CHINA'S tax man is taking unprecedented steps to strengthen inspection and bolster enforcement in an effort to crack down on tax manipulation that is depleting government coffers in a year of tight finances.

The State Administration of Taxation has started nationwide audits on some of the nation's most profitable businesses - initially singling out highway construction firms and tire manufacturers, according to a reliable source familiar with the issue.

The tax body has also issued tighter rules related to transfer pricing that have placed multinational companies in the crosshairs.

"The tax authorities are taking an assertive position on tax inspection and other related anti-tax avoidance initiatives," said Jessica Tien, an Ernst & Young tax partner in Shanghai. "More enforcement initiatives are likely to be rolled out later this year."

Economic slowdowns shear government tax collections. China's tax revenue in the first seven months of this year dropped 3.5 percent from a year earlier to 3.55 trillion yuan (US$519.8 billion). Total revenue in that period, buoyed by some gains in the last three months, slid 0.5 percent to 4.07 trillion yuan.

China, which has announced a 4 trillion yuan economic stimulus package for the two years ending 2010, is intent on minimizing declining revenue needed to pay for it.

In July, SAT issued Guoshuihan (2009) 363, an internal tax notice to all state tax bureaus nationwide, which tightens the definition of single-function operations of MNCs in China - an initiative aimed at transfer pricing manipulation.

Transfer pricing refers to the allocation of prices when goods or services are exchanged within a large business, whether among divisions in one country or among affiliates in other countries. Manipulation occurs when that allocation is expressly conducted to skew profit and avoid taxes in one or more countries.

The new notice stipulates that the Chinese operations of MNCs are undertaking a single function and thus should not take risks in a financial crisis and must maintain reasonable profits in China when using transfer pricing practices.

The rationale is that such single-function entities didn't enjoy a higher margin in the heydays of an economic boom. So when the global financial fallout came, the entities are also not eligible to report lower margins because of a change in external demand.

Companies involved in distribution and research and development are included in the notice. Previously, only manufacturing entities were cited under the regime.

"China's State Administration of Taxation has formulated a simplistic transfer pricing position on single-function companies to mandate profit from their limited functions," said Tien. "Now that the tax authority position is firmed up, these entities are prioritized as audit targets."

Over-simplified view

If these entities report losses, they must supply documented evidence to Chinese tax authorities showing that transfer pricing practices are business-driven, not tax-driven. If companies fail to do so, the tax body may make adjustments that require additional taxes be paid.

"The new notice has triggered lively discussions in the business community as companies find that the profit mandate in a global economy is often an over-simplification," Tien said.

However, businesses are being advised to follow the rules or possibly face higher compliance costs.

Transfer pricing may be regarded by the tax authorities as a means for companies to avoid taxes by shifting profits to countries with lower tax rates through cross-border-related party transactions. Foreign firms face the most scrutiny because of their frequent cross-border transactions. If a MNC in China is losing money while expanding business with frequent cross-border transactions, it is likely to be the target of an audit.

China has sharpened its focus on tax-driven transfer pricing recently, including devoting a separate chapter of its new corporate tax law to the issue.

"China's tax authorities have been become stricter on transfer pricing audits and the implementation of anti-avoidance measures," said Jeff Yuan, a PricewaterhouseCoopers tax partner.

Yuan said the new documentation requirements mean that the burden of proof will be shifted to companies which will have to pay closer attention to transfer pricing issues.

The tax man has more than one foot in the door. The SAT this year has also issued two notices that require big-name companies in five major industries - banking, insurance, petrochemicals, electronics and telecommunications - to check their tax audit to see whether there is unpaid tax, sources said. The names of the companies have not been made public.

It's the first time China's tax authority has singled out companies for the self-inspection program.

Self-inspection is like a second chance, or grace period, the tax man offers. The tax authorities give companies time to make sure that they have paid all the taxes. If companies voluntarily pay back taxes they admit they owe, penalties will be waived.

Actually, the self-inspection campaign has existed for years as a means to shore up tax income.

"In the past, it seemed more like a procedure than a reality," he said. "However, this year, the tax authorities appear to be taking it very seriously and their determination to collect back taxes is apparent."

The targeted companies are mainly large taxpayers from sectors with high profits or are in industries where tax avoidance has been prevalent.

The tighter measures on tax collection come as China is seeking to increase domestic spending as a hedge against the worldwide recession.

In addition to income tax, the government collects value-added taxes on imports, tariffs, consumption taxes and a stamp duty on stock transactions.

The government fiscal revenue fell in the first four months of this year but recovered in the last three months amid signs the Chinese economy was picking up.

"However, full-year revenue is still tight despite the recent growth," the Ministry of Finance said.

On the debit side, China's fiscal spending in the first seven months of this year climbed 23.5 percent to 3.39 trillion yuan.