13 May, 2015
New rules applicable to payments made by Chinese companies to ‘related’ companies offshore will prevent them from artificially shifting profits to lower tax jurisdictions through “unreasonable” service and royalty payments, the State Administration of Taxation (SAT) has said.
Circular 16, which came into force on 18 March, and its accompanying guidance set out certain “red-flag scenarios” in which a Chinese company will not be able to deduct a payment to an overseas related party for Enterprise Income Tax (EIT) purposes. Chinese law requires payments to overseas related parties to be made on an “arms-length” basis, and allows the tax authority to adjust a transaction price if it does not reflect the fair market price.
Shanghai-based corporate tax expert Dr Bernd-Uwe Stucken of Pinsent Masons, said that the testing methodologies set out in the guidance would assist local tax authorities to assess whether particular outbound payments were being used for tax avoidance purposes.
“Importantly, it provides a legal ground on which a local tax authority can deny deductibility of outbound payments that fall into red-flag scenarios,” he said.
“Bulletin 16 does not provide detailed guidance on implementation, nor is there any leading precedent for reference. It remains uncertain how the tax authorities will apply these testing methodologies to assess and deal with non-compliant outbound payments in practice. Nevertheless, considering the active participation in the OECD Base Erosion and Profit Shifting (BEPS) discussion, SAT may be inclined to follow the OECD guidelines and BEPS when assessing the reasonability of outbound payments,” he said.
China signed the OECD’s ‘Multilateral Convention on Mutual Administrative Assistance in Tax Matters’ in 2013. The OECD is currently working on a single set of international tax rules to prevent multinational companies from artificially shifting profits to low-tax jurisdictions, which is due to be completed by the end of 2015. In July 2013, the OECD set out 15 ‘actions’ to address the practice of so-called ‘base erosion and profit shifting’, and set deadlines for implementation.
The SAT pledged to crack down on tax avoidance by multinational companies at the end of last year, after it emerged that some companies were making excessive service and royalty payments to overseas companies in the same corporate group. Abuse of ‘transfer pricing’ arrangements, referring to the prices charged for commercial transactions between various parts of the same group of companies, is one of the issues that the OECD is tackling as part of the BEPS project.
The SAT’s new circular and bulletin list certain categories of payment that tax authorities are entitled to deny for deduction for EIT purposes. These include any payments made to overseas related parties that perform no function, bear no risk or have no substantial operating activities; payments for services provided by an overseas company that do not directly or indirectly benefit the recipient company’s economic interests; and royalty payments where the overseas company owns only the legal right to the asset but did not contribute to the value creation.
“For non-deductible outbound payments, Bulletin 16 is unclear on whether they will be dealt with in the course of annual tax filing as a regular adjustment item of taxable income, or if they are subject to a special tax adjustment,” said Stucken. “A regular annual tax filing adjustment can be done by the taxpayer and generally does not trigger penalties; but a special tax adjustment requires SAT approval, and the adjusted tax amount is subject to interest and may trigger additional interest penalties.”
“Besides these potential problems, there is also an issue over double taxation when an outbound payment is regarded as taxable income of the overseas related party. It is also unclear if there is scope for a concerned party to start the Mutual Agreement Procedures to resolve double taxation issues created by non-deductibility treatment against the Chinese enterprise,” he said.
For further information, please contact:
Bernd-Uwe Stucken, Pinsent Masons