On October 5, 2015, the Organization for Economic Co operation and Development (“OECD”) released its final report on the 15 key elements of international tax rules set out in its Base Erosion and Profit Shifting (“BEPS”) Action Plan.
The OECD launched the BEPS Action Plan in 2013 at the request of the G20 to address the growing problem of multinational companies (“MNCs”) moving profits to low- or no-tax jurisdictions to avoid taxation. Over the past 12 months tax authorities around the world, including China, have been focusing their attention on the implementation of BEPS-related measures. One major challenge faced by China is the current direct and indirect tax planning practices of MNCs, which involve the use of various types of fee structures, including royalties and franchise fees, to transfer profits out of China.
Tax Authority’s Focus on Transfer Pricing & Related-Party Payments
With the March 18, 2015 release of its Public Notice Regarding Certain Corporate Income Tax Matters on Outbound Payments to Overseas Related Parties (SAT Public Notice  No.16, hereinafter referred to as “Public Notification 16-2015”) and its official Interpretation the following day, China’s State Administration of Taxation (“SAT”) demonstrated its intent to vigorously police transfer pricing and the payments made between related parties.
Public Notification 16-2015 brings together SAT’s views on intra-group outbound payments, including those relating to intra-group services and management fees as stated in China’s official response to the United Nations (“UN”) in March 2014. In that response the SAT reaffirmed its view that service fees paid and received by related parties must be in compliance with the “arms-length” principle. It also stated that management fees are expenses generally related to shareholder activities and, as such, the SAT would limit or not allow their deductibility for corporate income tax (“CIT”) purposes. Public Notification 16-2015 also takes into consideration an internal circular, Shuizongbanfa  No. 146 (“Circular 146”), in which the SAT requested all local level Chinese tax offices to launch comprehensive tax examinations of taxpayers with significant outbound service fee and royalty fee payments to related parties overseas.
The tax authority will analyze and determine whether payments to related overseas parties are actual and reasonable, using six types of tests: beneficiary testing, demand testing, repetitive testing, value add testing, compensatory testing and authenticity testing.
If a payment made to a related party overseas is found not to be in accordance with the arms-length principle, the tax authority can require tax adjustment to be made any time within 10 years from the date of the transaction. The adjustment may result in the payment not being allowed for CIT deduction.
Articles 3 to 6 of Public Notification 16-2015 specify the types of payments that are not deductible for CIT purposes, including:
- Article 3 – Payments to overseas related parties not undertaking functions, bearing risks or having no substantial operations or activities.
- Article 4 – Service fee payments to overseas related parties for services which do not enable the taxpayer to obtain direct or indirect economic benefits.
- Article 5 – Royalty payments, not in compliance with the “arms-length” principle, paid to overseas related parties that only hold legal ownership rights with no contribution to the value creation of the underlying intangible asset.
- Article 6 – Royalty payments to overseas related parties in compensation for incidental benefits arising from financial or listing activities, where a holding or financing company is established offshore for the main purpose of financing or listing.
Customs’ Concerns about Related Party Fees
An additional complication relating to the use of various types of fee structures, such as royalty and franchise fees, has arisen in the indirect tax arena. In recent years audits by China Customs have focused on whether imported goods encompass such factors, and whether the declared value of parts and components imported for production include such fees. China Customs can, and does, conduct import value verification audits and post-entry audits to determine if the prices of goods imported by MNCs are actual and reasonable.
Decree No. 392 of the State Council of the People’s Republic of China dated November 23, 2003 stipulates the key conditions that must be met before royalty or franchise fees can be added to the Customs value:
- The payment must be related to the goods being imported; and
- The payment must be made as a condition for the sale of such goods to the Customs territory of the People’s Republic of China.
These are similar conditions to those established under the WTO Agreement on Customs Valuation.
China Customs will assess the related-party fee payment based on the above-mentioned conditions to determine if it should be added to the value of the imported goods for customs purposes. Notably, when implementing a fee structure under China Customs’ valuation rules, any fee that is paid as a condition of sale for export to the People’s Republic of China is always included into the customs value.
If an offence is discovered, China Customs has the right to recover the import duty and VAT short-paid for the preceding three years, as well as to impose a penalty of 30-200 percent of the short-paid amount. If there is evidence of fraud by the consignee, consignor or the enterprise, the matter will be transferred to China’s Anti-Smuggling Bureau for action.
From Tax Documentation to Customs Actions
With BEPS implementation, the SAT will require Chinese enterprises to hold greater transfer pricing documentation. This means that the Chinese entity will have in its possession key information on the global enterprise, its transfer pricing policy and fee structure. This also means that such information will be accessible to China Customs during an audit. The transfer pricing documentation will reveal all payments made to related entities and it is very likely that China Customs will ask the enterprise to justify such payments. We note that SAT’s substantive requirements on related party fees (i.e., based on “arms length” principle) will also apply in case of a China Customs query.
China Customs and the tax authority are two separate enforcement agencies. Thus, if the related- party fees are not clearly spelt out in the contracts or in the transfer price, the enterprise may end up having to make duty/tax reparations to both agencies.
Suggestions on Compliance
Based on past experience, we understand that many existing royalty agreements, technology transfer agreements and trademark agreements were drafted more than 10 years ago and continue to be in use today. Enterprises should, therefore, review their existing royalty agreements, technology transfer agreements and trademark agreements, as well as their tax strategies, to ensure compliance with the new rules. This type of review is also likely to facilitate a better understanding of a firm’s Chinese subsidiaries and the entire group’s transfer pricing policy.
Several critical factors to highlight:
- When drafting fee agreements, it is very important to consider both a direct and indirect tax perspective, as well as any other factors.
- Besides ensuring that the related party fee is set on a true “arms-length” basis, it is also important that such fee agreements are kept separate from sales agreements or contracts, and that there is substantive justification for the fee arrangement.
- When drafting a royalty agreement relating to domestically manufactured goods, the agreement must clearly state that the royalty is for goods manufactured in China. In other words, the agreement must clearly state what the fee payment is for and provisions within the agreement, including the annexes, should not contradict the subject of the fee payment.
- Enterprises should establish an effective operational framework and mechanism to manage fee payments, and to respond to and correct mistakes in a timely manner. Such work will involve the overseas parent company, other related enterprises and the Chinese subsidiaries. Enterprises should be prepared to respond effectively and quickly to transfer pricing investigations initiated by China Customs and/or the tax authority, including appropriate documentation and clear and concise explanation of intra-group payments.