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Cheng Chi, Ho Yin Leung and Eden Yamaguchi
KPMG Advisory (China) Ltd.
4. Comment on the frequency of transfer pricing audits involving services, or on any other trends in this area. Have you noticed an increase in attention geared toward the transfer of intercompany services in your jurisdiction?
5. What are the expectations of tax authorities in your jurisdiction with respect to applying allocation metrics? What type of support and justification is typically needed for applying allocation metrics?
6. Concerning your country's view of the provision of R&D services. Are contract R&D services permissible? When will the provision of intercompany services be assumed to be a transfer of intangible property requiring compensation?
Although in China the State Administration of Taxation (“SAT”) does not officially release data related to the particular focus of transfer pricing audits, recently-issued circulars, directives and discussion papers highlight the SAT's current focus on intercompany services, particularly as key audit targets for transfer pricing investigations. SAT officials have emphasized in recent public addresses the need for stricter analysis of intercompany service transactions, outlining six specific tests to determine the reasonableness and deductibility of intercompany service charges. A detailed discussion of examples of the application of the following six tests was provided in the last issue of the BNA Transfer Pricing Forum:
• Benefit Test. Does the service recipient benefit more from obtaining the services than the service provider benefits from engaging in such services?
• Need Test. Are the services necessary for the day-to-day operations of the Chinese subsidiary and if needed, why does the Chinese subsidiary not engage a local third party or perform such services for likely a lower price due to theoretically lower-cost operators in China?
• Duplication Test. Does the Chinese entity perform the same or similar services on its own behalf? (e.g., intra-group management services are likely duplicative and, thus, should not be charged if the Chinese subsidiary has its own management team making strategic decisions and approvals.)
• Value Creation Test. Do the services provided directly result in, or can be reasonably anticipated to result in, identifiable economic and commercial value to the Chinese affiliate?
• Remuneration Test. Are the charges for services already remunerated through existing transfer pricing policies for other related-party transactions?
• Authenticity Test. Are the services actually provided and is the cost allocation mechanism considered reasonable in this regard?
It can be deduced that satisfying all of these tests to the expectations of the tax authority is a burdensome task for any taxpayer and some of the tests are very difficult, if not impossible, to wholly satisfy. The overarching theme is apparent: tax authorities in China are expecting increased transparency into these service transactions, which necessitates supporting documentation and analysis that can shed light on the specific nature of the services as they relate to the Chinese taxpayer. Asymmetric information, such as analyses that focus on the nature of the services from the perspective of the service provider with a generic list of potential benefits to any worldwide service recipient affiliate (in China or elsewhere) can no longer serve as satisfactory justification for both the principle and form of the service charge.
Therefore, the burden of proof on the taxpayer has intensified twofold: tax authority attention geared towards the transfer pricing of intercompany services has not only increased, but the spectrum of requirements that need to be met in order to justify the service charge has also become more detailed and exhaustive.
Thanks to the Directive 146 (“Circular 146”) issued by the SAT in July 2014, we expect transfer pricing audits involving services to increase significantly since Circular 146 summoned provincial and local tax authorities to examine and report on intercompany service fees carried out during the previous 10 years (2004-2013) which fall under the Chinese statute of limitations for transfer pricing adjustments. Previously, services were generally considered targets for investigative scrutiny when the nominal amount comprised a significant portion of the Chinese taxpayer's business, there were multiple service charges to or from related parties, and/or the associated transfer pricing policy (e.g., mark-up) was considered unreasonable. Circular 146 now invites the examination of intercompany services, which will inevitably broaden the scope of investigation for all levels of tax authorities to capitalize on this opportunity for potential tax revenue.
Taxpayers should be mindful of creating a distinction between the parties responsible for, and the value attributable to, both management/control functions and on-the-ground/local execution functions related to the service activities. Although guidance has not been solidified on these points, the Chinese tax authorities can try to argue to their advantage depending on the fact pattern of the situation. For instance, this could result in the potential recharacterization of the transaction and assertion that the local Chinese entity should be entitled to at least a portion of the residual profits due to its perceived role in the management or strategic development of the services, or due to its value-adding execution functions (when there is only superficial oversight provided to China). Alternatively, another favorable position may relate to, in fact, the creation of a related-party transaction that remunerates (likely on a cost-plus basis) the Chinese affiliate for its routine services provided on behalf of its related party. This has occurred in such cases as when a trading company has operating losses due to significant marketing costs—the Chinese tax authority demanded that the excess advertising and promotional expenses (the amount of costs exceeding the threshold set by the comparable companies) be remunerated by the overseas affiliate at a mark-up for the China taxpayer's role in routine marketing activities.
The increased scrutiny by the SAT will likely require taxpayers with outbound related-party non-trade payments, especially to tax haven jurisdictions, to provide more convincing support for their transfer pricing positions. Against this background, taxpayers in China need to ensure that adequate evidence is in place to support their related-party arrangements, potentially through additional layers of documentation and internal evidence to support that intercompany service transactions are being carried out in accordance with the arm's-length principle.
Recently, the SAT has been increasing its scrutiny towards evaluating the role of Chinese taxpayers in the development and maintenance of intangible property (“IP”). Further, the SAT has stated that it is seeking guidance from the United Nations (“UN”) with respect to the issue of differentiating technical service fees from royalties.
In particular, the SAT has placed a heavy emphasis on the concept of “value creation”, and aims to ensure that risks and ownership of IP are not being contractually shifted overseas in cases where the Chinese entity creates value through its R&D activities or other services, especially in cases in which the overseas related party is not actually involved in the day-to-day management of such services performed in China. Such issues will be covered in further detail in the response to Issue Six (below).
China tax regulations specifically disallow the deduction of “management fees.” In general, “head office charges” also face scrutiny due to the focus on justifying real economic benefit derived from such services, especially if they resemble services already performed locally in China. As more multinational companies (“MNCs”) establish their Asia-Pacific (“ASPAC”) regional headquarters in China, Chinese tax authorities may need to take a more symmetric evaluation approach in the context of inbound service fees for these regional services versus outbound service charges paid by Chinese taxpayers receiving services similar in nature from overseas affiliates.
As there are no specific Chinese transfer pricing regulations related to intra-group services, Chinese taxpayers and tax authorities rely on the general principles outlined in Chapter VII of the OECD Guidelines, which state that allocation keys should appropriately reflect the level or amount of benefits received.
The developing nature of China adds a certain complexity in service fee analyses, in that allocation metrics applied by global MNCs in their worldwide service charging models can, as argued by Chinese tax authorities, at times be disadvantageous to taxpayers in China who may generate significant turnover (a commonly used allocation metric) and/or could have achieved additional cost savings if they had, for instance, outsourced such services provided by overseas affiliates to local third-party service providers. Appropriately considering such China-specific concepts in the application of allocation metrics is generally favored by tax authorities in China in order to support the validity of the service charge, and shifts the burden of proof away from the taxpayer to address such concerns. Going forward, Chinese tax authorities will have to re-think their strategy regarding the scrutiny of cost allocation methodologies to potentially be more consistent across inbound and outbound service charges with this growing proportion of service income.
Similar to other jurisdictions, taxpayers need to have extensive supporting documentation in place, not only to validate the allocation key(s) applied, but also to demonstrate the specific economic benefit received by the Chinese affiliate. This recordkeeping can include, but is not limited to, such items as: company guidelines outlining the chain of command and the distinct (non-overlapping) roles of the service provider versus the service recipient; internal policies governing the services; e-mails or other communication documenting the actual provision of services; travel itineraries; meeting agendas and minutes; etc.
Contract R&D services are generally “permissible” in China; however, these have recently become subject to increasing scrutiny from the Chinese tax authorities. While the prevailing transfer pricing regulations in China do not offer specific guidance regarding the determination of the transfer of IP as a result of service provision, Chinese tax authorities have recognized the need to fully consider the role of local enterprises in value creation, as further emphasized in the OECD's Base Erosion and Profit Shifting (“BEPS”) Action Plan. There is potential for the tax authorities to deem an effective transfer of IP requiring compensation by utilizing the concept of economic ownership to assert that a contract R&D affiliate should be entitled to at least a portion of the ongoing system profits associated with the IP to which it contributes value, even if it is not the legal owner of such IP.
While the BEPS initiative seeks a more consistent approach to addressing transfer pricing issues, the SAT may utilize the tools laid out by the OECD and the G20 to argue to its advantage. For instance, the SAT has contended that, when understanding the significance of people functions, value should be attributed to execution functions, and not just strategic functions. Emphasis is placed on the day-to-day oversight and on-the-ground decision-making activities, such as in the case of contract R&D service providers. If the substance in regards to control and execution of the R&D activities is in actuality performed substantially by the Chinese affiliate, then the tax authorities are likely to recharacterize the function and risk profile of the entity and argue that the taxpayer should be entitled to the residual profit related to its R&D contributions.
In light of this heightened focus on contract R&D service providers, Chinese tax authorities may challenge royalty payments made by these local service provider entities for related IP. In the past, Chinese tax authorities may have directed their focus to ensuring the appropriate mark-up on costs that should be earned by the Chinese affiliate. Now, however, Chinese tax authorities are extending their argumentation to invalidate the substance of any royalty payments made by these entities, or at least demand the application of a profit split methodology.
Cheng Chi is the Partner-in-charge for China and Hong Kong SAR, Ho Yin Leung is a Partner and Eden Yamaguchi is a Manager in Global Transfer Pricing Services at KPMG Advisory (China) Limited, based in Shanghai. They may be contacted at:
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