TaxTransfer pricing

China’s State Administration of Taxation has spent the past year deciding how best to crack down on multinational companies that disguise base erosion and profit shifting as transfer pricing. George

W. Russell reports on its efforts so far and how Beijing’s policies might differ from those pursued by OECD member states

Illustrations by ID WORKSHOP

PUTTING A STOP TO BEPS

26 July 2015

aplus

A year ago, China’s State Administration of Taxa-tion issued Shuizongbanfa

(Circular) No. 146, which ordered provincial and municipal tax authorities to investigate payments by Mainland-based companies to their affiliated entities overseas described in their tax returns as service fees or royalties.

Circular 146 constituted one of the first salvoes in a battle by Main-land tax authorities to rein in trans-fer pricing, which is a method of setting prices of goods and services among divisions within an enter-prise. The SAT had long suspected that multinational corporations were repatriating profits out of China disguised as royalties and fees.

That 29 July 2014 order – entitled Notice of Anti-Avoidance Examination on Significant Outbound Payments – and more intense levels of scrutiny by rev-enue authorities have galvanized many multinational corporations into reviewing their entire China tax systems.

Part of China’s motivation is to maintain tax revenues at a time of slowing economic growth, but the crackdown on transfer pricing practices also echoes a global move-ment, led by the Organisation for Economic Cooperation and Devel-opment to eliminate inappropriate tax avoidance schemes and reduce base erosion and profit shifting.

BEPS, as it is known, is an effect of transfer pricing in which national tax rules are exploited to enable companies to shelter in tax-advanta-geous locations so little or no corpo-rate tax is paid. In 2013, the OECD issued a 15-point BEPS Action Plan designed to curb its effects.

The Chinese tax authorities have long been known for their inclination to question the value obtained from intra-group services. “Circular 146 was leveraged off the OECD BEPS Action Plan’s empha-sis on aligning taxation and value

creation,” says Christopher Xing, Asia Pacific Regional Leader, International Tax, at KPMG China and a member of the Hong Kong Institute of CPAs’ Mainland Taxa-tion Sub-committee.

“Since the issuance of Circular 146, there appears to be a trend of China’s tax authorities looking hard at payments made to overseas related parties,” notes Amy Ling, a Tax Partner in the Shanghai office of the Baker & McKenzie global law firm and an American Institute of CPAs member. “There also appears to be a trend of more multinationals being investigated for transfer pricing issues.”

The SAT is expected to focus initially on three egregious cat-egories: fictional payments, for services not provided; unneces-sary payments, for services not required; and ineligible payments, for royalties to which the overseas recipient did not contribute.

While Circular 146 called for a broad review of transfer pricing, SAT’s Public Notice 16, issued in March, more clearly set out the tax agency’s intentions.

“PN16 is arguably the most far-reaching transfer pricing ruling from China in recent years, as a vast majority of foreign-owned Chinese entities do have routine needs for cash remittance to their overseas parent or group affiliates,” says Richard Bao, Partner and transfer pricing specialist at Grant Thornton in Shanghai.

Drilling down on taxThe heart of PN16, says Lu Chen, Director, Transfer Pricing, at KPMG China, is its emphasis on requiring commercial substance of the overseas affiliate receiving the service fees and the benefi-cial nature of the services being rendered in intra-group services transactions. It lays down four major criteria governing payments that are not deductible:• Fees are paid to a recipient

that is an unqualified overseas related party, i.e. not undertak-ing functions, bearing risks or having no substantial operation or activities;

• Service fees are paid that do not qualify under SAT guidelines;

• Royalties are paid to the over-seas related-party owner of the rights to an intangible asset, but which made no contribution to its value creation; and

• Royalties are paid to an over-seas related party in compen-sation for incidental benefits arising from financing and listing activities.

In a comparison of PN16 with corresponding OECD actions, Anthony Tam, a Tax Partner at Mazars and Convenor of the Insti-tute’s Mainland Taxation Sub-com-mittee, sees the Chinese model as stricter. “In PN16, if it is noted that the overseas related party is merely the legal owner of the intangible, and is making no contribution to value creation, the royalty is non-deductible,” he says.

“On the other hand, Actions 8, 9 and 10 would attribute some value to the legal ownership,” he adds, referring to three points of the OECD BEPS Action Plan that relate to a number of closely related topics, including rules to prevent transfer risks or allocating excessive capital; engaging in transactions which would not, or would only very rarely, occur between third parties;

“ There appears to be a trend of China’s tax authorities looking hard at payments made to overseas related parties.”

The State Administration of Taxation is

the highest tax authority in China and is a ministry-level department directly under the

State Council.

July 2015 27

TaxTransfer pricing

and special measures for transfers of hard-to-value intangibles.

One aspect likely to affect Hong Kong companies is intellec-tual property. “It is not uncommon that IP rights are owned by Hong Kong entities,” notes Tam. “[But] questions remain whether pay-ment for such service fees would be deductible. The payments may risk being non-deductible if the Chinese tax authorities take the position that such payments are really for the benefit of the Hong Kong parent company rather than the Chinese subsidiary.”

As a result, multinational corpo-rations with IP holding companies might have to restructure. “The value creation requirements in PN16 could pose problems for IP holding companies that only fund and assume all of the risks associ-ated with the development of IP, but outsource other functions, such as research and development work or brand building, to other entities,” says Ling at Baker & McKenzie.

Under PN16, the Chinese enterprise is obliged to determine to what extent the overseas affiliated parties contributed to the creation of the IP, and pay the entities involved on that basis,” says Sowmya Varadharajan, Managing Director of IC Advisers, a tax advisory boutique in Singapore. “This is likely to increase the transfer pricing documentation compliance burden faced by Chinese enterprises.”

Long-simmering issuesConcerns over the effects on tax revenue of aggressive transfer pricing are not new. In 1961, John F. Kennedy, then president of the United States, lamented that “more and more enterprises… have arranged their corporate structures aided by artificial arrangements between parent and subsidiary regarding intercompany pricing, the transfer of patent licensing rights… and similar practices…

to reduce sharply or eliminate completely their tax liabilities both at home and abroad.”

More recently, plunging tax revenues in the wake of the global financial crisis have prompted austerity-minded world leaders to seek ways to maximize revenue. In 2013, the G20 – a forum for the governments and central bank governors of 20 major economies – asked the OECD to develop proposals to give governments domestic and international instruments to prevent corporations from paying little or no taxes.

While the G20, including China, endorsed the resulting 15-point action plan, experts expect Main-land policy to go further than the OECD recommendations. “China has worked hand in hand with the OECD but I think China is going to take a different angle,” says Cecilia Lee, a Partner at PwC Hong Kong.

Lee says the OECD focuses on the value contribution of goods or services to determine whether any payment qualifies as tax deductible. “While China will follow that as well, the SAT would look at the whole supply chain and want to see the full picture outside China before saying what is the right amount to be left in China.”

A recent paper produced by KPMG China noted that while Bei-jing supported the OECD project, some of the 15 points don’t apply. For example, hybrid loans are rare due to foreign exchange controls,

while existing laws already allow the SAT to disregard tax arrange-ments that it decides are lacking business purpose.

Chinese tax authorities say the Mainland’s position in the global supply chain sets it apart from other jurisdictions. For example, labour, infrastructure and other costs are lower, while less competition and the purchasing power of China’s middle class allow companies to set higher prices. This would limit transfer-pricing opportunities as, according to the SAT, any excess profits so generated would be sub-ject to domestic Chinese tax.

“They contend that the unique characteristics of the Chinese market allow companies to reap more profits in China than in other countries,” says Xing at KPMG.

Beijing’s limitationsObservers say that the SAT will face challenges in enforcing new transfer pricing policies. With a renewed spotlight on transfer pricing, accounting firms have had to ramp up their capabilities. The SAT already had few experts on transfer pricing and the Big Four and law firms have snapped up several of the most experienced officials. “The SAT in Beijing has limited resources but extensive responsibilities for a number of issues,” points out Lee at PwC. “They constantly seek the most efficient way to operate.”

As a result, the administration had devolved investigation and enforcement powers to lower-level tax bureaux in the provinces and cities. Last year, the Jiangsu Provincial State Administration of Taxation issued guidance on the OECD’s BEPS report. Tax officials in Jiangsu, home to many foreign enterprises, issued administrative measures that have been used as a blueprint for national policy.

“Some provincial tax officials have gained more international knowledge through dealing with

“ The SAT contend that the unique characteristics of the Chinese market allow companies to reap more profits in China than in other countries.” Many Hong Kong

companies face restructuring

their tax systems if China tightens transfer

pricing rules on intellectual

property.

28 July 2015

aplus

foreign companies,” says Lee. “They have a team of people at the provincial level who are talented. These people may not be recruited to work in Beijing but nonetheless they can help a lot in terms of enforcement.”

In addition, provincial and municipal tax authorities are cooperating with each other to double-check assessments as well as conduct internal examinations for staff. The SAT is also making the most of its limited manpower by upgrading its automation. “They have adopted a lot of data mining technology,” Lee says. “They have the biggest taxpayer database in the country and they are using that internally for their audit targetting purposes.”

The agency has also invited companies to voluntarily conduct their own assess-ments using what is known as a “self-adjustment mechanism.” It reserves the

right to perform confirmatory checks on self-adjustments, but the mechanism allows the agency to enforce policy without using a lot of actual manpower.

The SAT is expected to continue to provide more details of China’s transfer pricing policy in the next few months: a major revision of Circular 2 (Special Adjustments Implementation Measures (Trial Implementation)) – the SAT’s core transfer pricing document – is due before the end of 2015. “When Circular 2 comes out there will be more clarity,” says Lee.

And clarity is sorely needed, special-ists say. “Right now there are indeed a lot of somewhat conflicting technical positions,” says Lee. “It leads to different behaviour by different local tax authorities. This is creating a lot of challenges for our clients.”

Transfer pricing is a rapidly evolving system, and confusion is inevitable until a stable format emerges. One way to ensure a higher level of clarity is through an advance pricing agreement.

An APA is a legal contract between a taxpayer and a tax authority (unilateral APA) or between two or more tax authori-ties (bilateral or multilateral APAs) speci-fying the pricing method that will apply to related-company transactions.

“APAs are effective tools to minimize tax controversies and disputes,” says Anthony Tam, a Tax Partner at Mazars and Convenor of the Institute’s Mainland Taxa-tion Sub-committee. “It provides certainty on a tax position.”

China has signed more than 100 unilateral, bilateral or multilateral APAs since the initiative began in 2005. However, the State Administration of Taxation says it has an APA team of just six people. “It is public knowledge that they have experienced a huge backlog of APA applications,” says Cecilia Lee, a Partner at PwC Hong Kong.

The Hong Kong Inland Revenue Department introduced its Advance Pricing Arrangement programme in 2012. Due to staffing constraints, Hong Kong enters into only bilateral and multilateral APAs. It signed its first bilateral APA with its counterpart in the Netherlands in 2014 and a second, with Japan, earlier this year.

The bilateral APAs cover the types of related party transactions commonly used by multinational corporations. Under an APA, the Commissioner of Inland Rev-enue cannot impose additional profits tax on relevant transactions other than the tax payable agreed under the APA pricing.

“With the conclusion of this second APA, people may change their conventional wisdom towards Hong Kong as a laid-back jurisdiction for transfer pricing,” suggests Richard Bao, Partner and transfer pricing specialist at Grant Thornton in Shanghai. “Hong Kong is demonstrating more assertiveness in the global tax arena.”

Signing APA helps to avoid uncertainty

July 2015 29