China's SAT Moving Needle on OECD Intangibles Guidance, Influencing BEPS Action on Country-by-Country Reporting

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

Forthcoming guidance from the Organization for Economic Cooperation and Development will incorporate concepts long advocated by China's State Administration of Taxation, such as location savings and treatment of intangibles. China has taken an active role in the OECD's project to combat base erosion and profits shifting, and its influence on the project not only reflects its growing economic clout, but parallels some forthcoming changes in its domestic policies and regulations on transfer pricing.  

By Kevin A. Bell  

Jan. 21 --China's active participation in the work of the Organization for Economic Cooperation and Development to combat base erosion means that the organization's forthcoming September 2014 guidance on intangibles will incorporate concepts long advocated by the State Administration of Taxation.

Location savings and intangibles concepts that are embodied in China's chapter of the United Nations' Transfer Pricing Practical Manual for Developing Countries also are included in the OECD's revised discussion draft on intangibles. The OECD draft--likely to be adopted without significant changes in September--means that multinationals will record more profits in countries, such as China, where they have the greatest activities.

Moreover, China's participation in the joint G-20 and OECD project on base erosion and profit shifting (BEPS) not only has influenced the project's work on intangibles, but is helping to shape other BEPS actions, including country-by-country reporting.

According to Shanghai practitioners, Action 13 of the BEPS action plan, which will spawn a new country-by-country reporting template in September, intersects with a major Chinese transfer pricing development looming on the horizon in 2014--an overhaul of Circular No. 2 [2009], the nation's first comprehensive transfer pricing regulations.

SAT Priorities

Spencer Chong of PricewaterhouseCoopers in Shanghai told Bloomberg BNA Jan. 14 that China's State Administration of Taxation supports the BEPS initiative in its G-20-member capacity and that the SAT has established a BEPS task force.

Chong said the SAT's BEPS priorities are transfer pricing (Actions 8, 9, 10 and 13), the digital economy (Action 1), tax treaty abuse (Action 6), and permanent establishments (Action 7).

Jessica Tien of Ernst & Young in Shanghai said Jan. 14 that China is closely watching the progress of the BEPS project. “Some of the BEPS action plan is consistent with what the Chinese tax authorities want to do.”

However, Tien said her prediction is that China “will act very, very, cautiously and very slowly.”

Brett Norwood of KPMG in Shanghai said Jan. 3 that China over the last several years has been strengthening its tax code “consistent with the issues identified in the BEPS action plan.”

So while the BEPS action plan touches on some challenging issues, Norwood said, “China has a vested interest in helping forge ahead with the action plan and the SAT has demonstrated its willingness to do so.”

The three Shanghai practitioners said a major priority for the SAT in 2014 is rewriting Circular No. 2.

Chong said the SAT also is interested in Action 4, which addresses possible base erosion via interest deductions, even though “China has a stringent thin cap rule resulting in rather limited base erosion.” Action 4 is high on the agenda of other tax administrations, Chong said, “and the SAT wants to support the international trend and contribute to the debate.”

However, Chong said the SAT is not supporting all of the BEPS actions “in the sense that some issues identified are less, or not relevant to China,” including Action 2 on hybrid mismatch arrangements and Action 3 on controlled foreign corporations rules.


Norwood said the limited number of personnel at the SAT in Beijing means that the “highly experienced, approximately 10” officials leading China's transfer pricing efforts nationally must carefully determine how to invest their time, focusing on areas of greatest importance to China. Two of these areas are likely to be value creation and intangibles “as they turn up increasingly often in transfer pricing disputes in China.”

Tien said the SAT probably will not make legal changes that have a broad-based BEPS application. “I think actual actions coming out from rules or circulars will be very, very, limited.”

Norwood said even if the BEPS project reaches agreement on some parts of the action plan within the next year or two, “there will be a period of time as officials throughout China ramp up their knowledge and understanding at the administrative level in order to effectively administer any changes enacted in China, so the effective implementation could take longer.”

“I anticipate the enactment of much of the BEPS action plan will be supported by China,” Norwood said, “though to what extent depends on the details of how the plan develops” against a backdrop of other government priorities:

• reviewing a large volume of annual transfer pricing documentation reports;

• strengthening the country's permanent establishment regulations and concluding a number of related tax audits;

• participating in global efforts to combat tax avoidance under the Convention on Mutual Administrative Assistance in Tax Matters, which China signed in August;

• engaging in more competent authority discussions and gradually becoming more successful in resolving issues through the mutual agreement procedure; and

• enacting general anti-avoidance provisions.


Norwood said China is beginning to make the most of existing dispute resolution mechanisms. Introducing additional mechanisms at this stage may be challenging and, if they are enacted, they “potentially [will] slow down recent progress which has been made in this area as the new mechanisms are explored.”

Challenges for China and for the other countries participating in the BEPS project, Norwood said, “may be exacerbated if they touch on sensitive issues such as sovereignty, as one point of the action plan, mandatory and binding arbitration, appears to do.”

Norwood said much work is yet to be done on the BEPS action plan, and the far-reaching implications, “including a potential future where tax authorities have greater visibility into the details of a global group's entire value chain, are going to be of great interest to taxpayers as the action plan develops over the next 12 to 18 months.”

Digital Economy  

Chong said the SAT continues to be actively involved at the United Nations “focusing on multiple UN initiatives as the SAT still considers that the UN is an appropriate sounding board for developing economies like China.”

The SAT, Chong said, is very active in the UN work “on the digital economy-orientated action that is tackling international taxation issues by strongly considering the taxation of cross-border trade of services.” A final report will be submitted to the UN tax committee in June 2014.

Chong said the key question here is whether this report will capture the same principles as the ones identified by the OECD. “Aspects relating to cloud computing are the ones that bring the most technical and practical challenges.”

In an October article, Tien said the SAT is likely to assert that a company has location-specific advantages--an argument the SAT often makes in existing transfer pricing audits and advance pricing agreement negotiations--in transfer pricing cases involving the digital economy (22 Transfer Pricing Report 735, 10/3/13).

Tien said the SAT might attempt to argue that China should be entitled to a share of the benefit derived from its unique local market attributes, such as market premium in terms of being possibly the largest user or customer base for Web traffic by country, and the advantage of cost savings in relation to China's massive research and development and sales promotion workforce.

Chong said discussions on the digital economy “are taking place in a China task force that includes academics, industry experts, and some professional advisors.”

Revised Discussion Draft on Intangibles

Value Creation  

Recent public statements by OECD officials indicate that the organization's revised discussion draft on intangibles is likely to be adopted without significant changes.

Tien said Chinese tax officials have actively participated in the OECD meetings on the revised discussion draft and that much of the draft is “consistent with what China wants to do.”

The most welcome aspects of the draft, Tien said, “highlight value creation activities and functions, and downplay the dominance of legal ownership.”

Chong said the SAT provided the OECD with comments on the revised discussion draft and the SAT “is fine” with the proposed broad definition; however, the SAT made it clear that “unique knowledge, skills, and techniques used in the implementation of an intangible also satisfy the criteria of an intangible.”

The SAT, Chong said, “focuses on all intangibles that enable the monetization of value derived in the supply chain.”

Alexis De Meyere, also in PwC's Shanghai office, said the SAT believes that the discussion draft “captures quite well the allocation in accordance with value creation”; however, China is concerned about how these principles will apply in practice.

Norwood said “challenges may exist in some areas of the BEPS project for China.” For example, while China has indicated that it would very much welcome revisiting the role of intangibles in transfer pricing, as well as that of value creation, “it is not clear that all countries will come at this problem from the same direction.”

The United States, Norwood said, “often views intangibles developed at the headquarters as a, or even the, leading contribution to nonroutine profits,” whereas China may view the role of local marketing, local research and development, or other local activities, and location-specific advantages, as key to giving rise to nonroutine profits.

Location Savings  

Tien said Chinese tax officials are very persistent in pursuing discussions with taxpayers regarding location-specific advantages, which, according to China, constitute a specific intangible entitled to remuneration.

“It is mandatory for taxpayers to analyze and discuss location savings,” Tien said. “We can't wait for the OECD to give clear guidance. It is happening on audit and is an important part of APA negotiations.”

Chong agreed with Tien that “LSA analyses have to be comprehensively and exhaustively captured in the APA request. This has been recently confirmed by the SAT to local taxation offices.”

Tien said the discussion draft's treatment of location-specific advantages, which are hard to define and value, is cursory and lacks clarity on how to treat them. “It is unclear to China how the new intangibles chapter will, or will not, help their agenda in terms of pursing location-specific advantages.”

The discussion draft devotes a mere eight paragraphs to location savings and other local market features.

Norwood said China's tax authorities view location savings, referred to in the discussion draft as “local market features,” as part of a broader issue, encompassing many location-specific advantages, such as cost savings, price premium and overall market scale.

The addition of this discussion in the revised discussion draft may be helpful from China's perspective, Norwood said, since while the draft indicates they are comparability factors to consider rather than intangibles in their own right, “this characterization still permits adjustments in some cases allocating additional profits to Chinese entities due to such local market characteristics, thus increasing income tax due in China.”

Chong said as a comparability factor, location-specific advantages can justify the application of a profit split mechanism because of unique and valuable contributions.

However, Chong said, location-specific advantages should not be negatively perceived by tax professionals. “Sometimes location-specific advantages constitute an opportunity to repatriate China profits when [the] volume of intragroup transactions is limited by applying a profit split method.”

Norwood said that to the extent the discussion draft brings tax authorities closer together in terms of how they approach cost savings and other local market features, “it may decrease the likelihood of double taxation.”

According to Tien, it is not accurate to characterize the SAT's position as expecting the return associated with a location-specific advantage to be grossed up with a remuneration. Location-specific advantages are a necessary analysis under certain circumstances, she said. “So far we have seen the SAT accepting LSA as a comparability factor, as one of the factors in a profit split analysis, or the location-specific disadvantage to be a risk factor.”

UN Manual Chapter  

Chinese tax officials are participating in the BEPS project and are explaining the tax agency's views at international seminars, Norwood said, noting that in 2012 the SAT contributed a chapter to the United Nations transfer pricing manual setting forth China's views

China's UN chapter differs significantly from the OECD transfer pricing guidelines in its treatment of entitlement to intangible-related returns and location-specific advantages.

Chapter 10.2--“China Country Practices”--states that Chinese related parties must be appropriately remunerated for their location-specific advantages. The added profit is appropriate to reflect China's unique economic and geographic factors that contribute to the profitability of Chinese taxpayers and their foreign parent companies. These unique factors include readily available migrant labor, low labor and infrastructure costs, first-mover advantages in certain industries, foreign exchange controls, and growing population and consumer demand for foreign and luxury products.


Norwood said in some cases China's tax authorities have argued that the intangibles have declined in value, or have been improved upon locally by the Chinese affiliate, and as such the royalty should decrease or be terminated over time.

The OECD's revised discussion draft, Norwood said, “does appear to make allowances for this type of analysis, as it emphasizes that careful determination of the nature and value of intangibles should be undertaken, and appears consistent with views of China tax officials to the extent this is the case.”

Norwood said one area that China has wrestled with regarding intangibles is the payment of royalties to overseas entities by Chinese affiliates for the use of foreign-developed intangibles. In these cases, the SAT will seek to determine a reasonable royalty rate, as well as whether royalty rates should be considered static or fixed in all cases versus decreasing over time in some cases.

Norwood said the statute of limitations for transfer pricing audits is 10 years in China, and so a number of related questions may arise under audit:

• What exactly is being paid for at the end of the audit period?

• What is being paid for at the beginning?

• Are the intangibles the same?

• Have any of the intangibles' values changed?

• Is the royalty rate charged appropriate during the entire audit period?


Variable Royalty Rates  

Norwood said another area where China has not necessarily been in agreement with other tax authorities is in the application of “variable royalty rates,” whereby the royalty rate is determined on a yearly basis so as to leave the tested party performing “routine” functions with a post-royalty, benchmarked profit level.

The implementation of such variable royalty rate arrangements has long been a challenge for multinational companies, Norwood said, and questioned for its reasonableness by Chinese in-charge tax officials of entities making such payments.

Norwood said this is one area where the OECD draft “should offer additional comfort to China,” as it acknowledges broadly that multiple entities often participate in the creation of nonroutine profits, stating at paragraph 151 that “it is important not to simply assume that all residual profit, after a limited return to those providing functions, should necessarily be allocated to the owner of intangibles.”

Country-by-Country Reporting

Chinese Support  

Tien said country-by-country reporting “will be very much welcomed by China.”

Norwood said “China already requires considerable disclosure,” and under audit it is common for Chinese tax officials to seek to understand the entire value chain and the role of Chinese entities in value creation.

Against this backdrop, Norwood said “I would expect China to be generally supportive of any measures that increase the information available to its tax officials regarding the overall value chain, though it may also wish to ensure the information that China-based companies are asked to provide is appropriate and reasonable.”

Chong said, “At this stage, China does not have a project to formally adopt a [country-by-country reporting] template and Action 13 is not to be linked with the selection of the most appropriate transfer pricing method.”

De Meyere said Circular No. 2 already provides that taxpayers have to disclose “their applicable tax rates and possible preferential tax treatments of other related parties in the tested transactions.”

Nationwide Implementation  

De Meyere said China already has adopted a partial reporting system. Many Chinese provinces and municipalities already have released guidance requiring taxpayers to disclose their effective tax rates.

One can expect that the local guidance will be implemented nationwide, De Meyere said. “This brings new challenges for taxpayers as disclosing an effective tax rate without elaborating and explaining the substance in those overseas companies does not make a lot of sense. Moreover, calculating an effective tax rate can be challenging.”

De Meyere said it would be better to develop a template that would contain transparent reporting guidance if it does not result in significant additional costs for taxpayers.

Chong said multiple consultations are taking place at the local tax authority level in China to improve the quality of transfer pricing documentation and streamline assessment procedures. “Score card assessments are becoming more and more a principle.”

Transfer pricing reports that contain weaknesses in terms of technical content, transparency, or information sharing might be rejected by many tax bureaus, Chong said. “We also see that taxpayers submitting these reports can face in-depth scrutiny and formal investigation.”

Profit Splits  

Norwood said that because there are many industries in which nonroutine contributions are made by foreign related parties, and at the same time, local contributions to value creation may be highly valuable as well, “the use of profit splits, where information and data availability permit, can sometimes address this challenge and is likely to continue to be endorsed as a reasonable transfer pricing method.”

“Perhaps even more so,” Norwood said, if the proposal discussed in the OECD's October 2013 is further developed and adopted, providing more information on activities outside of China, “though again much depends on how the proposal develops in the future.”

China repeatedly has indicated its support for profit splits, he said. Many multinational companies located manufacturing operations in China a number of years ago, and have more recently expanded their footprint in China to include, sales, regional management, research and development and other activities.

Correspondingly, Norwood said, Chinese tax authorities increasingly seek to understand the contribution of each of these activities to the process of value creation, and the application of profit splits also is increasingly considered.

For example, Norwood said, over the last several years, in various venues, Chinese tax officials consistently have indicated that taxpayers in the automotive industry need to propose how to share nonroutine profits between technical contributions by foreign related parties and local contributions in terms of marketing and other valuable local activities if they wish to sign a bilateral APA.

New SAT Guidance in 2014

Circular No. 2  

Tien said the SAT is in the process of revising Circular No. 2 [2009] requiring taxpayers to prepare contemporaneous transfer pricing documentation “and the revisions to the documentation requirements could be very significant.”

The circular must be revised, Tien said, because China now has had five years of experience with the circular's documentation and disclosure requirements.

Tien said that under China's corporate income tax law, tax officials during transfer pricing audits may demand information from third parties and the existing documentation requirements already require related parties to disclose their effective tax rates.

The local tax bureaus, Tien said, are frustrated because taxpayers often refuse to make voluntary disclosures and the OECD's work on country-by-country reporting will embolden the bureaus to ask for even more profit disclosures.

Tien said Chinese tax officials believe there is an overuse of the transactional net margin method and are very frustrated at not being able to see the whole picture, “and country-by-country reporting would give them more support for going outside of TNMM.”

Chong said that if efforts to create a new reporting template are successful at the local level, the new template then may be implemented nationwide. “We expect a revised version of Circular No. 2 to be released in the coming quarters.”

Service Fees  

Tien said the SAT is working on a circular to address base erosion resulting from foreign headquarters charging their Chinese related parties excessive service fees. The tax authorities, she added, have just successfully concluded a large number of audits on service fees that began in 2013.

Tien said the catalyst for the forthcoming new circular has come from U.S. regulations on the treatment of controlled services transactions and the allocation of income from intangible property. The adoption of U.S. Internal Revenue Service Regs. §1.482-9, she said, has “sent a lot of costs into China.”

The SAT, Tien said, also is working on a new circular clarifying the procedures that a provincial tax agency should follow when applying the general anti-avoidance rule “that will put the GAAR on a more transparent framework.”

Chong said he expects the SAT soon will release guidance on mutual agreement procedure cases involving transfer pricing issues.


To contact the reporter on this story: Kevin A. Bell in Washington at

To contact the editors responsible for this story: Dolores W. Gregory at, Molly Moses at

The OECD's BEPS project and intangibles guidance will be discussed at the Global Transfer Pricing Conference in Paris March 31-April 1. For more information, visit /agenda-m17179870460/.


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