1 October, 2015
SAT Issues Discussion Draft of New Transfer Pricing Guidance
1. Introduction
On 17 September 2015, the State Administration of Taxation (SAT), released a long-awaited discussion draft of the revised Implementing Measures for Special Tax Adjustments (“Draft Measures”), which will provide comprehensive guidance on China’s transfer pricing rules and replace the current Circular 21. The public comment period for the Draft Measures will close on 16 October 2015. It is expected that the Draft Measures will be finalized and issued as an SAT Decree before the end of 2015. Decrees hold the highest legal authority among all the rules and regulations issued by the SAT.
China has been actively involved in the G20/OECD Base Erosion and Profit Shifting (BEPS) Project (“BEPS Project”), which aims to reform international tax rules in order to prevent multinational corporations (MNCs) from artificially shifting profits to low tax jurisdictions. China has already been active in pursuit of similar issues and has released general anti-avoidance procedural guidance2, indirect transfer rules3, and base-eroding payment rules4. The Draft Measures, which aim to turn the transfer pricing concepts and recommendations introduced under the BEPS Project and the China Chapter of the United Nations Practical Manual on Transfer Pricing (“UN Manual”) into domestic legislation, take China’s focus on BEPS style issues to another level. By taking this much bigger step consistent with the BEPS initiative, the Draft Measures could well have the most far-reaching impact on taxpayers.
In this alert, we will discuss key provisions introduced under the Draft Measures, including:
- new transfer pricing documentation requirements, which include country-by-country (CbC) reporting;
- the value contribution allocation method (价值贡献分配法) as an alternative to other transfer pricing methods for allocating MNC profits;
- mandatory secondary adjustments;
- corresponding adjustments for purposes of taxes other than enterprise income tax (EIT)
- the use of reasonable methods to allocate profits arising from location specific advantages (LSAs); and
- a new chapter on intangibles to distinguish legal ownership and economic ownership of intangibles.
2. Transactions affected by the Draft Measures
Any MNC engaged in a cross-border, related-party transaction can expect to be significantly affected by the Draft Measures. The Draft Measures expressly state that they do not apply to domestic related-party transactions.
While the Draft Measures do not contain an effective date, it is expected that the Draft Measures will be effective from 1 January 2016. However, the Draft Measures will also apply to any transaction that occurred before 1 January 2016 for which the tax authorities have not yet made a determination as to the tax treatment. Therefore, the Draft Measures appear to be retroactive at least to 1 January 2008, which is the effective date of the new Enterprise Income Tax Law of the People’s Republic of China (“EIT Law”), and possibly as far back as 10 years, which is the statute of limitations for special tax adjustment cases.
3. New transfer pricing documentation requirements
Consistent with the OECD proposals under the BEPS Action Plan 13, Guidance on Transfer Pricing Documentation and Country-by-Country Reporting, the Draft Measures require each taxpayer to prepare: (i) a master file containing general information about an MNC group’s global business operations, (ii) a local file containing detailed information about the related-party transactions of the Chinese enterprises in the group, and (iii) a Country-by-Country Report containing information about the global allocation of the MNC group’s income and taxes (“CbC Report”). In addition, the Draft Measures also require taxpayers to prepare special files for intragroup services, cost sharing agreements, and thin- capitalisation.
As taxpayers are currently only required to prepare a local file under Circular 2, the Draft Measures will impose a significant additional compliance burden on taxpayers in terms of transfer pricing documentation. Taxpayers that fail to comply with the new transfer pricing documentation requirements (including providing false or incomplete documents) will be subject to a punitive interest penalty equal to the RMB loan benchmark rate published by the People’s Bank of China plus 5 percentage points if and when the PRC tax authorities make a final transfer pricing adjustment. It is not yet clear whether the new transfer pricing documentation requirements under the Draft Measures will commence for accounting periods starting on or after 1 January 2015, which would mean that the new transfer pricing filings would be due by 31 May 2016. However, based on the recommendations under the BEPS Project, we expect the new transfer pricing documentation requirements to commence for accounting periods starting on or after 1 January 2016.
Master file
The master file provides a “blueprint” of the MNC group and contains:
1) the MNC group’s organizational chart;
2) a description of the MNC’s business(es) (including profit drivers, major product supply chain, intercompany service agreements, main geographic markets, brief functional and value creation analysis for entities, recent restructurings and M&A, etc.);
3) the MNC’s intangibles, e.g., a list of intangibles important for transfer pricing with legal owner(s) and a general description of MNC group’s transfer pricing policies for R&D and intangibles;
4) the MNC’s financial arrangements, including related and unrelated financing; and
5) the MNC’s financial and tax positions, e.g., the latest consolidated financial statements of the MNC group, unilateral advance pricing arrangements (APAs) and tax rulings on income allocation.
A Chinese affiliate required to prepare a master file5 must do so by May 31 of the following year and submit it to the tax authorities upon request. Normally, the Chinese affiliate does not have direct access to most (if
not all) of the information that must be included in the master file, so the Chinese affiliate must request the information from the MNC group’s ultimate parent company. Technically, the Chinese affiliate has no legal right or means to demand the information from a parent company or from any other entity in the group because each corporate entity in the MNC group is a separate, independent legal entity. If the Chinese affiliate fails to provide all the required information, the Chinese tax authorities may impose the punitive interest penalty when making any final transfer pricing adjustment. Therefore, Chinese affiliates are advised to actively communicate with the MNC group’s parent company when preparing the master file.
Local file
Although Chinese affiliates are already required under Circular 2 to prepare a local file by May 31 of the following year and submit it to the tax authorities upon request, the Draft Measures will require more detailed information and analysis in the local file. The new information and analysis mainly focus on value chain analysis, outbound investment, related-party equity transfers, and intragroup services.
The principal objective of the BEPS Project is to ensure that “profits [are] taxed in the jurisdiction where economic activities occur and value is created”. The SAT enthusiastically insists that “value chain analysis”is consistent with this objective and has consistently instructed local tax authorities to conduct value chain analysis when making a transfer pricing adjustment. In a typical example, where an MNC sets up multiple companies in China with each company performing a single function, such as contract manufacturing, limited risk distribution, contract R&D and supporting services, PRC tax authorities take the view that all economic activities occur in China and value is created in China, and therefore the MNC should earn more than a routine return in China. We expect that value chain analysis as part of the local file will encourage the PRC tax authorities to use profit splits more frequently when determining the Chinese affiliates’ proper returns.
PRC tax authorities have been increasing their scrutiny of related-party equity transfers in recent years. Although no rule currently requires a valuation report for related-party equity transfers, PRC tax authorities generally require it as evidence that the related-party equity transfer was conducted at arm’s length. The Draft Measures, for the first time, codify this practice and require a valuation report and other relevant information when preparing the local file for transfer pricing documentation purposes.
Requiring information about outbound investment and intragroup services in the local file is also consistent with the increasing scrutiny on outbound investment and intragroup services by PRC tax authorities.
CbC Report
Consistent with BEPS Action Plan 13, the Draft Measures require some Chinese enterprise taxpayers to enclose a CbC Report with the taxpayer’s annual enterprise income tax return.
The Chinese enterprise taxpayer that is obligated to file the CbC Report is:
The Chinese ultimate holding company in an MNC group if the group’s consolidated revenue for the last fiscal year exceeds RMB5 billion; or
The Chinese enterprise designated by the MNC group as a reporting entity for the CbC Report if the ultimate holding company in the MNC group is a foreign enterprise.
In addition, PRC tax authorities are empowered to request the Chinese affiliate to submit a CbC Report during a tax audit if (i) the ultimate holding company in an MNC group is a foreign enterprise which has an obligation to prepare a CbC
Report under its own domestic legislation, and (ii) the PRC tax authorities fail to obtain the CbC Report through an information exchange programme.
The CbC Report must contain aggregate country-by-country data about entities (and permanent establishments) in every country. The Draft Measures do not include a CbC template, but it is expected that the CbC template adopted by China will be consistent with the OECD proposed CbC
template, which includes information about revenue, profit (loss) before income tax, income tax paid (on cash basis), income tax incurred, stated capital and accumulated earnings, number of employees, and tangible assets other than cash and cash equivalents. For many businesses, particularly for large MNCs with different divisions and subsidiaries in different countries, such information is often not readily available and may not be easily obtained. Thus, CbC reporting may create significant compliance burdens for MNCs.
In addition to the compliance burden, MNCs have other concerns with CbC reporting. The biggest of these may be that CbC reporting presents a significant and unacceptable moral hazard6 for the tax authorities. In other words, when the PRC tax authorities have in hand a document that shows high profits sitting in a low-tax trading partner jurisdiction, they will be pressured to bring those profits into the Chinese tax net even if the initial income allocation is objectively correct. In practice, when seeing a huge amount of profit sitting in the low-tax jurisdiction, there is a risk that PRC tax authorities may employ simplistic assumptions about how and where the group earns money, without understanding the group’s business model and country-by-country differences.
4. Transfer pricing methods
MNCs will welcome the Draft Measures’ confirmation that tax authorities should use the arm’s length principle when reviewing related-party transactions7. However, in addition to the five traditional transfer pricing methods8 listed in the current Circular 2, the Draft Measures introduce two new transfer pricing methods: value contribution allocation and asset valuation.
According to the Draft Measures, the value contribution allocation method would typically be used for transactions that lack comparable information. By applying the value contribution allocation method, tax authorities would allocate the group’s consolidated profits among related enterprises located in different jurisdictions based on each party’s value contribution to the group’s consolidated profits. In determining the value contribution, the tax authorities would consider factors such as assets, costs, expenses, sales revenues, and number of employees. In other words, by applying
the value contribution allocation method, PRC tax authorities may simply allocate profits based on these factors. This is particularly concerning for any MNC that derives value from intangible assets such as IP and branding rather than tangible assets. The value contribution allocation method appears to be similar to the global formulary apportionment method, which is generally regarded internationally as a transfer pricing method that is inconsistent with the arm’s length principle. Therefore, it is questionable whether the value contribution allocation method is consistent with the arm’s length principle to which the tax authorities should adhere based on the EIT Law.
The asset valuation method comprises cost method, market method and income method (i.e., discounted cash flow method), which are typical valuation techniques used by appraisal firms. Although the Draft Measures do not expressly state so, we expect that the asset valuation method would typically be used to determine the arm’s length price of related-party equity/asset transfers, as is already common practice in China today.
5. Secondary adjustments
The Draft Measures include a specific provision requiring the upward adjustment of the audited company’ taxable profits to be reflected to accounting books and the relevant funds to be remitted back to the audited company. If the audited company fails to make accounting adjustments or to receive relevant funds within the time required by the tax authorities, the audited company will be deemed to have made a dividend distribution subject to withholding tax. In addition, the Draft Measures provide that there should be no refund or adjustment of withholding tax previously imposed on outbound payments (e.g., royalties and interest) after the tax authorities make a final transfer pricing adjustment. Therefore, an MNC may potentially be subject to double taxation in China where the outbound payment is subject to downward adjustment (including non-deductibility) for the Chinese affiliate and withholding tax is imposed on the deemed dividend distribution.
This adjustment mechanism required by the Draft Measures is commonly referred to as a “secondary adjustment”. We note that the Draft Measures limit the secondary adjustment to transfer pricing adjustments imposed by the tax authorities after audit. In other words, the secondary adjustment will not apply to voluntary transfer pricing adjustments made by taxpayers themselves.
It is not yet clear how the accounting adjustments should be made and how the remittance of relevant funds would work under the PRC’s current foreign exchange control regime. It is also questionable whether it is appropriate to deem a dividend distribution if the foreign related-party
is not a shareholder of the audited company. The characterization of the payment matters because the applicable treaty benefits or domestic withholding tax would vary depending on the characterization (e.g., dividends, royalties, or loan).
6. Corresponding adjustments for purposes of taxes other than EIT
The Draft Measures require taxpayers to make corresponding adjustments for purposes of taxes other than EIT after they receive a final transfer pricing adjustment notice and pay EIT. In other words, taxpayers must report and pay other taxes (e.g., value-added tax and business tax) in addition to EIT after they receive a transfer pricing adjustment.
As a matter of law, since a transfer pricing adjustment is only authorized under the EIT Law, it is questionable whether the tax authorities have any legal basis to make tax adjustments for taxes other than EIT.
7. Location specific advantages
The LSA concept is not new in China. In 2009 and 2010, the SAT mentioned the location savings, the market premium and the LSA concepts in Guo Shui Han [2009] No. 106 and Guo Shui Han [2010] No. 84. More recently, the SAT formally stated its comprehensive views on the LSA concept in the UN Manual issued in October 2012. According to the UN Manual, the LSA concept covers production advantages arising from location-specific assets, resources, government policies and incentives. Location savings generally refer to supply-side LSAs while market premiums refer to demand-side LSAs.
The Draft Measures will formally require tax authorities to routinely apply LSA analysis to identify whether extra profits are being generated from
an LSA; if extra profits are being generated by an LSA, the tax authorities are required to allocate those extra profits to the audited companies using reasonable methods. Currently, PRC tax authorities arbitrarily apply the LSA concept as a bargaining chip in transfer pricing negotiations rather than routinely identifying and quantifying LSAs. Routine LSA analysis in transfer pricing audit cases will result in MNCs facing an increasing number of tax authority challenges to their profits.
Without detailed guidance on how to identify and quantify LSAs, it is not hard to imagine tax authorities arguing that an MNC’s Chinese operations should be attributed a greater share of the MNC’s global profits because the lower labor costs and tremendous consumer base in China are
LSAs. Also, if there are no local comparables, and Japanese and Korean companies are used as comparables instead, the tax authorities could claim that the costs in China are even lower and the Chinese company should have even higher margins.
Therefore, it is more important than ever for MNCs to prepare strategies to defend against PRC tax authorities employing faulty LSA analysis.
8. Special chapter on intangibles
The Draft Measures introduce a new chapter on intangibles. This new chapter generally incorporates recent developments in the OECD BEPS action plan on intangibles.
The Draft Measures define intangibles as non-financial assets that have no physical form, that are capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated in a transaction between independent parties in comparable circumstances. MNCs will be glad to see that the definition does not include LSAs such as location savings because they are not capable of being owned or controlled. Instead, location savings are considered features of the local market and are to be addressed in the comparable analysis.
The Draft Measures, for the first time, formally introduce the concept of economic ownership of intangibles. According to the Draft Measures, if the legal owner of an intangible makes no contribution to the value of the intangible, the legal owner will not be entitled to retain returns attributable to the intangible. Rather, those returns will be allocated among the parties that make contributions to the value of the intangible, i.e., those returns will be allocated among the economic owners.
Contributions that confer economic ownership include performing functions, contributing/using assets and bearing risks related to developing, enhancing, maintaining, protecting, exploiting and promoting (“DEMPE”) the intangibles. The economic owners making these contributions should retain a portion—or in some cases all—of the returns attributable to the intangibles in proportion to their contributions.
The economic owner concept under the Draft Measures may pose problems for IP holding companies that fund IP development but outsource to other entities all of the other functions, such as R&D work or brand building. Specifically, according to the Draft Measures, if a party merely funds an intangible but does not perform any functions or assume any risks related to the intangible, then it should only be entitled to a reasonable return on the funding itself.
9. What actions should MNCs consider?
China has been actively involved in the BEPS Project in recent years.
The Draft Measures are the latest in a series of steps the SAT has taken to translate proposals under the BEPS Project into domestic laws and regulations. According to a keynote speech9 delivered by Tizong Liao, Director General of the SAT’s International Tax Department, other forthcoming actions in response to the BEPS Project include revising the Tax
Collection and Administration Law, adding anti-avoidance rules to the Individual Income Tax Law, drafting anti-treaty abuse rules, and updating the tax authorities’ IT systems to support the monitoring of MNC profit ranges.
In response to the pending issuance of the Draft Measures and other actions taken by the SAT to counter aggressive tax planning, every MNC should consider the following actions to safeguard its tax interests in China:
• Invest in HR and accounting systems to comply with new transfer pricing documentation requirements;
• Review and amend transfer pricing methods and documentation through a BEPS lens;
• Manage tax risks from BEPS by using APAs where appropriate;
• Prepare for “dawn raids” and other extraordinary investigative procedures;
• Review legal and economic ownership structures for intangibles such as IP, and ensure that income from intangibles follows contributions to DEMPE functions; ;
• Proactively advance the strongest legal and technical arguments possible to defend tax planning rather than just passively responding to information requests from the tax authorities; and
• Prepare to challenge tax authority decisions through administrative review processes, litigation or other procedures when a sound legal basis exists and it is commercially necessary and feasible to do so.
1 Circular of the State Administration of Taxation on Printing and Distributing the Implementing Measures for Special Tax Adjustments (for Trial Implementation), Guo Shui Fa [2009] No. 2, dated 8 January 2009, retrospectively effective from 1 January 2008.
2 Administrative Measures for the General Anti-Avoidance Rule (for Trial Implementation) (SAT Decree No. 32 , dated 2 December 2014. For more details , please refer to our client alert in December 2014.
3 State Administration of Taxation’s Bulletin on Several Issues of Enterprise Income Tax on Income Arising from Indirect Transfers of Property by Non-resident Enterprises, SAT Bulletin [2015] No. 7, dated 3 February 2015. For more details, please refer to our client alert in February 2015.
4 State Administration of Taxation’s Bulletin on Enterprise Income Tax Issues Related to Outbound Payments by Enterprises to Overseas Related Parties (SAT Bulletin [2015] No. 16), dated 18 March 2015. For more details, please refer to our client alert in April 2015.
5 A Chinese affiliate is required to prepare a master file and a local file if during the current fiscal year the Chinese affiliate has: (i) RMB200 million or more in related-party purchase and sale transactions; (ii) RMB40 million or more for all other related-party transactions (e.g., services, royalties, and interest); or (iii) losses while performing only limited functions and assuming limited risks.
6 In economic theory, moral hazard is a situation where the behaviour of one party may change to the detriment of another after the transaction has taken place.
7 Previously, it was reported that China was considering adding the profit apportionment principle as an alternative to the arm’s length principle.
8 The five traditional transfer pricing methods are: comparable uncontrolled price method, cost-plus method, resale price method, profit split method, and transactional net margin method.
9 Bloomberg BNA Global Transfer Pricing Conference on 17 September 2015.
For further information, please contact:
Glenn DeSouza, Baker & McKenzie
glenn.desouza@bakermckenzie.com
