriate, it may lead to further in-depth inspections, and even turn into administrative and even criminal cases.

3. In terms of coping principles, first, multinational companies need to make overall planning from the perspective of the group, considering the regulatory requirements of all parties; second, the legal affairs, taxation, finance, compliance, and other departments of the company should take their own responsibilities and cooperate with each other, and at the same time, pay attention to the priority and independence of the compliance department in the compliance mechanism; the third is to establish and improve the internal compliance mechanism, set a warning red line. Once the red line is touched, the emergency plan will be activated immediately, and external experts will be invited to intervene in a timely manner to avoid delaying the opportunity and expanding losses.