The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
David Chamberlain and Ho Yin Leung,
China plays a major, and growing, role in the extractive industries globally. China's oil and gas reserves make up just over one percent of the world's proven reserves; its oil production accounts for nearly five percent of world supply. China is easily the largest coal producer in the world and is also the leading producer of aluminium, gold, rare earths, tin and many other minerals. As a consumer, China's role in world markets looms even larger due to its size and rapid economic growth. China imports over half of its oil needs. Despite having the largest mining industry in the world, China's imports of metals make up nearly half of the world's entire trade in metals.
With respect to petroleum extraction, China's three main national oil companies (NOCs) dominate the landscape and are responsible for nearly 90 percent of the country's oil and gas production. Foreign companies are able to gain a foothold in highly complex operations where advanced technology and expertise are needed, primarily in offshore development efforts. A number of the key global players – including Conoco Phillips, Shell, Chevron, and BP – have entered into production sharing contracts (PSCs) with the government for major offshore projects. Further, since so many critical services are outsourced in the oil and gas industry, the Chinese market for foreign oilfield service companies and equipment suppliers is robust.
Outbound investment by the Chinese NOCs has been strong in recent years, whether it is in the form of new PSCs throughout the world, acquisition of concessions or existing PSC interests, or even acquisition of foreign oil and gas companies. Just as other industry players are coming to understand the Chinese way of doing business, the Chinese NOCs are increasingly becoming truly global enterprises and adopting international best practices.
In a PSC, the contractor initially bears all costs in the exploration and development phases of an oil and gas project. If the oilfield eventually becomes productive, the contractor is able to recover these costs out of the oil revenues. Once the costs have been recovered, the contractor and the government split the remaining oil revenues.
Often several oil and gas companies join together to act as the contractor in a PSC. In these cases, the relations among the companies are governed by a joint operating agreement (JOA). Under the JOA, the contractor companies share the costs and revenues of operations in proportion to their ownership interests. JOAs invariably include a so-called “no loss no gain” requirement, which provides that any services provided by any of the companies or their affiliates will be charged to the joint account at cost without any profit mark-up.
China's mining sector is considerably more fragmented than the core oil and gas sector. Before 1995, mining was inconsistently regulated and there were numerous mining operators without legal permits and with poor environmental and safety records. Since that time, efforts have been made to regulate and consolidate mining operations. In the 1990s, China opened up the country's vast mineral resources to international investment, seeking to speed up modernisation of the sector. Between 2001 and 2004 the number of foreign mining projects quickly increased from 150 to 279; but by 2010, this number had declined to 92.
Chinese tax authorities are among the most aggressive in the world with respect to transfer pricing enforcement. In a number of areas, Chinese approaches to transfer pricing issues differ from those typically taken by developed countries. The extractive industries are no exception to the rule that transfer pricing planning and enforcement are crucial areas for any tax department. The oil and gas industry, in particular, raises a number of difficult and unusual transfer pricing issues.
While China remains a challenging place to do business due to the regulatory environment, its corporate tax regime is not especially difficult. The basic income tax rate is 25 percent while a 15 percent tax rate is available for qualifying high and new technology enterprises. In addition, companies can take a 150 percent “super deduction” for qualifying R&D expenditures. For extractive industries, there is also a five percent resource tax based on the sales price. Further, for oil and gas enterprises, a special revenue “windfall” levy applies on sales of crude oil to the extent the weighted-average price for any month exceeds US$55 per barrel.
In the transfer pricing area, historically, China generally follows the OECD Guidelines. However, the country has been very active in the development of the UN draft manual on transfer pricing for developing countries. China contributed a “Country Practices” section to the manual that shed light on the country's key concerns about so-called “location specific advantages” (LSAs) such as location savings and market premium. If a company moves operations to China to reduce operating expenses through lower wages or other savings, then the tax authorities will expect the Chinese subsidiary to retain a share of these location savings. Similarly, China will expect higher profits if goods sell in the Chinese market at a premium to the price in other markets. Chinese approaches to LSAs likely have limited application to extractive industries but still the tax authorities may argue that the Chinese subsidiary should retain a higher profit margin given the lower costs of operation. It will be very hard to argue that there is any market premium for products that sell in commodity markets.
Another less noticed yet very important and relevant concept from the Chinese tax authorities' perspective is the so-called “environmental cost”. This refers to the costs relating to consumption of natural resources and the damage to environment. It has been disputed about whether these hidden costs are to be compensated and should be considered as part of the taxable income in China.
One other area where Chinese practice differs from many other countries is the taxability of a transfer of shares in a Chinese company. A direct transfer of shares to a non-resident purchaser has long been subject to a 10 percent withholding tax. Since December 2009, China has applied a higher level of scrutiny to an indirect transfer of shares as well. If the intermediate holding company enjoys a corporate tax rate of less than 12.5 percent, then the non-resident taxpayer is required to provide Chinese tax authorities with a wide range of information. If the holding company does not have sufficient substance, it may be disregarded and the transfer subjected to the 10 percent withholding tax. It should be noted that these rules apply both to transfers to third parties as well as to intergroup transfers as part of a corporate reorganisation. For intergroup transfers, an analysis of the arm's length transfer price is required.
Supply chain restructuring in the extractive industries is subject to certain inherent limitations due to China's expectation that profits attributable to exploitation of Chinese resources be taxable in China. Therefore, Chinese subsidiaries engaged in extraction activities generally cannot be de-risked. For example, because the Chinese subsidiary would be the contracting party in an oil and gas PSCs, the subsidiary would bear the costs and risks of exploration and would be entitled to profits generated in the production phase. It would not be possible to set the Chinese subsidiary up as a service provider for its parent company that would be entitled to a modest and stable return.
The Chinese subsidiary would be subject to general corporate tax rules, including:
• a five year limitation on carryover of net operating losses
• inability to offset losses in one subsidiary against profits in another due to lack of consolidated returns.
Therefore, a key focus of supply chain structuring is to ensure profitable operations and loss-making operations are combined in a single taxable entity. This type of structuring is facilitated by the lack of “ring-fencing” restrictions in Chinese tax law. In many other countries, tax rules in the oil and gas industry are co-ordinated with rules for the recovery of costs in PSCs, which often do not allow the offsetting of costs of exploring and developing one oilfield against production profits from a different oilfield.
Extractive industry typically requires a high level of capital investment and multinationals often send experienced and skilful engineers to China to manage and operate their Chinese ventures. Some segments in the extractive industry are highly regulated, and foreign companies need to form a joint venture with a local partner which further complicates the issue. Typically, before the establishment of a joint venture company, both the Chinese and foreign partners usually agree the salary scale – with expatriate engineers normally having a higher salary than that stated in the salary scale. Issues then arise around which entity – the multinational's China headquarters, the overseas headquarters or any other related party – should bear the difference. Should the Chinese headquarters assume such costs, questions will then be asked about whether it should charge out or absorb the difference as its own cost. In the former case, the taxpayer needs to assess if a mark-up should be applied, where the fee should be charged and whether it would create an overseas transfer pricing issue. In the latter case, the taxpayer needs to have a strong justification on why it has to bear such costs and what benefits it will obtain.
An associated issue relates to a construction permanent establishment. Expatriate engineers who are seconded from overseas to China may be considered to have created a permanent establishment for their original overseas employer. The tax authorities in China may ask for various supporting documents to assess, including the expatriate's secondment contract, his/her reporting line, and number of days present in China, among others. While in the past the Chinese tax authorities might apply a straightforward approach by adopting the cost plus method to ascertain the profits to be attributed to the permanent establishment, they have been trying to adopt the OECD Guidelines on profit attributable to a PE. This will be one of the key development areas for the Chinese taxation authorities, who have an ambitious agenda to build technical expertise.
Although oil and gas subsidiaries are full-risk, entrepreneurial entities for transfer pricing purposes, they rely heavily on their parent company, or other affiliates, for a wide range of support services. An oil and gas group typically has subsidiaries in many different countries, so there are significant advantages to centralising functions and expertise.
Many general and administrative functions are most efficiently run on a centralised basis and have few if any local staff in the host countries. These range from information systems to legal services. Other functions have both local and centralised components. For example, the human resources function needs an in-country presence to fulfil local hiring requirements but also depends crucially on the parent company because many staff are assigned from headquarters to work at a particular subsidiary on a medium-term assignment.
While each subsidiary is fully staffed with personnel able to handle day-to-day oil and gas operations, there is still a need to take advantage of headquarters-level expertise. For example, the exploration department at headquarters may collect and analyse seismic data from each of the subsidiaries in order to construct subsurface maps of the most promising oil reservoirs.
A distinguishing feature of oil and gas industry transfer pricing is that the costs of headquarters supportive services must be allocated to the subsidiaries on a cost basis. This requires an intensive benefit test, dealing with a multiplicity of allocation keys for different activities, and complex systems to identify and allocate costs. As noted before, it is not possible to treat the subsidiaries as “tested parties” and provide them with a simple mark-up on readily identifiable costs. Because unrelated parties in the industry transact on a “no gain no loss” basis, identification of actual costs is paramount. Most tax authorities will not allow a local subsidiary to pay service fees that include a mark-up. Likewise, comparable uncontrolled prices generally cannot be used since they include a profit element.
Historically, companies in the extractive industries have sold commodities to related parties based on well-established indices, such as NYMEX prices for petroleum, with appropriate adjustments for differences such as quality, location and volume. For transfer pricing purposes, the companies have considered the indices to be comparable uncontrolled prices that are above challenge. However, the tax authorities have begun to challenge the differential adjustments, often rejecting them entirely. Because these transactions tend to involve very high volumes, even a small adjustment to the price can result in a very large overall adjustment.
Taxpayers are well advised to keep excellent records of how the indices were used, including any averaging assumptions, and be prepared to prove the reliability of the adjustments. Often, the operative agreements, such as PSCs and JOAs for oil and gas, provide detailed rules on how prices will be determined in settling accounts between the participants. If these same provisions are used to determine intercompany prices, a very strong transfer pricing case can be made.
Companies in extractive industries may engage in financial derivative transactions to hedge their physical positions and in some instances arbitrage, often through an overseas related party. This partially arises from the fact that the prevailing Chinese regulations do not allow Chinese resident companies to engage in financial product transactions in an overseas exchange. This then leads to a transfer pricing issue in terms of how to share the profit or loss of the integrated position. Although taxpayers may wish to split the profit or loss according to the arm's length principle, they face practical issues in remitting money in and out of China. For example, they need to obtain tax clearance with the responsible tax bureau who are more process-focused and are not experienced in transfer pricing. Moreover, the characterisation of the payment would create various issues with indirect tax and withholding tax, as well as foreign exchange. All these issues are not easily settled without going through a “ruling” type procedure, such as a pre-event discussion or even an advance pricing arrangement.
At the same time, the Chinese tax authorities are becoming increasingly sophisticated in terms of issues surrounding integrated trading. They would inquire what functions and risks are assumed by the Chinese entity and the overseas entity, respectively, under the integrated trading and would adopt the concept from the OECD Guidelines on profit attributable to permanent establishments in assessing how much profit or loss should be assumed by the Chinese entity. Tax officials may also bring in a China-specific concept and argue the Chinese entity is entitled to a greater share of the profits.
With these, multinational companies are advised to establish a sound transfer pricing policy, understand the underlying risks and develop a risk management strategy before carrying out the integrated trading.
China's PSCs are relatively unusual with respect to the treatment of interest expense. Most countries do not allow oil and gas companies to recover interest expense. Similarly, with respect to interest accrued during the exploration phase, China's PSCs also do not allow the recovery of interest expense. However, PSCs generally do allow the recovery of interest expense during the development and production phases, in the amounts and at the interest rates agreed and specified in the PSC.
In any event, interest expense is deductible for Chinese income tax purposes regardless how it is treated under a PSC. Interest deductions are, however, subject to thin capitalisation rules. For non-financial institutions, interest can only be deducted to the extent the company's related-party debt-to-equity ratio does not exceed 2:1. For this purpose, only debt and equity from the related party are considered; it is possible for the company's overall debt-to-equity ratio to be higher than 2:1 if it also has borrowings from third party lenders. The interest rate on related party loans must be consistent with the arm's length standard. If the taxpayer's thin capitalisation ratio exceeds 2:1, the taxpayer needs to prove to the satisfaction of the tax authorities why that is the case. Otherwise, the excess portion of the intercompany interests would be disallowed.
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