China's State Administration of Taxation (SAT) has released the Administrative Measures on Special Tax Investigation Adjustments and Mutual Agreement Procedures in the Public Notice  No. 6 (Bulletin 6).
Bulletin 6, released on March 17, 2017, updates China's rules on special tax investigations, special tax adjustments and mutual agreement procedures. When it becomes effective on May 1, 2017, it will supersede the corresponding provisions under the existing transfer pricing regulations, Guo Shui Fa  No. 2 (Circular 2).
According to the SAT, the purpose of Bulletin 6 is to amend and improve existing rules on special tax investigations, special tax adjustments and mutual agreement procedures in line with the general principle of "aligning transfer pricing outcomes with value creation" advocated by G20/OECD in the Base Erosion and Profit Shifting (BEPS) Action Plan.
SAT also expects to strengthen the monitoring of taxpayers' profit levels and to improve taxpayers' compliance through implementation of Bulletin 6, as well as the inter-company transaction reporting and contemporaneous documentation requirements under the Public Notice  No. 42 (Bulletin 42).
Bulletin 6 contains many significant provisions that are expected to impact how multinationals implement their transfer pricing policies and practices in respect of subsidiaries in China. In particular, Bulletin 6 contains far-reaching measures to:
- Encourage self-review and voluntary adjustment by taxpayers: As well as empowering local tax authorities to identify taxpayers with special tax adjustment issues, it also encourages taxpayers to conduct voluntary adjustments, either upon receipt of notification from the tax authorities or by way of a self-review.
- Expand the scope of taxpayers with high-risk features for special tax investigations: In addition to taxpayers with long-term losses, consistently low profits, highly volatile profits and/or other usual transfer pricing risk features, the Bulletin also identifies as high-risk taxpayers those that (i) earn a profit below their industry average; (ii) engage in inter-company transactions with affiliates located in low-tax countries/region; or (iii) earn a profit which is not commensurate with their business risks and functions.
- Clarify the special tax investigation procedures and burden of proof: Bulletin 6 sets out the rights and obligations of the investigated taxpayer and reinforces the burden of proof on the investigated taxpayer. Taxpayers are obligated to provide relevant overseas information with indication of source, and also may be required to notarize the overseas information. At the same time, tax authorities are guided on what to require and how to collect, review and document paper, electronic or verbal evidence provided by the investigated taxpayer.
- Revise guidelines on comparable analysis: Cost savings and market premiums are identified as two special geographic factors to be evaluated in comparability analysis in China, in line with Actions 8 through 10 of the G20/OECD BEPS Action Plan.
- Revise guidelines on use of transfer pricing methods: The Bulletin introduces the valuation method for intangibles adopted in Action 8 of the G20/OECD as an additional transfer pricing method in China. Under this new method, intangibles can be valued based on market price, replacement cost and projected revenue.
- Include guidelines on assessment of intangible-related inter-company transactions: The new guidelines require proper allocation of intangible related returns based on each parties' contributions to the development, enhancement, maintenance, protection, exploitation and promotion of intangibles (DEMPEP functions).
- Strengthen administration on inter-company services: Tax authorities may disallow the deduction of services fees related to six types of "Non-Beneficial Services". Such services include duplicated services, shareholder activities, services that provide benefits to the Chinese subsidiary only through "passive association", services with overlapped compensation, services that are irrelevant to the recipient's business activities, and services that are not directly beneficial or would not have been purchased in an uncontrolled business environment.
- Clarify principles for working capital adjustment: The Bulletin limits the application of a working capital adjustment so that it can be applied only to assess the arm's length return of a toll processing service provider, subject to certain conditions. If the working capital adjustment results in a change to the profit level of over 10 percent, reselection of comparable companies is required.
- Clarify expectation on profit level of single-function entities: Single-function entities that only provide contract R&D or contract manufacturing services should not bear any market risks and should earn a stable and reasonable profit level. If a single-function entity suffers losses derived from mismanagement, underutilization of capacity, poor sales or R&D failure, tax authorities may deny such losses and impose a special tax adjustment.
- Clarify and standardize mutual agreement procedure: Bulletin 6 outlines a specific mutual agreement procedure, and clarifies the rights and obligations of tax authorities at different levels in the procedure. It also emphasized that the tax authorities may reject a taxpayer's application or terminate a mutual agreement procedure, if the taxpayer fails to provide relevant and necessary information required by the tax authorities.
Bulletin 6 signals a renewed focus by SAT on transfer pricing policies and practices in China. Given that the new rules will become effective from May 1, 2017, it is expected that they will be applied by the local tax authorities in their review of taxpayers' 2016 transfer pricing documentation, as well as in the future. The rules may also be used in any on-going special tax investigations. Taxpayers are recommended to prepare their 2016 documentation and recalibrate their transfer pricing practices with reference to the Bulletin.
The new rules confirm many practical elements that taxpayers have had to address for many years, such as the concept of location savings and market premiums. Interestingly, while the new rules generally confirm that tax authorities should give priority to public data in comparability analysis, they may also use comparables that are not publicly available. Exactly what priority should be given to public data has not been clarified, and this aspect is likely to continue as a practical issue to be explored on a case by case basis.
With regard to intangibles, the Bulletin brings Chinese guidelines broadly in line with OECD principles. However, there are some noteworthy differences. In contrast with the DEMPE functions under the G20/OECD BEPS Action Plan, the Bulletin adopts DEMPEP functions as the benchmark and includes "intangible promotion" as a significant function separately (rather than including it as a part of the exploitation function).
In this context, the Bulletin does highlight, in line with OECD guidelines, some principles for inter-company intangible transfers and licensing arrangements. Under the new rules, intangible related returns shall not be allocated to an entity that merely holds legal ownership of intangibles without any contribution to the value of the intangibles. Furthermore, an entity that only provides funding for the development of intangibles shall only be entitled to a return commensurate to its funding risks/costs.
Regarding inter-company royalty payments, the new rules require taxpayers to monitor and implement adjustments when the value of the underlying intangibles being licensed has changed substantially, when the related parties' functions, risks and asset profiles have become different, or when an entity's DEMPEP functions have been considered in the royalty payments.
Finally, the Bulletin also clarifies the application of profit split method by stating that "profit allocation among related parties may be carried out based on each party's value contributions, with due consideration to the factual circumstances and value contribution factors such as revenue, costs, expenses, assets and employee headcounts, when comparable information is difficult to obtain and when the consolidated profit derived from the inter-company transaction can be reasonably determined." The new guidelines in the Bulletin appear to be inconsistent with current OECD thinking on the circumstances where it is appropriate to adopt the profit split methodology. In particular, the OECD have so far resisted the use of this methodology as a default method when comparable information is difficult to obtain.