Related party transactions must be conducted under the arm’s length principle in accordance with the Chinese transfer pricing rules. On July 29, 2014, the State Administration of Taxation (“SAT”) issued Shuizongbanfa [2014] No. 146 (“Circular 146”) to mandates a nationwide crackdown on outbound services fees and royalties paid to related parties, especially those located in low tax jurisdictions, over a period of 10 years from 2004 until 2013. Circular 146 was intended for internal circulation within the Chinese tax authorities.

On March 18, 2015, the SAT acted again in this area by promulgating the SAT Announcement [2015] No. 16 (“Announcement 16”) with respect to outbound payments to related parties. Clearly, the scope of Announcement 16 goes beyond what was stated by Circular 146. This time, the SAT highlights the transfer pricing aspect of these related-party payments without much emphasis on the vague standards of reasonable business purpose and economic substance. Announcement 16 became effective upon issuance. The key points of Announcement 16 are as follows.

Arm’s Length Principle

Under Announcement 16, related party outbound payments are subject to the arm’s length principle. The in-charge tax authorities may request relevant contracts and documentation to substantiate whether the underlying transactions are genuine in nature. If not, the in-charge tax authorities will have power to make a special tax adjustment. While the in-charge tax authorities cannot invalidate the suspicious transactions per se, the amount of such payments involved will not be deductible for the income tax purposes. The message is that you can pay but cannot deduct such pay. The statute of limitation for the special tax adjustment is ten years starting from the taxable year in which any payment occurs.

Focus of Deductibility

Related party outbound payments will not be deductible for the income tax purposes in the following circumstances.

First, to the extent a foreign related payee performs no function, bears no risk, and has no substantive operational activity, payments cannot be deducted.

Second, the default rule is that receipt of foreign services should directly or indirectly benefit a domestic related party financially. Payments for foreign services cannot be deducted in the following violations of such default rule.

  1. Foreign services are not relevant to function, risk, or operation of the domestic related party;
  2. Foreign control, management, and supervision services are provided to protect direct or indirect investor’s interest in the domestic related party;
  3. Foreign services are redundant to services the domestic related party has performed or purchased from a third party;
  4. The domestic related party receives no direct services despite obtaining extra benefits from being a part of business group;
  5. Foreign services have already been compensated in other related party transactions;
  6. Foreign services otherwise provide no direct or indirect financial benefits to the domestic related party.

Third, to the extent that foreign legal owner of an intangible contributes nothing to its value, a domestic related party cannot deduct payments of royalties inconsistent with the arm’s length principle. Pricing for royalties should be determined based on respective degree of contributions in creating the value of such intangible as well as economic interest of each contributor.

Fourth, it is possible that an offshore holding structure is set up to raise capital or conduct initial public offering (“IPO”). A domestic related party cannot deduct payments of royalties to its offshore affiliates in exchange for incidental benefits out of such fundraising or IPO.

Our Observations

The SAT’s only power in this war is to deny deduction of paying related party outbound payments without affecting the money flow. Announcement 16’s approach is essentially about the underlying substance of foreign related parties or transactions involved. It will require substantial work on the part of both taxpayers and the Chinese tax authorities as to each case. Since tax disputes will certainly arise as a result of Announcement 16, taxpayers should just get ready.