Annual review: China and Hong Kong

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

Jeff Yuan, Cecilia Lee, Rhett Liu and Deborah Li, PwC Shanghai and Hong Kong

Jeff Yuan, Cecilia Lee and Rhett Liu are partners; Deborah Li is a senior manager.

Transfer pricing dominated the global limelight in international tax news, particularly with the OECD's recent work on a variety of transfer pricing-related projects during 2013. Transfer pricing is an area that China is very much involved in, particularly with international organisations such as the OECD and UN. International involvement allows China to accumulate more practical experiences, contribute its opinion as a thought leader, and to gain international influence on concepts that it holds in high regard. While the level of transfer pricing activity is relatively lower in Hong Kong, there has been a noticeable increase in the level of breadth and depth of queries raised by the Inland Revenue Development (“IRD”).

l. SAT's core position and focus areas

The State Administration of Taxation (“SAT”) continues to apply and advocate its transfer pricing position to local taxpayers and to the international community. Concepts that China hold in high regard include location specific advantages (“LSA”), market intangibles, services and equity transfers.

In particular, the SAT has publicly stated that it will focus on the following areas in 2014:

• Guo Shui Fa [2009] No.2 (Circular 2): revision of China's core transfer pricing regulations.

• General anti-avoidance: clarification and continued work on detailed guidelines on this topic.

• Services transactions: issuance of guidelines on intercompany services transactions.

• Equity transfer: clarifications on requirements and processes on intercompany equity transfers, such as its preference for the income approach for valuations.

ll. International influence

Two of the OECD projects that are particularly relevant for China are the OECD's Action Plan on Base Erosion and Profit Shifting (“BEPS”) and the Revised Discussion Draft on Transfer Pricing Aspects of Intangibles (“Intangibles Draft”). Although China is not a member of the OECD, the underlying principles and intentions behind BEPS and the Intangibles Draft had long been in development within China's evolving transfer pricing policies, evidenced by its domestic policies on equity transfer and transfer pricing position on cost savings and market premiums under the umbrella of LSAs.

During the OECD's public consultation on transfer pricing matters in Paris during November 2013, the SAT sent a representative to attend the meeting to advocate China's position on transfer pricing issues that the OECD and SAT have different views on. For example, the OECD's Intangibles Draft outlines that LSAs should be considered as a comparability factor rather than a type of intangible. However, the SAT regards the China market as unique and this results in LSAs such as cost savings and market premiums, which could be considered as an intangible. The SAT's position is that if there are no local comparables then LSAs must be specifically addressed and analysed in a transfer pricing analysis, or the profit split method adopted in order to acknowledge the benefits derived from LSAs.

lll. Developing the services regulations

China is developing its domestic regulations on related party services transactions. In the international arena, China has taken the lead in developing the services guidance for the UN framework on transfer pricing for developing countries. These developments, in conjunction with the Chinese government's intention to relax foreign exchange restrictions on non-trade payments, may mean that more taxpayers will be able to remit payments of services fees to their overseas related parties in the long term.

In the short term, we expect that the SAT's focus on services transactions will result in an increase of queries and audits on the deductibility and calculation of services fees. We have observed cases where taxpayers were audited due to overseas service charges, despite relatively high profit levels. Tax authorities were concerned, amongst other things, whether the services were of a stewardship nature or duplicative. Therefore, in the event that a taxpayer's profit falls below a certain level, the tax authorities may further scrutinise the taxpayer's services charges in detail and potentially disallow the deduction of part or all of the service fees. Taxpayers will need to ensure that they have even more robust evidence and support for their inbound related party services charges, and be prepared to submit such documents for the scrutiny of tax officials to justify the nature and substance of the intercompany services charges.

lV. Audit trends

Tax authorities in the North (e.g. Beijing), Central (e.g. Shanghai and Jiangsu) and South (e.g. Guangzhou and Shenzhen) are now very savvy on transfer pricing issues. As a result of the SAT's effort to aggressively enforce its transfer pricing rules throughout China, we have observed an increase of audit cases in the inland and Western cities (e.g. Sichuan), instead of the traditional first and second tier cities or coastal areas only. There has also been an increase in the sophistication of the transfer pricing topics under audit. Generally speaking, there is an increase of general anti-avoidance cases focusing on intangibles, services, and equity transfer transactions, and not just the traditional buy-sell transactions. Consistent with China's position on the importance of LSAs, case officials on transfer pricing audit cases are alsosexpected to address LSA issues.

The SAT has established a new audit procedure to include an independent review panel to further examine the cases which are controversial and complex in nature. The panel consists of tax officials who are considered as experts on the international tax issues. The case officials who manage the taxpayer's case are not included in the panel to ensure independence in the review process for the audit case.

V. APA status update

In August 2013, the SAT released its fourth China APA annual report which outlined a summary of the APA programme and statistics for the year ended December 31, 2012. A total of three unilateral APAs and nine bilateral APAs were signed in 2012 (being five with Asian countries, one with a European country and three in North America). Manufacturing continues to be the dominant industry for APAs signed in 2012 but there is a trend of diversification in the types of industries covered.

The overall APA process remains slow due to SAT resource constraints, however it is pleasing to see that the SAT now has eight full time persons dedicated to the APA programme and transfer pricing-related MAP cases. The SAT has also developed teams and organised them according to expertise and geographic locations. There are three teams responsible for Japan and South Korea, the rest of Asia Pacific (i.e. US, Canada, Australia, Singapore, Hong Kong), and the European countries (i.e. UK, Germany, Netherlands, Italy, Belgium, Luxemburg, Denmark, Sweden, Switzerland).

We are cautiously optimistic that there will be greater movements in the APA pipeline in the coming year. The key to push an APA case forward depends on both the strength of the APA submission and effective communication with various levels of tax officials. When prioritising the APA requests, tax authorities will consider the following factors:

• the time,

• the quality,

• the industry or region, and

• the intention of the BAPA partner country.


Quality is the most important factor and the SAT will place priority on submissions that apply transfer pricing principles in an innovative manner, or contain high quality quantitative analysis on areas such as intangibles, cost savings or market premiums.

Vl. Documentation

During 2013, several different levels of provincial tax authorities across China publicly shared their views on transfer pricing documentation (“TPD”) risk factors and sample results of their internal TPD reviews with tax practitioners and taxpayers. There is nothing particularly new regarding TPD requirements as they have existed since January 2009 when China's main transfer pricing guidelines, Circular 2, were implemented effective January 1, 2008. What is new, however, is the shift in attitude of the tax authorities. The first batch of TPDs (i.e. FY2008 TPDs) were due by December 31, 2009, and the tax authorities have been steadily gaining experience in collecting and reviewing TPDs in the last three years.

The change in attitude by the tax authorities means that taxpayers should also change their perception of TPD compliance and follow a well-planned TPD strategy. Standard country reports with specific facts regarding the taxpayer may no longer be sufficient. Tax authorities are now taking a more systematic approach to TPD review and expect taxpayers to take their compliance requirements with respect to transfer pricing matters more seriously. Essentially, tax authorities in China are now more transparent, but at the same time, more demanding of taxpayers.

Vll. Hong Kong IRD documentation and queries

While there is no mandatory requirement for TPD in Hong Kong, the IRD has stated its expectations for TPD within Departmental Interpretation and Practice Notes Number 46 - Transfer Pricing Guidelines (“DIPN 46”), which is largely based upon the OECD's Transfer Pricing Guidelines.

Over the past year, we have observed a marked increase in the breadth and depth of queries concerning transfer pricing issues compared to the queries on the same issues four years ago, when DIPN 46 was first released in December 2009. In a query or audit situation, the IRD are now likely to explicitly request a copy of the transfer pricing policy or documentation supporting a taxpayer's transfer pricing arrangements. The IRD will expect local input from the taxpayer and a globally prepared transfer pricing report without any localisation or consideration from a Hong Kong perspective is unlikely to be sufficient by itself.

We note the IRD is active in OECD forums on transfer pricing and hosted an OECD workshop on transfer pricing dispute resolution and avoidance in December 2013, which was attended by various tax authorities and tax administrators around the world. In line with global developments on TPD, we expect that Hong Kong taxpayers should be accustomed to a greater level of transparency with the IRD going forward.

Transactions and situations that may arouse the IRD's interest in transfer pricing may include (but are not limited to):

• Significant related party transactions, especially payments of services fees or royalties.

• Volatility in profit levels, especially where there are losses for the Hong Kong taxpayer.

• Related party transactions with “tax haven” jurisdictions.

• Group structures resulting in double non-taxation (e.g. offshore regimes).


Vlll. Looking forward

Going forward, we expect that the international development of BEPS and the Intangibles Draft will have a significant impact on the regulation and regulatory enforcement for China in the next years. We also expect the SAT to aggressively enforce the existing transfer pricing rules, to advocate its own transfer pricing position and to have active influence in the international arenas. For Hong Kong, we expect the IRD to continue to be receptive and knowledgeable of transfer pricing developments in the international area, with potentially greater levels of transparency expected of taxpayers especially with respect to their international tax structures.

In the coming year, we are likely to see significant developments in China's transfer pricing regulation and regulatory enforcements. Taxpayers should be prepared to explain their LSA position in the event of queries from the tax authorities and expect their TPD to be subject to a high level of scrutiny. In addition, taxpayers should expect their service charges, especially inbound charges, to be carefully reviewed in detail by the tax authorities.

For Hong Kong, we expect to see an increase in queries touching on specific transfer pricing issues and a general expectation from the IRD that taxpayers would have prepared appropriate documentation to support their intercompany arrangements.

Jeff Yuan is PwC's Transfer Pricing leader for China, based in Shanghai; Cecilia Lee is a Transfer Pricing Partner, Rhett Liu is a Transfer Pricing Partner Kong and Li is Transfer Pricing Senior Manager, all based in Hong Kong. They may be contacted at:


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