US Subsidiary of Chinese Company: 29 Compliance Questions Answered
- Jeff Chang
- Jan 10
- 13 min read
If you're running a US company that's majority-owned by a Chinese parent, you're navigating one of the more complicated business structures in international commerce. The IRS watches your pricing. Customs scrutinizes your import values. And you, as an officer or director, carry personal exposure that most people don't fully appreciate until something goes wrong.
These are the questions I hear most often from clients in this situation. They're not theoretical. They come from real conversations with people trying to do things correctly while building a business.
Transfer Pricing and IRS Compliance
The Chinese parent sells products through our US subsidiary. How do we set prices between the two companies correctly?
The IRS requires that transactions between related parties be priced as if the companies were dealing at arm's length, meaning what unrelated parties would agree to in similar circumstances. This is governed by Internal Revenue Code Section 482.
For a US subsidiary buying products from a Chinese parent, this typically means the transfer price should allow the US company to earn a profit margin consistent with what independent distributors earn in your industry. The IRS provides several approved methods: comparable uncontrolled price, resale price, cost plus, comparable profits, and profit split. Which method fits depends on your specific facts, available comparable data, and the functions each entity performs.
Getting this wrong isn't just a paperwork problem. The IRS can reallocate income between the entities, assess back taxes, and impose penalties up to 40% of any underpayment.
When a Chinese parent owns most of the US company, does the IRS scrutinize pricing more closely?
Yes. The IRS pays particular attention to US subsidiaries of foreign parents because income shifted out of the US reduces US tax revenue. Foreign-controlled domestic corporations file Form 5472 annually, disclosing reportable transactions with foreign related parties. This gives the IRS visibility into your intercompany dealings.
Certain patterns attract additional scrutiny: US subsidiaries that report losses year after year, pricing that results in minimal US taxable income, or significant payments to the foreign parent for services, royalties, or management fees. If your US company consistently shows little profit while the Chinese parent thrives, expect questions.
What documentation do I need to show our intercompany pricing is legitimate?
The IRS expects contemporaneous documentation, meaning records created at or near the time you set your transfer prices, not assembled years later during an audit. At minimum, this should include a description of your company's business and organizational structure, an explanation of the pricing method you selected and why, an economic analysis showing your pricing produces arm's length results, and any contracts or agreements between the related parties.
Having proper documentation doesn't just help during an audit. It can reduce or eliminate accuracy-related penalties if the IRS does challenge your pricing. Without documentation, you're exposed to penalties even if your pricing turns out to be reasonable.
Can the Chinese parent charge the US subsidiary for R&D, management, or technical support?
Yes, but only for services actually provided, and only at arm's length rates. The IRS allows intercompany charges for legitimate services, but scrutinizes these payments closely because they're an easy way to shift profits out of the US.
To support these charges, you need documentation showing what services were actually rendered, that the US subsidiary received a benefit from the services, and that the pricing reflects what an unrelated party would pay. Vague management fees or blanket charges without substantiation are red flags. If you can't articulate what the parent did and why it was worth the amount charged, you'll have difficulty defending the deduction.
What happens if the IRS decides our intercompany prices aren't arm's length?
The IRS has authority under Section 482 to reallocate income between related parties to reflect arm's length results. Practically, this means the IRS will increase the US subsidiary's taxable income, resulting in additional tax owed plus interest from the original due date.
Penalties can be significant. A 20% penalty generally applies to substantial valuation misstatements, and a 40% penalty may apply to gross valuation misstatements. The specific thresholds and calculations depend on factors including the size of the adjustment and your company's gross receipts. These penalties can often be reduced or avoided if you maintained qualifying contemporaneous documentation.
The parent wants us to sell at cost initially to build market share. Will that create tax problems?
Potentially, yes. While there are legitimate business reasons to price aggressively when entering a new market, the IRS will question arrangements where the US subsidiary consistently earns no profit. Unrelated distributors don't typically agree to operate at a loss indefinitely.
If you pursue this strategy, document the business rationale, set a defined time period for the market-entry pricing, and establish benchmarks for transitioning to normal pricing. A written agreement between the parties reflecting these terms helps demonstrate that this is a deliberate business strategy, not profit-shifting.
What is a transfer pricing study and do we need one?
A transfer pricing study is an economic analysis that documents your intercompany pricing methodology and demonstrates that your prices produce arm's length results. It typically includes a functional analysis of what each entity does, an industry and economic analysis, selection and application of a transfer pricing method, and a benchmarking study comparing your results to comparable companies.
Whether you need a formal study depends on the size and complexity of your intercompany transactions. For substantial ongoing transactions, a study provides significant protection. It satisfies the documentation requirements that reduce penalties and creates a contemporaneous record of your analysis. For smaller operations, a less formal but still documented approach may suffice. The cost of a study should be weighed against your exposure if the IRS challenges your pricing.
Customs and Importing
When our US company imports from the Chinese parent, what value do we declare to customs?
Customs valuation for related-party transactions is governed by different rules than transfer pricing, though the concepts overlap. The primary method is transaction value, the price actually paid or payable for the goods. However, when buyer and seller are related, Customs and Border Protection (CBP) will examine whether the relationship influenced the price.
You may need to demonstrate that your transaction value closely approximates the transaction value in sales to unrelated buyers, or that it produces acceptable results under test values like deductive value or computed value. Many importers use their transfer pricing analysis to support customs valuation, but the standards aren't identical, so the analysis may need adjustment.
What if CBP thinks we're undervaluing imports to pay less duty?
If CBP determines that your declared value is too low, they can assess additional duties plus interest from the date of importation. Under 19 USC 1592, penalties vary based on the level of culpability (negligence, gross negligence, or fraud) and whether there was an actual loss of duties. Maximum penalties can range from a percentage of the dutiable value up to the full domestic value of the merchandise, depending on the circumstances. CBP may also increase scrutiny of future shipments, potentially delaying clearance and increasing compliance costs.
CBP may also increase scrutiny of future shipments, potentially delaying clearance and increasing compliance costs. In serious cases, CBP can issue penalty claims that take years to resolve.
I think we made mistakes on past customs entries. Should we self-report or wait?
Generally, self-reporting through a prior disclosure is advisable if you've discovered errors. Under CBP's prior disclosure process, if you voluntarily notify CBP of a violation before they discover it, maximum penalties are significantly reduced. You'll still owe the unpaid duties plus interest, but penalty exposure drops substantially.
Waiting and hoping CBP doesn't notice is risky. If CBP discovers the errors through an audit or investigation, you lose the prior disclosure benefits and face higher penalties. The decision involves judgment calls about the nature and scope of the errors, but the prior disclosure framework generally favors proactive disclosure.
We're bringing demo equipment to a trade show. Do we have to pay full duties?
Not necessarily. Temporary Importation Bonds (TIB) allow you to bring goods into the US for specific purposes, including trade shows, demonstrations, and testing, without paying duties. The goods must be exported or destroyed within one year, with possible extensions up to three years total.
You'll need to post a bond, typically 110% of the estimated duties, and comply with the terms. If the goods aren't exported timely, you'll owe liquidated damages (often double the duties) plus potential penalties. TIBs require careful tracking and documentation to ensure compliance.
Can we route shipments through a third country to reduce China tariffs?
Transshipment alone doesn't change country of origin. Simply routing goods through Vietnam, Malaysia, or another country without substantial transformation doesn't make them Vietnamese or Malaysian goods. CBP determines country of origin based on where the goods were substantially transformed, not where they were last shipped from.
Attempting to evade duties through false origin claims is a customs violation with serious penalties, including potential criminal liability. If you're considering restructuring your supply chain, the manufacturing operations, not just the shipping route, need to genuinely shift.
How much extra are we paying because of China tariffs? Are there legal ways to reduce this?
Products from China currently face multiple layers of duties that vary significantly by product category. The tariff landscape has changed rapidly and continues to evolve, so current rates should be verified for your specific products. Generally, Section 301 tariffs, fentanyl-related tariffs, and other measures may stack, creating combined duty rates that can be substantial for certain product categories.
Legitimate tariff reduction strategies include tariff engineering (modifying products to qualify for lower-duty classifications), first sale valuation (using the manufacturer-to-middleman price rather than middleman-to-importer price as the customs value), duty drawback (recovering duties on imported materials that are later exported), and foreign trade zones (deferring or reducing duties through FTZ procedures). Each strategy has specific requirements and limitations. Some may not apply to related-party transactions without additional documentation.
Corporate Governance and Personal Liability
I'm a director of the US subsidiary but the Chinese parent makes most decisions. What's my personal exposure?
As a director, you owe fiduciary duties to the US company, not to the parent. These include the duty of care (making informed decisions) and the duty of loyalty (acting in the company's best interest, not your own or a third party's). The fact that the parent controls the board doesn't relieve you of these obligations.
If the parent directs actions that harm the US subsidiary or its creditors, and you simply go along without independent judgment, you can face personal liability. This is particularly acute if the US company becomes insolvent, when creditors may look to hold directors accountable for decisions that benefited the parent at the subsidiary's expense.
How do I protect myself when the parent company controls the board?
First, ensure the company's governing documents include robust indemnification provisions and that the company maintains directors and officers (D&O) insurance. Delaware law, which governs many US corporations, allows broad indemnification for directors acting in good faith.
Second, document your decision-making process. When approving related-party transactions, ensure the record reflects that you considered the transaction's fairness to the US company, not just the parent's wishes. If you have concerns about a proposed action, state them on the record. If you're being asked to approve something you believe harms the US company, you may need to dissent or resign.
What documentation do I need when approving transactions between the US company and the Chinese parent?
Related-party transactions require heightened procedural protections. Best practices include written board resolutions specifically approving the transaction, documentation of the terms and why they're fair to the US company, any independent analysis or third-party input (such as valuations or market comparisons), disclosure of any conflicts of interest, and where possible, approval by disinterested directors or shareholders.
This documentation matters most if the transaction is later challenged. A well-documented record showing that the board exercised independent judgment and considered the subsidiary's interests provides significant protection.
I'm basically the only US-based officer. How do I properly document corporate decisions?
Even a one-person operation needs to maintain corporate formalities. Hold regular board meetings (at least annually, quarterly is better), keep written minutes of all decisions, document any actions taken by written consent in lieu of a meeting, maintain separate records for the US company (don't commingle with the parent's records), and ensure required filings (annual reports, tax returns) are made timely.
Failure to observe corporate formalities can lead to "piercing the corporate veil," which means you or the parent lose the liability protection the corporate form normally provides. This becomes critical if the US company faces claims it can't pay.
Intercompany Agreements
Do we need formal agreements between the Chinese parent and US subsidiary, or can we just operate as one business?
You need formal agreements. From a legal perspective, the US subsidiary is a separate entity regardless of common ownership. Operating as if you're one business, without clear agreements defining the relationship, creates multiple problems.
For tax purposes, the absence of written agreements makes it harder to support your transfer pricing positions. For customs, you'll struggle to document how your transaction value was determined. For liability purposes, blurring the lines between parent and subsidiary can lead to veil-piercing arguments. And for your personal protection as an officer or director, you need written terms that demonstrate arm's length dealing.
Who is responsible if goods are damaged or lost in transit?
This depends on the delivery terms in your agreement. International sales typically use Incoterms to allocate risk. Under DDP (Delivered Duty Paid), the seller (Chinese parent) bears risk until delivery at the US destination. Under FOB (Free on Board), risk transfers when goods are loaded onto the vessel in China. Under DAP (Delivered at Place), the seller bears risk until arrival but the buyer handles import clearance.
Your intercompany agreement should specify which Incoterms apply and address insurance requirements. Without clear terms, disputes about who bears a loss can damage the business relationship and create accounting complications.
How does a distribution agreement protect me and the US subsidiary?
A properly drafted distribution agreement establishes the terms on which the US company operates, clarifies each party's obligations and the standards for performance, allocates risk for things like product liability, regulatory compliance, and intellectual property, sets pricing terms that support your transfer pricing position, and defines termination rights and what happens to inventory and customers if the relationship ends.
For you personally, a clear agreement demonstrates that you're operating the US company as a genuine business with defined rights, not simply as an extension of the parent. This supports both the corporate separateness that protects against veil-piercing and the arm's length character that tax authorities expect.
Should intercompany agreements address transfer pricing?
Yes. Your agreements should reflect the economic terms that underlie your transfer pricing analysis. If your transfer pricing method assumes the US distributor performs certain functions and bears certain risks, the agreement should be consistent with that characterization.
Mismatches between your legal agreements and your transfer pricing documentation create vulnerabilities in both tax and customs contexts. Ideally, your transfer pricing advisor and the attorney drafting your agreements should coordinate to ensure consistency.
Sales Contracts with Customers
What should be in our sales contracts when selling equipment to US or international customers?
Commercial equipment sales contracts should address price and payment terms (including currency, payment schedule, and security for payment), delivery terms (Incoterms for international sales), specifications and acceptance procedures, warranties and warranty limitations, limitation of liability and exclusion of consequential damages, intellectual property rights and restrictions on use, installation and training obligations if applicable, governing law and dispute resolution, and compliance with export controls and sanctions.
The appropriate level of detail depends on the transaction value and complexity. For high-value equipment sales, a well-drafted contract is essential. For smaller transactions, standard terms and conditions may suffice.
How do I limit our liability when selling to universities or research institutions?
Standard liability-limiting provisions include warranty disclaimers (limiting warranties to specific terms rather than open-ended fitness guarantees), caps on total liability (often tied to the contract value), exclusion of consequential and incidental damages, and defined acceptance procedures that start limitation periods running.
Be aware that some institutional purchasers, particularly government-funded entities, may resist certain limitations or have procurement rules that override contract terms. Also, some liabilities can't be disclaimed, such as product liability for personal injury in some jurisdictions. Review your insurance coverage alongside your contractual limitations.
What payment terms should we require?
For new customers or international sales, payment security is critical. Common approaches include payment in advance (full or partial), letters of credit (provides bank guarantee of payment upon documentary compliance), and documentary collections (bank assists in exchange of documents for payment but provides less security than LC). For established customers, open account terms (net 30, net 60) may be appropriate based on credit evaluation.
The appropriate terms depend on the customer relationship, transaction size, and your risk tolerance. Don't assume that institutional customers like universities are automatically low risk. Budget cycles, bureaucratic delays, and currency issues can all cause payment problems.
Should contracts use US law or the customer's local law?
Generally, you want your contracts governed by law you understand and can efficiently enforce. For a US-based seller, US law (often the law of your state of incorporation or principal place of business) is typically preferable.
However, enforceability matters more than the governing law clause itself. If your customer is in Germany and has no US assets, a US judgment may be difficult to enforce. In some cases, agreeing to a neutral choice of law or international arbitration may be more practical. For sales within the US, your state's law with jurisdiction in your state's courts is usually appropriate.
Legal Representation
Can one lawyer represent both the US subsidiary and the Chinese parent?
Sometimes, but it requires careful analysis and informed consent. When the interests of parent and subsidiary align, joint representation can be efficient and appropriate. However, conflicts can arise, particularly around transfer pricing (where what's good for one entity's tax position may be bad for the other), intercompany agreement terms, and situations where the subsidiary faces claims that the parent wants to distance itself from.
Ethical rules require that before undertaking joint representation, the lawyer assess whether the representation can be competent and diligent for both clients, and obtain informed consent from both after full disclosure of the potential conflicts. In some situations, separate counsel is necessary.
What happens when the parent company's interests conflict with the US subsidiary's interests?
This is where your role as a director of the US company becomes important. Your fiduciary duty runs to the US company. If the parent is pushing for actions that benefit the parent at the subsidiary's expense, you need to advocate for the subsidiary's interests, document your concerns, and potentially seek independent advice.
From a legal representation standpoint, if a conflict emerges during an engagement, the lawyer may need to withdraw from representing one or both parties on the conflicted matter. This is one reason why understanding the potential for conflicts at the outset, and having clear engagement terms, matters.
Ongoing Compliance
How do I know if our business triggers sanctions or export control issues?
US sanctions and export controls have expanded significantly in recent years, particularly regarding China. Key areas of concern include the Entity List (companies restricted from receiving US-origin items), the Specially Designated Nationals (SDN) List (blocked parties), sector-specific restrictions on semiconductors, AI, and other technologies, and military end-user and end-use restrictions.
If your products have US-origin content, use US-origin technology, or fall within controlled categories, you need to screen customers and end-users against restricted party lists and may need export licenses for certain destinations or uses. The penalties for violations are severe, including criminal liability. If your business involves controlled technology, you should have a compliance program in place.
US-China rules keep changing. How do I stay on top of new regulations?
The regulatory environment for US-China business has become significantly more complex and continues to evolve. Key sources to monitor include the Bureau of Industry and Security (BIS) for export controls, the Office of Foreign Assets Control (OFAC) for sanctions, CBP for customs and tariff developments, and the IRS and Treasury for tax regulations affecting international transactions.
Realistically, staying current requires either dedicating significant internal resources or working with advisors who focus on this area. Periodic compliance reviews can identify gaps before they become problems. If your business model depends on US-China trade, building compliance into your operations, rather than treating it as an afterthought, is essential.
Have Questions About Your Situation?
Every US-China business structure has its own complexities. If you're navigating these issues and want to discuss your specific circumstances, contact Chang Law Group. We work with US subsidiaries of Chinese companies on transfer pricing documentation, customs compliance, corporate governance, and the full range of issues that arise in cross-border operations.
Contact:
Phone: (617) 307-1238
Email: info@jchanglaw.com
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Disclaimer: This article provides general information about US-China business compliance and is not legal advice. It does not create an attorney-client relationship. Tax regulations, customs procedures, tariff rates, and corporate governance requirements change frequently and vary based on individual circumstances. If you have questions about your specific situation, contact Chang Law Group to discuss how we can help.
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