China’s State Administration of Taxation (SAT) issued Bulletin 42 on 29 June 2016 to regulate the reporting of related party transactions and transfer pricing contemporaneous documentation. Bulletin 42 will replace the existing regulations under Guoshuifa [2009] Circular 2 (Circular 2).

The implementation of Bulletin 42 will bring considerable challenges for taxpayers. We highlight the major changes below.

A milestone in China’s transfer pricing regulations

In the context of the OECD Base Erosion and Profit Shifting (BEPS) initiative, Bulletin 42 is the implementation and localisation of BEPS Action 13 and other transfer pricing related BEPS Action items. This is a milestone in the internationalisation of China’s transfer pricing regulatory regime.

Bulletin 42 generally reflects the draft transfer pricing documentation requirements set out in the Implementation Regulation for Special Tax Adjustment (Draft for Comment) (Discussion Draft) issued by the SAT on 17 September 2015.

The SAT has not, at this stage, issued full implementation regulations as expected, but has instead issued Bulletin 42 focusing on transfer pricing compliance only. We expect that full implementation regulations will still be issued, however.

Bulletin 42 will be relevant for the preparation of 2016 transfer pricing documentation for Chinese entities.

Major changes, challenges and benefits

The key challenges and changes arising from Bulletin 42 are outlined below.

New challenges for taxpayers

Greater disclosure of group information

The new documentation requirements in Bulletin 42 significantly increase the level of disclosure of group information to the Chinese tax authority in the form of Country by Country Reporting (CbCR) and Master File reporting. For example, taxpayers must now disclose information relating to the profit contribution of group entities, intangible arrangements within the group, financial performance of group entities, the amount of tax paid and the workforce headcount of group entities.

In essence, in order for taxpayers to satisfy the CbCR and Master File requirements, the group global profit distribution must be disclosed to the Chinese tax authority. As a result, when the Chinese tax authority intends to conduct a transfer pricing audit in relation to such taxpayers, the tax authority will have more information to work with.

Value chain analysis

The SAT has consistently focused on value chain analysis as part of China’s implementation of BEPS in order to appropriately value a Chinese enterprise’s contribution in the global value chain. Importantly, Bulletin 42 is the very first time that value chain analysis has appeared in a formal document issued by the SAT.

According to Bulletin 42, Chinese taxpayers should state their contribution to profit in the group value chain in their Local File. This requires consideration of any Location Specific Advantages (LSAs) of the taxpayer, including location saving and market premium advantages. Taxpayers must consider LSAs in the analysis of related party transactions. It is uncertain at this stage whether taxpayers need to explicitly disclose whether or not they have LSAs in the report. We expect this may need to be further clarified by additional regulations or practical guidance.

Disclosure of outbound investments

Chinese companies with outbound investments must now disclose information about these investments in their transfer pricing documentation. Bulletin 42 explicitly focuses on information regarding the recruitment of high-level management and the location and identity of decision makers in relation to investments.

Chinese enterprises going abroad must prudently evaluate the tax and transfer pricing risks associated with such a venture. This includes the risk of foreign subsidiaries being treated as a Chinese resident company or a controlled foreign company for Chinese tax purposes. Although, broadly speaking, going abroad is encouraged, the tax and transfer pricing arrangements are likely to be scrutinised in the future. The 10 year time frame which applies to the retention of transfer pricing documentation is likely to give the Chinese tax authority sufficient time and flexibility for any investigations.

Continuing challenges for taxpayers

Full disclosure of all types of related party transactions

The recent updated guidance also specifically addresses difficult issues arising from group restructures and innovations in the financial sector. Unlike Circular 2, Bulletin 42 refers to more types of related party transactions, such as share transfers and transfers of account receivables and notes. The Chinese tax authority may seek to target these new transactions in audits and seek to adjust the terms of such transactions. For example, the tax authority may seek to adjust the terms of an accounts receivable between related parties that may in substance be financing. Such “hidden” transactions, which might have remained “below the surface” in the past, may become the subject of greater scrutiny in the new regulatory environment.

Scrutiny of related party services and intangibles

The supply of services and the methodology of service expense allocation are again focused upon in Bulletin 42. The definition of “intangibles” now extends to include commercial secrets, client lists, sales channels, government licenses and other similar items. This change highlights that the Chinese tax authority is aware of the transfer pricing risk involving intangibles and that the authority will likely focus on these high risk areas with some urgency.

Alternative transfer pricing methods may be applied

In Bulletin 42, the term “comparable uncontrolled transaction” is referred to repeatedly. This may be a signal that the Chinese tax authority is becoming more reliant on alternative transfer pricing methodologies and analysis compared with the current dominant profit based transfer pricing method in China, being the Transactional Net Margin Method (TNMM). For example, if, in a value chain analysis, it is contended that Chinese enterprises should have earned higher than “usual” profits, the traditional (and broadly applied) TNMM may not be applicable. Even if the TNMM does apply, it is possible that the TNMM should be applied more broadly, and not just to the Chinese enterprises.

Chinese enterprises who consider themselves “safe” with “bottom-line” profits may have their pricing policies challenged going forward. This change may bring considerable transfer pricing pressure for companies operating in technology industries or companies targeting China as their main market, in particular in relation to the global distribution of group profit.

Favorable changes for taxpayers (compared with the Discussion Draft)

Higher threshold for CbCR

The threshold to prepare CbCR is set at RMB5.5 billion, compared with RMB5 billion in the Discussion Draft. We are not sure at this stage whether or not the SAT will make adjustments where there is significant currency fluctuation in the future.

No special issue file for intercompany services

Unlike the Discussion Draft, Bulletin 42 does not provide for a special issue file for intercompany services. Instead, more detailed requirements for intercompany services are incorporated in the Master File and Local File.

Exemption from transfer pricing documentation requirements

Taxpayers with only domestic related party transactions are exempt from being required to prepare Master Files and Local Files. Interestingly, this change might present a new challenge for the tax authority in monitoring companies with indirect overseas related party transactions – that is, companies who only have domestic related party transactions themselves but who transact with counterparties which engage in cross-border related party transactions.

Extension of time for preparation of transfer pricing documentation

Under Bulletin 42, the new deadline for the preparation of transfer pricing documentation is June 30 of the next fiscal year and the deadline for delivery of the Master File is 12 months after the end of the fiscal year of the ultimate holding company.

What should multinational enterprises in China do now?

As the new rules will apply to the preparation of 2016 transfer pricing documentation, multinational enterprises in China should consider the following measures:

  • Review current transaction structures and make necessary adjustments. For example, consider setting up a China business center to centralise the cross-border related party transactions and lower the compliance burden.
  • Revisit current transfer pricing policies, related party agreements, transaction models and implementation arrangements, and make any necessary adjustments. In particular, this analysis should take account of any LSAs attributable to Chinese enterprises.
  • Evaluate the role of Chinese enterprises through a functional and risk analysis. Are the Chinese enterprises special purpose vehicles? Is it reasonable for the Chinese enterprises to maintain “routine” profits or should they participate in the distribution of “residual” profits? Is it sustainable for the Chinese enterprises to incur tax losses?
  • Prepare internal documents to support the transfer pricing policy, including factual information and analysis. For instance, in relation to intercompany services, documents should be prepared that demonstrate the benefit to the Chinese enterprise from those services.

In some cases, it may be necessary to make overall adjustments to the business structure and systems of the Chinese entity.

Further questions

While it is clear that the implementation of Bulletin 42 will bring considerable challenges for Chinese taxpayers, there are still many questions to be answered.

How will taxpayers achieve balance between compliance and risk management? How will taxpayers work with their headquarters to collect information in an efficient manner? How will taxpayers manage tax risk in other regions that the group operates in? For joint ventures, how will taxpayers effectively exchange information with their joint venture partners?

We welcome the opportunity to work with taxpayers to tackle these new developments together.