Country-by-Country Reporting: China

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Cheng Chi, Ho-Yin Leung, Wendy Zhu, and Eden Yamaguchi
KPMG Advisory (China) Limited

On January 30, 2014 the OECD published a revised Discussion Draft on Transfer Pricing Documentation and Country-by-Country Reporting.1 The Discussion Draft proposes substantial changes to Chapter V (“Documentation”) of the OECD's Transfer Pricing Guidelines, including the adoption of a master file and local country file approach and the reporting on a country-by-country basis of income, taxes and business activities. Large European banks and insurance companies are already required to report on a country-by-country basis under Directive 2013/34/EU of June 26, 2013 (see especially articles 17(g) and 17(r)). On April 9, 2013 the European Parliament agreed on country-by-country disclosure requirements for the extractive industry and loggers of primary forests (see European Commission Memo/13/323) and the European Commission may extend this reporting to all large taxpayers.

The “Model Template” at Annex III of the OECD Discussion Draft provides for information to be given by each taxpayer in its master file, section (e) (financial and tax positions), for each country, and separately for each constituent entity organised in each country, as follows:

  •  place of effective management
  •  important business activity code(s)
  •  revenues
  •  earnings before income tax
  •  income tax paid, on a cash basis, to the country of organisation, and to all other countries
  •  total withholding tax paid
  •  stated capital and accumulated earnings
  •  number of employees
  •  total employee expense
  •  tangible assets other than cash and cash equivalents
  •  royalties paid to constituent entities
  •  royalties received from constituent entities
  •  interest paid to constituent entities
  •  interest received from constituent entities
  •  service fees paid to constituent entities
  •  service fees received from constituent entities
  •  any additional information which could facilitate the understanding of the compulsory information provided in the template.
  • Concerns have been expressed that the reporting of this information will either not be helpful to tax administrations, or will encourage them to deviate from the application of transfer pricing methods according to the OECD's existing guidance, or even from the arm's length principle itself.


    The country-by-country information in the proposed master file is intended to be helpful in risk assessment processes, and is a response to the OECD's July 19, 2013, Base Erosion and Profit Shifting Action Plan for the development of rules to enhance transparency for tax administration. It is intended that it should facilitate the application of the OECD's (Draft) Handbook on Transfer Pricing Risk Assessment of April 30, 2013.

  •  To what extent has your tax authority indicated that it would make use of the full list of information that is required by the template in transfer pricing risk assessments?
  •  To what extent is it already asking for and making use of this information?
  • The information specified in the country-by-country reporting template overlaps with the factors which are often used to apply the OECD's Profit Split Method (in line with paragraph 2.135 of the OECD's Transfer Pricing Guidelines).

  •  To what extent have your local tax authority or your local courts shown a willingness or preference to use the Profit Split Method?
  • The information specified in the country-by-country reporting template overlaps with the factors (sales, tangibles assets, employees, payroll) proposed for use in the European Commission's Common Consolidated Corporate Tax Base (see COM(2011)121/4).

  •  To what extent have your tax authority or your local courts been prepared to adopt a global formulary apportionment of profit as opposed to following the arm's length principle set forth in Article 9 of the OECD Model Tax Convention?

    Issue One
    To what extent has your tax authority indicated that it would make use of the full list of information that is required by the template in transfer pricing risk assessments? To what extent is it already asking for and making use of this information?

    The governing Chinese transfer pricing regulations are contained within Guoshuifa No. 2 [2009] Implementation Measures of Special Tax Adjustments (Provisional) (“Circular 2”), and Article 14 of Circular 2 includes the information required for taxpayer's contemporaneous documentation. The reporting requirements are extensive, including mandatory form templates that must be filled in and submitted with the tax return or attached to the transfer pricing report prepared. The totality of information disclosed is generally consistent with the OECD's Discussion Draft on Transfer Pricing Documentation and County-by-Country Reporting (“OECD Discussion Draft”).2

    Furthermore, some items not formally listed in Circular 2 but included in the OECD Discussion Draft have been requested of certain taxpayers on a case-by-case basis by a relevant level of authority (provincial, national, etc.). For instance, China tax officials focused on information on some taxpayers' entire value chains during transfer pricing investigations or advanced pricing arrangement (“APA”) proceedings. The documentation trail comprising both external annual reporting disclosures as well as internal policy handbooks or records are increasingly being used by the tax authorities to examine and challenge taxpayers – evidence of inconsistencies or changes across years are investigated and thoroughly vetted against the actual conduct of the parties to appropriately justify a level of profits commensurate with the true nature of the functions and risks.

    On an overall basis, however, the current documentation obligations for Chinese taxpayers are not as exhaustive as what has been proposed in the OECD Discussion Draft. China's national tax authority, the State Administration of Taxation (“SAT”), has not released any formal comments on the OECD Discussion Draft.

    Parallel to the OECD's proposed information disclosures, the Chinese transfer pricing regime has notable recent developments that reflect increasing efforts towards transparency and scrutiny of non-arm's length arrangements. To begin with, the SAT intends to implement revised tax reporting forms that will be added to the current set of documents contained within a taxpayer's annual tax return package. These additional disclosures will help the relevant authorities garner more information on taxpayer's activities, including tax planning arrangements.

    Moreover, a tax bureau in China has developed an “advanced warning system” that utilises a few hundred indicators of risk to identify potential audit targets. Based on discussions with tax officials, this risk assessment tool was developed using information collected through historical transfer pricing documentation and tax return information, and has been considered favourable enough amongst the SAT that it may be adopted nationwide in the near-term. It is reasonably expected that there may be significant overlap between the information proposed by the OECD Discussion Draft template and this advanced warning system. This comes as no surprise since, in recent years, the tax authorities have regularly collected the transfer pricing documentation of all qualified taxpayers versus the historical approach of requesting documentation from only a subset of taxpayers who would then be subject to further scrutiny. The Shanghai tax bureau has diligently collected documentation every year since 2010, and other cities typically either follow the same approach or request a taxpayer's documentation every two to three years. This would lead us to believe that the information gathered recently has helped establish and enhance the tax authorities' insight and risk assessment ability, as well as build up the database of information used in the advanced warning system tool. At the very least, it allows tax authorities to be able to compare current-year profit levels and / or recent profitability trends across competitors located in the same jurisdiction.

    It is easy to see this is a positive feedback cycle – information disclosed by a taxpayer is archived in the system and can be used to build arguments against that taxpayer in the future based on the facts and circumstances at that time. Coupled with the fact that a transfer pricing audit in China can be initiated for up to 10 years in the past, it is imperative that taxpayers consider with foresight and prudence not only what information should be disclosed, but how to disclose it since changes or inconsistencies undoubtedly will be flagged by the system.

    Lastly, the SAT intends to actively participate in mutually beneficial information exchanges with overseas taxing authorities that can help identify transfer pricing arrangements targeted by the OECD's Base Erosion and Profit Shifting (“BEPS”) initiative. This is exemplified in China's recent signing of the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, which encourages foreign jurisdiction participants to share tax-related information on multinational enterprises' global operations (providing transparency beyond China's borders).3

    Issue Two
    To what extent have your local tax authority or your local courts shown a willingness or preference to use the Profit Split Method?

    There is no preferred transfer pricing methodology or hierarchy of methods outlined in Circular 2. Similar to most country regulations and the prevailing OECD Guidelines, Circular 2 states that a reasonable transfer pricing method should be employed when evaluating intercompany transactions, and that such transactions shall observe the arm's length principle. The guidance provided by Circular 2 for determining the most reasonable method states that a comparable analysis should be conducted in selecting and employing a reasonable transfer pricing method, and should mainly include the following five aspects:4

  • 1. the characteristics of assets or labour services involved in a transaction, mainly including the physical characteristics, quality, quantity, and other aspects of tangible assets, the nature and scope of labour services, the types of intangible assets, its modes of trade, term and scope, expected earnings and other aspects;
  • 2. the capabilities and risks of all parties to the transaction; the capabilities mainly include research and development, design, purchase, processing, assembling, manufacturing, stock management, distribution, after sales service, advertising, transportation, warehousing, financing, financial, accounting, legal and human resources management abilities; in comparing capabilities, attention shall be paid to the extent of similarity between assets employed by the enterprises concerned in playing their respective roles; the risks mainly include research and development risk, purchase risk, production risk, distribution risk, marketing promotion risk, management risk and financial risk and other risks;
  • 3. the terms and conditions of the contract involved, mainly including the subject matter of the transaction, the quantity and price of goods involved in the transaction, the manners and conditions of payment, the conditions of delivery, the scope and conditions of after sales services, stipulations for the provision of additional labour services, the right to change or modify the contract, the term of the contract, and the right to terminate or renew the contract;
  • 4. the economic environment, mainly including an overview of the sector involved, geographic location, market size, market hierarchy, market share, the extent of market competition, consumer purchasing power, the alternatively of the goods or labour services involved, prices for elements involved in the production, the cost of transportation, government regulations, and others; and
  • 5. business strategies, mainly including innovation and development strategies, multiple-sector business strategies, risk avoidance strategies and market share strategies or others.

    Circular 2 outlines that under the Profit Split Method, the amount of profits that shall be distributed respectively to an enterprise and its associated party shall be calculated on the basis of contribution to the consolidated profits of the associated transaction involved made respectively by them, and consists of the General Profit Split Method and the Residual Profit Split Method. Under the General Profit Split Method, profits are distributed to all relevant related parties on the basis of roles played, risks assumed and assets employed by all parties. Under the Residual Profit Split Method, the surplus profits are calculated as the amount remaining after normal profits distributed to all parties to an associated transaction are subtracted from the consolidated profits, and are then distributed based on the respective contributions of the parties. The Residual Profit Split Method generally applies to situations in which associated transactions are so closely integrated that it is difficult to make separate evaluations on the results of transactions for all parties.

    In practice, the Chinese tax authorities have shown a tendency to apply the Transactional Net Margin Method (“TNMM”). As described in the “China Country Practices” chapter published in the United Nation's Practical Transfer Pricing Manual (“China Chapter”), the challenges in applying the TNMM to developing countries such as China include a lack of reliable public information on comparables. Therefore, China takes the view that comparability adjustments are typically warranted to bridge the differences in a TNMM analysis; in practice, this typically involves heavy scrutiny of the comparable companies chosen / geographic markets searched and inquiry into how the taxpayer accounted for China-specific location-specific advantages (“LSAs”) affecting the tested party. Due to the extensive information requirements regarding transaction(s) and pricing needed to apply the Profit Split Method (along with the Comparable Uncontrolled Price and Resale Price Methods), these methods tend to be applied less frequently than the TNMM in China, as noted by the annual report on the country's APA programme.5 The SAT also states in this report that it wishes to apply the Profit Split Method (and Resale Price Method) more frequently within the APA programme, and will even prioritise APA submissions that present an innovative application of a(ny) transfer pricing method.

    The SAT may consider the Profit Split Method is more appropriate than the TNMM when the Chinese entity contributes significantly to the value of intangibles or performs high value-added functions and assumes additional risks. During audits and APA proceedings, the tax authorities are more than willing to assess the applicability of the Profit Split Method since this increases the potential upside for the Chinese taxable income base when the value chain benefits from above-average profitability (i.e., when there actually are residual profits to split). This typically comprises conducting in-depth interviews with the local marketing and research and development (“R&D”) teams in order to establish the breadth of these activities occurring in China. The Profit Split Method is deemed applicable if it is determined that intangibles are created locally as a result of these or other functions. Likewise, the Chinese tax authorities have also been known to compare the marketing and R&D spending at the local level to the marketing and R&D expense intensity incurred at the headquarter level in order to assess whether (additional) residual profit is further justified at the Chinese taxpayer. Frequently, the R&D spending in China is greatly overshadowed by the core R&D expense that occurs at the headquarter-level, so the results of this type of analysis may be limited. However, when it comes to marketing, there are many instances when local marketing activities and their associated expenses incurred by the Chinese taxpayer often demonstrate that the local affiliate engages in significant on-the-ground customer development / maintenance activities, which substantiates leaving at least some portion of the residual profit over and above the benchmarked return of a traditional “routine” entity. The SAT has continued to advocate for recognition of intangibles developed at the local level, as outlined in the China Chapter, which would motivate the use of the Profit Split Method over another method.

    However, practical considerations affect the ability to apply the Profit Split Method in China due to the interrelationship across the regulatory establishments tangential to the transfer pricing administration. For instance, both China's customs and foreign exchange regimes heavily influence the implementation procedures of a company's transfer pricing arrangement, many times presenting conflicts of interest that would be exacerbated by using the Profit Split Method. For example, both inbound and outbound remittances arising from variable annual residual profits would require the involvement of and approval from China's State Administration of Foreign Exchange (“SAFE”), which operates under a different set of rules and regulations than transfer pricing. Lastly, the tax clearance procedures associated with such a remittance are not undertaken by transfer pricing officials or authorities well-versed in transfer pricing, which adds another layer of complexity and administrative burden to making cross-border payments.

    Issue Three
    To what extent have your tax authority or your local courts been prepared to adopt a global formulary apportionment of profit as opposed to following the arm's length principle set forth in Article 9 of the OECD Model Tax Convention?

    Usage of the global formulary apportionment has not been discredited by the Chinese tax authorities. Certain senior officials expressed a willingness to apply a similar method if, in fact, the results of applying the traditional methodologies outlined in Circular 2 are not considered reasonable in the context of evaluating the functions and risks assumed by the relevant Chinese affiliate(s). It is likely the arm's length principle will continue to be the preferred method used by the tax authorities, but a global formulary apportionment approach may be adopted in certain cases for which the arm's length standard did not provide a sufficient expedient. As noted previously, the Chinese tax authorities may take a more non-traditional approach to applying the arm's length standard when determining the reasonableness of a taxpayer's position in order to account for China-specific market or industry considerations or other factors affecting a company's transfer pricing arrangement in China.

    The same problems arising from the application of the Profit Split Method exist for formulary apportionment, including information disclosure requirements, post-transaction adjustments that question the validity of the original import price and associated customs duties, and the required involvement of both China's SAFE bureau and tax clearance officials.

    Overall, the Profit Split Method provides more flexibility than a strict formulary apportionment of profit. In consideration of the priorities and concerns outlined in the China Chapter and other official statements made by the SAT, on the surface, a formulary apportionment of profit still lacks the flexibility needed to fully account for China-specific LSAs and market factors (without materially changing the fundamental formulary apportionment calculation). For instance, the use of payroll expense and / or asset values as factors contributing to the profit allocation due to a Chinese taxpayer still discounts the relatively lower costs associated with operating in China. Therefore it is likely that the Profit Split Method (or in general, a more traditional application of the arm's length principle) would still be considered a preferred method over the formulary apportionment method by the tax authorities.

    The Chinese tax authorities will likely clarify their position on various transfer pricing matters, potentially including their thoughts on the global formulary apportionment, once Circular 2 is updated. Its initial issuance was titled as a provisional version, which provided flexibility to improve the effectiveness and efficiency of China's transfer pricing administration in the future. Therefore, both Chinese taxpayers and transfer pricing professionals should closely monitor further developments of Circular 2, especially in this fast-changing global transfer pricing environment.

    Cheng Chi is the China and Hong Kong SAR leader of Global Transfer Pricing Services at KPMG China. Ho-Yin Leung is a partner; Wendy Zhu is a senior manager; and Eden Yamaguchi is an Assistant Manager in Global Transfer Pricing Services at KPMG China in Shanghai. They may be contacted at:,, and



    2Please refer to Bloomberg BNA's Transfer Pricing Forum, Vol.4. No.4, September 2013, “Documentation”, for detail on China's documentation requirements.

    3“China joins international efforts to end tax evasion.” 27 August 2013. OECDCentre for Tax Policy and Administration.

    4Article 22, Circular 2.

    5China Advance Pricing Arrangement Annual Report (2012) issued by the SAT.