What is the Right lmport price for a Flce

Foreign companies are starting to establish wholly-ownedtrading companies in China to import and distribute products tothe domestic market. The trading company is called a ForeignInvested Commercial Enterprise (FICE) and has been gainingpopularity since late 2004 when the limitation on foreign-ownedcompanies trading in China was lifted. In the short time sincethis change a number of developments in the new trading modelare starting to appear. One such trend is for the FICE to assumenew roles， risks and responsibilities previously managed byanother party， acting as the distributor in China. This party couldhave been operating overseas or be established in China.

As the FICE takes on these new roles， it is important theyearn a reasonable return on their activities. In order to do so，some c ompanies may decrease the import price to compensatefor the increased workload and expenses to be incurred. Someorganizations， such as Customs， may request the FICE to explainthe basis of the reduction and support the new declared prices.Some companies are prepared with sound reasoning behind theprice reduction， while other companies struggle to sufficientlysupport the price drop.

But what is the right import price for a FICE or how much ofa price decrease， if any， is warranted? This will depend on anumber of factors such as the factors present in the restructuring，the level of activities transferred to the FICE and where theseare transferred from， among others. Each must be analyzed ona case-by-case basis due to the variations in the restructuringplans of every company.

We will discuss in greater detail the establishment of a FICE，transition in the supply chain and how these impact the importprice.

The FICE

Three years after China joined the World TradeOrganization， Decree No. 8 was released. This Decree waseagerly anticipated by foreign companies as it opened up apreviously unavailable avenue of business in China - the import，export and distribution of finished goods by a wholly-ownedforeign enterprise.

A FICE is now permitted to import， export and distributegoods throughout China and can import through multiplelocations. It can conduct sales in RMB. The approved activitiesare specifically stated in the FICE's business license whichshould be as broad as possible. With the creation of such anentity， a foreign company is no longer legally required to utilizea local Partner or other unrelated company to distribute theirproducts in China unless such relationship is consistent withthe company's strategy.

It took some time before the FICE's detailedimplementation guidelines were issued. As a result， manycompanies took a wait and see approach before leaping into anew operating structure. This conservative approach seemedreasonable as the application procedures and customs， VAT，tax and foreign exchange treatment were unclear. These havenow been clarified for the most part.

Currently， many companies have established or areplanning to establish a FICE in China. That is， they are pushingahead to take over the distribution function with their own relatedparty located inside China. Experience shows that some arenot prepared to address the numerous side effects that resultfrom such a restructuring.

Restructuring the Supply Chain

Since foreign companies in China were not permitted toperform the distribution function in China， many employed theservices of an Import/Export Agent (I/E Agent) to facilitate theprocess. Except for those foreign companies established in aBonded Zone， sales in RMB to local China customers wasnot possible.

This was different in many other jurisdictions wherecompanies strive to maintain as much control as possible overtheir supply chain. The distribution function plays a key roleand so companies are restructuring their operations to controlthis area of their business. This restructuring may result inthe FICE taking over the distribution function from the partiespreviously performing this role. These parties usually tookone of more of the following forms:

1. A related or unrelated party located overseas (e.g.Hong Kong or other country);

2. An unrelated party or Partner located in China; or

3. A Bonded Zone trading company (e.g. a WaiGaoQiaoTrading Company).

For the remainder of the article we have focused only on#1 (the change from an overseas distributor to an onshoredistributor) as it illustrates the most dramatic change andtypically has the largest impact on the import price. Thefollowing flowchart illustrates this transition:

The FICE assumes the roles， risks and responsibilitiesof the distributor and becomes the official importer of the goodsinto China. In most cases， additional responsibilities， such asplanning， marketing， promotion， may also be transferred aspart of this restructuring. The number of staff can increasewith the workload. Obviously， the FICE's new cost structurewill differ from the previous distributors but the FICE must beable to cover its costs and earn a reasonable profit. What isthe appropriate pricing strategy to achieve this?

It is difficult to say and one size does not fit all. Thedecision may be accompanied by a detailed transfer pricingand customs valuation analysis. This is especially true whentransactions are conducted between related parties as theyare open to more scrutiny by both the Tax and Customsauthorities. Unfortunately， this analysis is overlooked manytimes and the impact on the customs values is not considereduntil very late in the implementation process.

The Problem

In any restructuring a certain amount of change isunavoidable. The FICE trading modet is no exception and theimpact on the transfer prices and customs values of importedgoods can be significant. Based on a 2006 survey conductedby Ernst Young's Customs and International Trade Practiceof 89 importers， supply chain restructuring and transfer price/customs value were cited as two of the top issues companiesbelieve they will face with Customs in the future. Both issuescan be present when comp'anies restructure the distributionfunction by establishing a FICE.

Previously， the distribution function may have beenperformed overseas and the value for these services (i.e. thedistributor's margin) was included in the cross-border valuedeclared to Customs. In the case of an unrelated distributor inChina， they may have earned a lower， or limited， margin asfewer functions were performed than a related party distributor.Again， the value for the overseas portion of services wasincluded in the customs value.

The trend we are seeing is that the some customs valuemay decrease when a FICE becomes the distributor. A pricedecrease from the restructuring may be reasonable andexpected because the distribution function has been movedonshore and the FICE has more responsibilities for which ismust be compensated. But how much of a decrease iswarranted and why? This requires careful consideration andanalysis.

A transfer pricing (TP) study may be conducted as part ofthe restructuring. The TP study is conducted based onanalyzing financial results of comparable companies on anannual basis according to tax requirements and based onOECD guidelines. For TP purposes， irrespective of individualproduct or transactional pricing， if the annual profitability resultsare within a range of comparable companies， then thetransactions as a whole may be considered arm length. Thiscan differ with the practice of pricing products for customsvaluation purposes based on the WTO Valuation Agreement.

For customs valuation purposes， each transaction shouldbe reviewed individually to ensure it covers the seller's costsplus a reasonable margin. This is because different productshave different duty rates and the customs rules are structuredin such a way to discourage companies from shifting higherChina margins to high duty products and lower China marginsto Iow duty products. When analyzed， many times companiesdiscover that the methodology applied to product-level pricingdiffers from the methodology determined for TP purposesbecause of various commercial circumstances for product lines.

In such a restructuring， Customs would observe a drop inprice (and revenue) at the same instant when the importerbecomes a related party. The natural reaction is to questionwhether the relationship has influenced the price and if the pricedecrease is too high. In China， there may also be similarsituations.

Customs in many countries (including China) may be， aswe speak， challenging importers when such a price drop isnoticed. They are issuing more valuation queries requestingthe importer to support the assertion that the related partyrelationship did net influence the prices. To explain theappropriateness of the new prices， the importer may describethe pre and post-restructuring supply chain， illustrate what haschanged and preferably provide objective and quantitative data.Such data will greatly enhance the effectiveness in explainingand supporting the price changes resulting from.the restructuring.

Conclusion

What to de if a FICE trading model is implemented and theimport price will decrease?

This issue is likely to impact all who have， are or willimplement a FICE to import and distribute goods locally in China.The ramifications must be considered during the planning phasesto prepare robust supporting documentation and explanationsas part of the transition plan. Without proper planning you mayfind the supply chain disrupted.

Is it better to consult Customs prior to implementing thereductions or implement the price change and wait for them torequest an explanation? There is no easy answer to thesequestions. But， companies can proactively approach Customsto discuss the impact the restructuring will have on import prices.This discussion can facilitate both parties' understanding of therestructuring and work to prevent clearance delays. Closercooperation with Customs may help smooth the transitionprocess.

The areas of supply chain restructuring and customs value/TP are difficult issues in their own right. But when coupledtogether they present an even greater challenge to companiesand to China Customs. As a result， careful consideration andanalysis will be required by both parties to ensure the pricechanges are appropriate and supportable.