The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
The author examines China's transfer pricing regime as outlined in three bulletins, the most recent of which was issued in March. Taken together, the guidance heralds a new focus on aggressive tax planning and is intended to bring China's tax take up to a level that officials believe more accurately reflects the valuable contributions to the global enterprise made in China.
By Glenn DeSouza, Dentons, Shanghai
Glenn DeSouza is a principal economist and transfer pricing leader at Dentons Shanghai.
Forty-five years after President Nixon visited China, the country is firmly established as America’s number-one economic partner and competitor. No country is as important to American multinationals as China. For many of these companies, China is simultaneously their main source of products and their most important foreign market. But although China is America’s major investment destination, it accounts for only 3 percent of U.S. multinational companies' global tax bill—significantly below the Netherlands and Ireland.
The recently released Bulletin 6 (along with two earlier bulletins) provides China with a framework to align that share with its true economic role. The new guidance, which the State Administration of Taxation formally released March 28 under the title “Announcement on Special Tax Investigations, Adjustments and Mutual Agreement Procedures,” contains 62 articles and covers transfer pricing methods, royalties, service fees, intangibles, audits and the mutual agreement procedure (MAP). In the “Interpretation to Bulletin 6” released April 1, the SAT states that Bulletin 6 was issued to reflect the consensus reached at the Group of 20 countries' summit held in Hangzhou to implement a tax policy that “stimulates economic growth and promotes amicable relationships between business and the tax authorities.”
Despite these positive sentiments, U.S. companies should be on guard. Bulletin 6 heralds a new direction for tax enforcement in China that will impact multinationals for years to come. The guidance focuses intently on companies that use aggressive tax planning via low-tax entities that have no substantial operations. Moreover, the SAT has announced a profit-monitoring system that it will use to encourage many more companies to make so-called self-examinations and voluntary adjustments.
With these new bulletins, China is fully embracing the OECD's Action Plan on Base Erosion and Profit Shifting (BEPS), the organization's comprehensive rewrite of the global tax rules to curb tax avoidance. The U.S. attitude to BEPS could not be more different. When it comes to BEPS, the U.S. Internal Revenue Service is clearly a wallflower at the party. The U.S. has not implemented the Organization for Economic Cooperation and Development's recommendations for the transfer pricing documentation master file and local file under Action 13 of the BEPS plan and is one of the only major economies not to sign the “Multilateral Competent Authority Agreement (MCAA) on the Automatic Exchange of Information of Country-by-Country Reports.”
Bulletin 6 is the third in a series of bulletins issued by the SAT to create a new transfer pricing platform. Together with Bulletin 42 on transfer pricing documentation and Bulletin 64 on advance pricing agreements, it establishes the framework to essentially replace the landmark Circular 2 enacted in 2009 and now obsolete.
|Bulletin Number||Focus||Issue Date||Description|
|42 (27 articles)||Documentation||June 29, 2016||The three-tier transfer pricing documentation requirements include master file, local country file and special files; guidance stresses value chain and location-specific advantages. It also contains an appendix of the new forms for related-party transactions|
|64 (22 articles)||APAs||Oct. 18, 2016||Outlines six-step process for APAs, identifies priority APA applicants|
|6 (62 articles)||Transfer pricing and the mutual agreement procedure (MAP)||March 17, 2017||Articles cover audit procedures, selection of audit targets, profit-monitoring system, self-adjustment procedures, transfer pricing methods, royalties, fees, tolling, DEMPEP analysis (explained below) and MAP procedures|
The bulletins need to be placed in context of some internal dynamics at the Ministry of Finance. In September 2015, the SAT issued a single comprehensive replacement to Circular 2 in the form of a consultation draft that it fully expected to be finalized by Dec. 31, 2015, at the latest. But the SAT does not operate in a vacuum—it is part of the Ministry of Finance and in China, tax has always been subordinate to economic growth. Higher levels in government expressed concern that the consultation draft was an overextension that went beyond the existing tax law. Pushback from the Ministry of Finance resulted in the consultation draft's being scrapped, and as a compromise the SAT was permitted to issue separate bulletins on specific issues.
Bulletin 6 is a kinder and gentler version of the 2015 consultation draft, and walks back some of the extreme positions taken in the 2015 draft. Bulletin 6 reflects complaints from taxpayers and feedback from other governmental bodies, and stresses cooperation over conflict. Notably, taxpayers are encouraged to step up and voluntarily adjust policies and pay taxes. And on a very positive note, Bulletin 6 affirms the arm’s-length principle. U.S. taxpayers will be reassured to learn there are 11 mentions of the principle in Bulletin 6. In particular, Bulletin 6 indicates that the arm’s-length principle will be honored when investigating royalties and service fees.
Based on a reading of the three bulletins as a set, along with discussions with the SAT and local tax bureaus, it is possible to identify the following major directions:
• Profit-Monitoring System. The SAT will use “big data,” desk-top analytics and review of the transfer pricing documentation to flag companies for transfer pricing risks.
• Cooperation Model. The SAT will stress cooperation over audits by introducing a new “Special Tax Adjustments Self-Payment Form.” Many more companies are going to be subjected to transfer pricing adjustments, but these adjustments are going to be “voluntary.”
• Focus on Aggressive Tax-Planning Entities. Regarding audits, it is clear that companies using low-tax jurisdictions are seen by the SAT as low-hanging fruit. In fact, the recent audit information data request (IDR) are focused almost exclusively on the overseas counter-party.
• BEPS and Beyond. In Bulletin 6, the SAT is taking full artistic license to uncover the “value chain” used by multinationals and has gone beyond BEPS to introduce China-unique concepts including DEMPEP—the OECD concept of “development, enhancement, maintenance, protection and exploitation” of intangibles, plus “promotion”—and secret comparables designed to lever more profits into China. In particular, the SAT rejects the view that western countries have a monopoly on intellectual property.
Consisting of 62 articles and running to almost 10 pages, Bulletin 6 is by SAT standards a very comprehensive and monumental contribution. The index below provides a quick guide to the key provisions.
|1||General provisions||This Bulletin is issued in accordance with the CITL, CITLIR, Tax Collection Law, Tax Collection Law Implementing Rules and Tax Treaties|
|3.1||Profit monitoring supervision management||The SAT will use three measures to flag companies who warrant further inspection. The tax authority will issue “Notice of Taxation Matters” and the taxpayer can choose to make a self-adjustment|
|4||Transfer pricing audit targets||Identifies nine targets (for example, “enterprises that have related transactions with related parties in countries or regions with low tax rates” )|
|5-14||Transfer pricing audit procedures||Defines the procedures for conducting a transfer pricing audit especially with regard to information requests|
|15||Comparables||Specifies the five criteria for selecting comparables|
|16-21||Transfer pricing methods||Endorses the five traditional OECD methods but does not mention value contribution allocation method|
|22||Other methods||Other methods including cost method, market method, income method can be used|
|23||Selection of tested party||The SAT can now pick the simpler party to test (which could be the overseas related party)|
|24||Secret comparables||When the tax authority does the comparability analysis, it can also use some non-public information|
|25||Statistical metrics||Now the SAT can also use arithmetic average and other metrics and can still force taxpayer up to median|
|26||Toll manufacturing||Add back cost of materials but limited working capital adjustment permitted|
|27||Location specific advantages||Location-specific advantages and market premium analysis needed if the economic situation of comparable set selected is different from that of the investigated enterprise|
|28||Single function enterprises||Losses not acceptable for single function enterprises such as contract manufacturers (consistent with Circular 363)|
|29||Commensurate principle / Hidden transactions||Benefits of related-party transactions should match functions performs and risks assumed. Any concealed transactions to reduce tax revenue will be restored|
|30||DEMPEP||China adds “P” for promotion to the OECD DEMPE|
|31-33||Royalty||Royalties should be adjusted over time and be commensurate with the economic benefits. DEMPEP should be reflected.|
|34||Beneficial services||Beneficial services can be charged out at an arm’s-length rate|
|35||Non-beneficial services||Six types of non-beneficial services that cannot be charged out are identified (for example, stewardship services).|
|36||Pricing for services||Methods to price intercompany services – direct are preferred but allocation keys permissible.|
|37||Adjustment to payment to overseas party||Challenge to companies who have payments made to overseas related parties with no substance.|
|38||Adjustment to domestic transfer pricing transactions||No transfer pricing adjustments to purely domestic transactions unless there is an overall loss of tax revenue within China.|
|39-46||Transfer pricing audit||Identifies tax adjustment procedures and deals with situations where enterprise disagrees with adjustment. Appears that the adjustments can go back as far as Jan. 1, 2008|
|47-57 and 59-61||MAP||The procedures for Mutual Agreement Procedures are laid out. MAP now needs to be made directly to the SAT and application should only be made after entity has been double taxed|
|62||Legislative effect||Bulletin 6 is effective May 1, 2017. This article identifies which prior legislation has been superseded.|
Of great concern to taxpayers will be the announcement at Article 3 of the new profit-monitoring system. Actually, there will be three measures to flag companies who warrant further inspection: first, a review of the related-party transaction forms filed with the annual tax returns; second, the transfer pricing documentation; and third, a monitoring of the profit level. Based on these analyses, a “Notice of Taxation Matters” will be issued. The SAT is looking to leverage “big data” and this system will allow it to significantly increase the number of companies that will have to make transfer pricing adjustments. Unfortunately, the SAT does not lay out guidelines on how profits will be monitored. But prior experience suggests that companies who are below their peers in same industry or who have experienced a sudden decline in profit can expect to be flagged.
These companies that have been identified by the profit-monitoring system's so called desk-top audit will receive the Notice of Taxation Matters. Taxpayers will be encouraged to make self-adjustments if they agree with the issues raised by the authorities in the Notice of Taxation Matters—although the tax authorities still reserves the rights to conduct a full-blown transfer pricing audit in the future. Thus, many more companies are likely to be subjected to transfer pricing adjustments, but these adjustments are going to be “voluntary.”
While many companies can expect a “voluntary adjustment”, certain enterprises should prepare for a full-blown, cross-border audit. Article 4 states that when selecting targets the tax authority should focus on and pick up enterprises with nine types of “profiles.” The targets include enterprises that:
• have related transactions with related parties in countries with low tax rates; and
• implement certain tax planning or arrangements without reasonable business purposes.
To put it bluntly, Bulletin 6 confirms what is well known among tax practitioners in China: that companies with sophisticated tax planning involving Singapore and Ireland are going to be slammed. This is especially the case if they operate in “discouraged sectors” such as luxury goods and are enjoying visible market success in China. The handwriting is clear. These companies should expect to pay to play. In the SAT's view they have no grounds to complain and nowhere to go.
Another development evidenced in recent audits is the single-minded focus on the overseas related party. This is echoed in Bulletin 6. Upon audit, companies will need to provide the financial statements of each entity in the chain, their effective tax rates and a justification of the profits they enjoy on the transactions with China. The Chinese entity must assist in such data collection. Article 6.1 states that if information is required on an overseas company, then the domestic party can be asked to help deliver the Notice of Tax Matters.
China views IP very differently than does the west. From the Chinese standpoint, the contention of western companies that all IP is owned outside China and is the major profit driver is not just false but even unfair and exploitative. To quote an SAT official, the “man who labors in the sun” has his value.
The Chinese want to stake a claim to IP and so the argument is that IP is created where it is used. The SAT's view is that value is created in the marketplace and if the Chinese enterprise is doing the marketing it is enhancing the IP value and it is only fair that the country that does the marketing share the surplus profit.
As noted, Bulletin 6 explicitly recognizes this philosophy by insisting that promotion be acknowledged as an IP creator, adding it as a sixth function to the DEMPE functions to make “DEMPEP.”
Because the promotion is taking place in China, this implies that the Chinese subsidiary is adding to the IP value. More broadly, the identification of promotion as a separate function demonstrates the importance China places on value created through marketing activities undertaken in China by the subsidiaries of U.S. companies. Indeed, in audits, the author has seen the tax bureau draw a “bright line” and assert that any selling, general and administrative expenses in excess of 8 percent signals creation of local IP.
Article 30 also states that overseas entities that have only legal ownership of IP shall not get economic returns and those that contribute funding but have not performed key functions or performed risks shall get only a financing returns.
With regard to royalties, China again sees it as one-way street. China runs a huge deficit on royalties. Chinese enterprises pay them out but don’t receive them. Rather than disallowing them, Bulletin 6 at Article 32 endorses the OECD viewpoint that they should be “commensurate with benefits.” Thus, U.S. companies that have valuable brands that command premium prices and profits should be able to charge a royalty in line with the economic benefits created by the use of that brand.
But in a new twist, Bulletin 6 states that multinationals cannot follow the time-honored practice of setting a royalty in place and leaving it there in perpetuity. Article 31 requires that timely adjustment should be made to the amount of royalty fees to reflect such factors as:
• the value of the intangible assets has changed fundamentally;
• the licensee of the intangible assets has conducted subsequent DEMPEP without receiving any reasonable compensation; or
• the functions performed, risks assumed and assets employed by enterprises and their related parties have changed when using the intangible assets.
China has always been a country where it has been difficult to pay out service fees. There are multinationals who have paid fees out of 80 nations but been blocked in China (India and Brazil are also outliers). Moreover, provinces within China may each have their own interpretation and while one province may sign off on payment of a service fee, it may be challenged elsewhere. This has been a source of great frustration to U.S. and European corporations that provide valuable human resource, information technology, finance, legal and other services to their overseas affiliates but hit a wall when trying to charge China. Bulletin 6 offers some light and hope. The arm’s-length principle is cited and allocation keys are recognized as necessary. In the past, many provincial tax bureaus have rejected service fee charges off the bat if they were based on allocation keys, arguing that the use of the allocation keys was proof that the charges were not market based.
Article 34 states that service fees can only be paid if:
First, it should be noted that Bulletin 6 moves closer to OECD orthodoxy compared to the September 2015 consultation draft. In Bulletin 6, the arm’s-length standard is endorsed, as are the traditional five OECD methods—comparable uncontrolled price, resale minus, cost plus, the transactional net margin method and profit split—and the controversial value contribution allocation method (VCAM) is not mentioned. When the consultation draft was released, the VCAM seemed like formulary apportionment by a different name. The SAT, perhaps reacting to these concerns, removed this method from its list.
Location-specific advantages and market premium are very briefly mentioned in Bulletin 6. Article 27 states that location cost savings and market premium should be specially analyzed if the comparables operate in different “economic conditions.” This is in line with the OECD position. However, this appears to contradict the clearer position in Bulletin 42, which requires that the transfer pricing documentation analyze and quantify how these factors contribute to profit, irrespective of whatever transfer pricing method is used.
The SAT may be standing down on location-specific advantages due to the change in economic conditions and the blowback over the factory closure by a Silicon Valley company on the heels of it's paying a landmark transfer pricing adjustment reported at $225 million. The fact that the company was expanding in Thailand highlighted that China no longer has locational advantages over other manufacturing locations in Asia and even Mexico.
However, on other areas, China appears to be taking positions at variance with OECD. For example, the SAT seems to be reserving the right to use secret comparables. At Article 24, it states, “When the tax authority does the comparability analysis, they should prioritize the use of public information in priority but they could also use some non-public information.” The SAT does not allow for working capital adjustments except for toll manufacturers. And the SAT rejects the basic concept of the interquartile range, insisting that upon audit, the profit be adjusted to the median. To further put the taxpayer at a disadvantage, the SAT now reserves the right to use the arithmetic average (or mean as it is called) as opposed to just the median. The mean is a metric that can be tremendously biased. The mean is subject to the so-called billionaire effect, whereby if Microsoft Corp. founder Bill Gates walks into a workshop of 40 people, the average person is now a billionaire while the median is not impacted.
The following table highlights some key areas of agreement and disagreement between the OECD BEPS plan and China's new transfer pricing platform (Bulletins 6, 42 and 64). In making this comparison we not only look at OECD sections on transfer pricing methods but also equally important the OECD specifications on local country transfer pricing documentation (TPD) SAT vs. OECD BEPS.
|OECD||China's new platform|
|Arm’s-length standard||Bedrock principle||Agree but provides many exceptions|
|BEPS||Profits should be aligned with value creation||Agree strongly|
|Location-specific advantages||Can be captured by comparables||Bulletin 6 “may agree” with OECD but Bulletin 42 on transfer pricing documentation requires full analysis and quantification of location-specific advantages irrespective of comparables|
|Market premium||Can be captured by comparables and no need to discuss in local file||Must be addressed and quantified in transfer pricing documentation per Bulletin 42|
|Overseas party financial statements||No requirement||Must be provided in transfer pricing documentation as per Bulletin 42 for entities in value chain|
|Tax preferences of overseas related party||No||Yes in local country file and related-party form|
|Detailed related-party transaction forms||No requirement||New and even more extensive|
|Value chain documentation||Not mentioned in local country file||Must be provided in transfer pricing documentation as per Bulletin 42 with quantification for each link in the chain|
|DEMPE||IP owner to get full returns must perform DEMPE||Bulletin 6 adds a P for promotion to indicate that if China entity undertakes promotion it is creating IP and deserves extra profit|
|Royalties||Arm’s-length||Agree that royalties should be commensurate with benefits but states they should be adjusted down over time to reflect contribution of local enterprise|
|Service fees||Arm’s-length||Agree with arm’s-length but identifies six non beneficial services|
|Secret Comparables||No||Yes—in some circumstances non-public data can be used|
|Interquartile range||Yes||No—the result must be at median or arithmetic mean; tax bureau decides which is appropriate|
|Working capital adjustments||Yes||Only for toll manufacturers (up to 10 percent)|
The Trump administration has made much of America’s huge trade deficit with China. And on trade, it is clear that China needs America. But China has its own card to play—namely, the large number of American companies invested in China. When President Trump threatened tariffs, Premier Li Keqiang fired back at his administration, warning, “We don’t want a trade war — but if there is one, you’d lose and your companies (in China) would bear the brunt.” This is no empty threat. Korean companies recently have suffered huge losses in business to pressure Seoul not to cooperate with the deployment of an American antimissile system.
No country is as important to American multinationals as China. Starting with sourcing, it should be noted that in the last 20 years, America’s leading companies have increasingly outsourced their manufacturing primarily to China. One hundred percent of Apple’s products are now “Made in China”” mostly by a third-party company, Foxconn-Hon Hai, who is China’s largest private employer. Retailers such as Target Corp., Sears, Roebuck & Co., Costco Wholesale Corp., Walgreen Co., J.C. Penney Co., Home Depot Inc. and Best Buy Co. also heavily depend on China to fill their shelves. The number-one importer from China in the world is Wal-Mart Stores Inc. Each year, Wal-Mart buys almost $60 billion of products from China and China-sourced product sales account for 70 cents in each dollar of revenue that Wal-Mart generates.
More recently on the marketing side, China has become the dominant market for raw materials, luxury products, smart-phones, agricultural products, construction equipment, aircraft, automobiles, semiconductors, machine tools and scores of other products. For Abbott Laboratories, a manufacturer of milk powder and pharmaceutical products, China is the most important market outside the U.S. For Yum Brands Inc., which operates KFC and Pizza Hut, China accounted for 53 percent of global revenue, which led to a spinoff. General Motors co. sells more Buicks in China than the U.S.
The crackdown on low-tax jurisdictions will hit U.S. companies hardest. The amount of funds held overseas by U.S. companies is stupendous. An August 2015 study by the Congressional Joint Committee on Taxation has placed the amount at $2.6 trillion. Of the 100 largest publicly traded companies by revenue, 82 have subsidiaries in offshore tax havens according to a report issued by the U.S. Public Interest Research Group report. A leading pharmaceutical company, for example, has $40 billion held offshore within 107 tax-haven subsidiaries in locations including Barbados, the Cayman Islands and Switzerland.
Theoretically these profits belong to the U.S. Treasury but it is likely that China and other nations will seek to attach those profits. The Chinese position is very simple: If Ireland or Singapore gets 90 percent of the profits on a transaction involving China but has a much lower head count, then there should be a reallocation toward China to more accurately reflect that China is where the economic activity is taking place. To enforce this argument, the government now has the authority under Bulletin 42 (Article 14) to request financial statements for each entity in the value chain.
Fair warning—the two largest transfer pricing audits concluded to date have both involved U.S. multinationals whose Chinese enterprises had a low-tax Singapore principal. U.S. companies should not be comforted by the notion that Singapore is not a tax haven. That distinction is no longer important. Bulletin 6 uses the term “low-tax country” (di shui guo jia) as opposed to “tax havens” (bi shui gang—literally, “tax-avoiding port”). It is well known by the tax bureaus that although Singapore has a headline rate of 17 percent, the Economic Development Board has granted concessionary rates as low as 1 percent to U.S. multinationals in return for commitments of high-quality jobs and investments.
In dealing with China, U.S. companies should not cling to a bygone era when America’s economic dominance was unquestioned. Today, when it comes to foreign investors, China holds the four aces. No company is going to walk away from the Chinese market. U.S. companies must recognize that the rules of engagement have changed and they have no choice but to play along. There is an early-mover advantage and multinationals who move proactively to realign their taxable profits in China with the true economic benefits received in China are going to find this to be the best option. Waiting for the audit and then hoping to win in a country with no real appeals process or litigation is not an advisable course.
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