As a result of China’s involvement in the G20 and OECD’s Base Erosion and Profit Shifting (“BEPS”) Action Plan, the State Administration of Taxation (“SAT”) has been working for the last two years on amending its transfer pricing regulations, i.e., Guoshuifa  No. 2 on Provisional Administrative Measures on Special Tax Adjustment (“Circular 2”), releasing a draft for public opinion in September 2015.
However, instead of pushing forward the draft and releasing all the amendments in one regulation, the SAT recently issued Announcement  No. 42 on improving related-party transactions reporting and administration of transfer pricing documentation (“Circular 42”).
Circular 42 focuses separately on the new requirements for related-party transactions reporting and administration of transfer pricing documentation, so companies in China have enough time to study the new requirements and prepare for the changes to be applied to the 2016 financial year and onwards.
Circular 42 will replace chapter 2 (related-party transaction reporting), chapter 3 (administration of transfer pricing documentation), article 74 (transfer pricing documentation for cost sharing agreement) and article 89 (transfer pricing documentation for thin capitalization) of Circular 2. It is expected the SAT will continue to work on the amendments for other chapters in Circular 2 and release them soon through other announcements.
The highlights of Circular 42:
- Circular 42 specifies that the subjects of related-party transactions reporting are (1) resident companies with account books and (2) non-resident companies with establishments in China being taxed based on actual accounting. These companies must comply with reporting requirements when submitting the enterprise income tax annual return, i.e., by May 31 of the following year.
- The new versions of related-party transactions reporting forms are attached to Circular 42, updated from the original eight forms to the current twenty-two forms, including the forms designed for country-by-country (“CbC”) reporting.
- Circular 42 clarifies the definition of related parties:
- Regarding shareholding, if two or more individuals who are spouses, linear descendants, brothers and sisters, or have other dependency or parental support relationships, jointly hold equity of one company, their shareholding must be consolidated.
- The circular establishes a new formula to assess whether parties are related when the ratio of total lending to paid-in capital exceeds 50.
- When the parties are related because of mutually appointed directors or senior management, the scope of senior management is expanded to include the secretary of the board of directors in a listed company, manager, deputy manager, chief financial officer and other personnel specified in the articles of association.
- When two individuals separately have related-party relationships with two companies based on any of the conditions defined, and these two individuals are spouses, linear descendants, brothers and sisters, or have any other dependency or parental support relationship, the two companies will be considered related parties.
- Parties are not considered related because they have a state shareholding or because the State-Owned Asset Management Commission appoints common directors or senior management.
- Circular 42 adds a new category of related-party transactions: transfer of financial assets, including accounts receivable, bills receivable, other receivables, equity investments, debt investments and financial derivatives.
- Circular 42 defines the subjects and content of CbC reporting, a significant implementation of BEPS Action 13.
The following resident companies must fill in the CbC reports attached to the related- party reporting forms:
- The resident company that is the ultimate parent entity of a multinational enterprise (“MNE”) group, and the MNE group’s total income in the last year’s consolidated financial statements exceeds RMB 5.5 billion (an amount more or less equivalent to the €0.75 billion threshold provided under BEPS Action 13).
A constituent entity of the MNE group is:
- Any separate business unit of an MNE group included in the consolidated financial statements for financial reporting purposes.
- Any business unit that would be included in the consolidated financial statements if the equity interests were traded on a public securities exchange.
- Any business unit excluded from the MNE group’s consolidated financial statements based solely on size or materiality grounds.
- Any permanent establishment of any separate business unit of the MNE group, provided the permanent establishment has independent accounting and prepares separate financial statements.
- The resident company appointed by the MNE group to prepare the CbC reports.
When a resident company is not under the above scope but the MNE group it belongs to prepares CbC reports under the laws of another country, the Chinese tax authorities can require the resident company to provide the CbC reports during a special tax adjustment inspection if:
- the MNE group does not disclose its CbC reports to any country;
- the MNE group discloses its CbC reports to another country with which China has not established an information exchange mechanism for CbC reports; or
- the MNE group discloses its CbC reports to another country with which China has established an information exchange mechanism for CbC reports but the CbC reports have not been successfully exchanged with China.
CbC reports have three forms: (i) an overview of the allocation of income, taxes and business activities by tax jurisdiction; (ii) a list of all the MNE group’s constituent entities in each tax jurisdiction; and (iii) additional information.
Transfer pricing documentation
- Further to BEPS Action 13, China has developed a three-tier approach to transfer pricing documentation, including master file, local file and special item file. Companies must prepare these files if they meet the conditions for each, so they may have to prepare multiple files.
- Master file: conditions and content:
- A resident company must prepare the master file if:
- it carried out related-party crossborder transactions during the year and the ultimate parent entity of the MNE group that prepares the consolidated financial statements has already prepared the master file; or
- the total of its annual related-party transactions exceeds RMB 1,000 million.
- The master file must describe the MNE group’s (i) organizational structure, (ii) businesses, (iii) intangibles, (iv) intercompany financial activities, and (v) financial and tax positions.
- Local file: conditions and content:
- A resident company must prepare the local file if:
- its transfers of tangible assets exceed RMB 200 million;
- its transfers of financial assets exceed RMB 100 million;
- its transfers of intangible assets exceed RMB 100 million; or
- the total of its other related-party transactions exceeds RMB 40 million.
- The local file must describe (i) the local entity, including the organizational structure, the management structure, the business and business strategy, segmental financial data and any corporate restructuring or transfer of intangible assets that may affect the local entity; (ii) related-party relationships, including basic information, tax position and any changes made; (iii) related-party transactions, including a detailed analysis of the value chains, foreign investment, related-party equity transfers and related-party services; (iv) benchmark analysis; and (v) choice and use of transfer pricing methods.
Compared to Circular 2, Circular 42 greatly increases the amount of information disclosed in the transfer pricing local file. Therefore, resident companies meeting the conditions should analyze these changes and prepare for next year’s filing.
- Circular 42 does not set a threshold amount for the special item file on cost sharing agreements. This means that any company signing a cost sharing agreement must prepare it. Any resident company whose ratio of related-party debts to capital exceeds the standards (5:1 for financial institutions and 2:1 for other companies) must prepare the special item file on thin capitalization.
- Circular 42 exempts the following from transfer pricing documentation:
- transactions under an advanced pricing arrangement; and
- resident companies carrying out only domestic related-party transactions regarding all files.
- Under Circular 42, the MNE group’s ultimate parent entity must prepare the master file within 12 months from the end of the financial year. The local file and the special item files must be prepared before June 30 in the year following the year the transaction takes place.
Transfer pricing documentation must be kept available for 10 years and be submitted to the tax authorities within 30 days at their request.
Date of issue: June 29, 2016. Effective date: January 1, 2016