On September 17, 2015, China's State Administration of Taxation (SAT) released the draft of "Implementation Measures of Special Tax Adjustment" (the "Draft") for public comments. As a response to the deliverables of the Base Erosion and Profit Shifting Action Plans (the "BEPS Deliverables"), the Draft absorbs many recommendations in the BEPS Deliverables and represents the most prominent development in China's transfer pricing ("TP") regime.  Once the Draft is officially issued, it is expected to significantly impact and shape multi-national companies' ("MNC") transfer pricing practice in China.

The Draft contains 16 chapters in total. Compared to the existing Guoshuifa [2009] No.2 ("Circular 2"), the Draft adds three new chapters, i.e. Chapter 6 - Intangible, Chapter 7 - Intra-group Services, and Chapter 13 - Profit Level Monitoring. Meanwhile, the original chapters under Circular 2 are expanded with more systematic and informative elaborations. Highlighted below are the salient points.


The Draft refines the definition of related party and provides a more concrete guideline for identifying related parties. Also, some additional types of transactions are specifically included in the range of RPT, for instance, transfer of financial assets, transfer of non-typical intangibles such as goodwill or going- concern value, and financing arrangements like advanced and deferred payments.


With reference to the BEPS Action 13 Deliverable, the Draft creates a new TP documentation structure composed of a Master File, a Local File and a Special Issue File. Specifically, the Master File requires disclosure of the MNC group's overall business operation, and also analysis of the group's global business, value contribution, intangible and financing arrangements coherently. The Local File requires disclosure of the local reporting company's RPT and comparable analysis, with emphasis on analysis of the company's position in the group's value chain as well as profit contribution to the group. The Special Issue File would be required to elaborate the relevant TP arrangement if the local company has intra-group services, cost sharing arrangement or related party financing arrangement.


The Draft provides two new TP methods, i.e. the Value Creation Attribution Method and the Asset  Appraisal Methods. The new TP methods are likely to be used to deal with complex intangible   transactions and situations where comparable transaction information is hard to locate. The Value Creation Attribution Method is a method to allocate combined profit of related parties by using one or several value contribution related allocation keys, by way of analyzing and comparing the value contribution of each related party. The Asset Appraisal Methods, on the other hand, are consistent with the general practice of asset appraisal, including the cost approach, market approach and income approach. Considering that China market comparable information is generally limited, and the RPT by and among the MNCs   frequently involves intangibles, these two new methods are likely to be used widely in practice.

Besides, the Draft introduces some new concepts as the factors to be considered and analyzed for implementing the TP methods, such as special geographical factor, marketing intangibles, and intra-group synergistic effects, which have been heavily discussed in the last few years.


The Draft includes some detailed provisions and illustrations on the rights and obligations of tax authorities and taxpayers during a TP investigation, and also provides guidance on some TP investigation issues that are not addressed in Circular 2. For example, the Draft confirms the circumstances where the tax authorities should have the right to request a taxpayer to provide the by-country report and other relevant materials of its overseas related parties, and the taxpayer shall not refuse this request.  For toll manufacturing services, the value of consigned materials and equipment should be added back for TP analysis, and the adjustment based on working capital different shall not exceed a prescribed limit. In an investigation, analysis of extra profit derived from special geographical factors such as cost saving and market premium is generally required.


The guidelines on intangibles under Chapter 6 of the Draft are generally consistent with BEPS Action 8  and Action 10, and coherently summarize the SAT's opinions on TP administration related to intangibles, including the positions set forth in the SAT Public Announcement [2016] No. 16 ("Announcement 16"). The concepts of intangibles, including legal ownership and economic ownership of intangibles, are clearly defined and distinguished, and a list of factors is provided for assessing the value contribution of intangibles. Also as a principle, Chapter 6 emphasizes that distribution of profit derived from intangibles shall be consistent with the distribution of economic activities and value contribution by different related parties. On one hand, if a participating party only contributes fund but does not perform functions or bear risks, the party shall only be entitled to a reasonable return for its funding. On the other hand, if a participating party that merely holds the legal ownership but does not contribute to the value of the intangible, they shall not share the profit derived from the intangible. Regarding the TP method, Chapter 6 encourages application of the newly introduced Value Creation Attribution Method and the Asset Appraisal Method, and also requires reasonable adjustment on royalty payment based on the change of related intangible's value.


Chapter 7 of the Draft re-emphasizes the beneficial principle for intra-group services that have been introduced in Announcement 16, and also enumerates the cases where intra-group services should be denied as beneficial. Furthermore, Chapter 7 mandates that pricing and fee allocation in intra-group services should be consistent with the benefit enjoyed by each of the related parties. Besides, Chapter 7 lists the scope of items which shall be covered in the intra-group service Special Issue File; and according to Article 19, the Special Issue File shall be prepared by all enterprises dealing with intra-group services, regardless of the amount of the intra-group services.


In light of tax administration, the Draft requires the tax authorities to establish and improve a dynamic administration index system for RPT profit monitoring. Under this system, dynamic assessment on enterprises' TP risk level will be conducted by using prescribed management index, warning value and risk analysis model. Accordingly, different administration and monitoring measures will be taken on enterprises with different TP risks.

In addition to the aforementioned salient points, the Draft also refines and enhances the chapters on advanced pricing arrangement, cost share agreement, controlled foreign corporations, thin capitalization and general anti-avoidance.

This Draft is meant for soliciting public opinion, and the deadline is October 16, 2015. Considering the consistency between this Draft and the BEPS Deliverables and the fact that the major changes have been more or less reflected and discussed in some previous tax circulars, it is expected that the final version of this new implementation measure will be released by the end of 2015, with limited difference from this Draft. Therefore, it would be highly advisable for MNCs to study and familiarize themselves with these changes as soon as possible, and start preparing for the work of 2015 TP documentation. At the same time, reviews of existing transfer pricing arrangements and reassessments of related TP risks will be an indispensable tax task for MNCs in China.