The domestic law does not provide specific rules for determining the arm’s length price of financial transactions and relies on the OECD transfer pricing guidelines.
Joint Activities / Cost-Sharing Arrangements
When calculating taxable income, costs incurred by an enterprise and related party for joint development or transfer of intangible assets, or for the joint provision of labor services, must be allocated based on an arm’s length principle.
When enterprises enter into a cost-sharing arrangement (CSA), the following items are to be contained in a CSA:
- Name of participants, their country (region) of residence, related party relationships, and the rights and obligations under the agreement;
- Content and scope of intangible assets or services covered by the cost-sharing agreement, the specific participants performing research and development activities or service activities under the agreement, and their respective responsibilities and tasks;
- Term of the agreement;
- Calculation methods and assumptions relating to the anticipated benefits to the participants;
- The amount, forms of payment, and valuation method of initial and subsequent cost contribution by the participants, and explanation of conformity with the arm’s length principle;
- Description of accounting methods adopted by participants and any changes;
- Requirements on the procedure and treatment for participants entering into or withdrawing from the agreement;
- Requirements on the conditions and treatment of compensating payments among participants;
- Requirements on the conditions and treatment of amendments to or termination of the agreement; and
- Requirements on the use of the results of the agreement by non-participants.
In addition, costs borne by the participants in a CSA should be consistent with those borne by an independent company for obtaining the anticipated benefits under comparable circumstances, and that the anticipated benefits should be reasonable, quantifiable, and based on reasonable commercial assumptions and common business practices. Failure to comply with the benefit test will subject the taxpaying enterprise to a tax adjustment in the event of an audit assessment.
Additional provisions on CSAs include:
- Service-related cost-sharing agreements generally should be limited to group procurement or group marketing strategies;
- Buy-in and buy-out payments are required when there is a change to the participants of an existing cost-sharing agreement;
- During the term of a CSA, if there is a mismatch between the shared costs and the actual benefits, then compensating adjustments should be made based on actual circumstances to ensure the shared costs match the actual benefits;
- If a CSA is not considered to be at arm’s length or does not have a reasonable commercial purpose or economic substance, costs allocated under the agreement (as well as any appropriate compensating adjustments) will not be deductible for CIT purposes;
- Taxpayers may apply for an APA to cover a CSA;
- Participants to intangible development-related CSAs should not pay royalties for intangible properties developed under the CSA;
- The costs allocated under a CSA and deducted for CIT purposes by the taxpayer would need to be clawed back if its term of operation turns out to be less than 20 years from the signing of the CSA; and
- In addition to the contemporaneous transfer pricing documentation requirements, specific requirements for preparation of contemporaneous documentation for CSAs apply, which needs to be submitted to the tax authorities by 20 June of the following year.
From 16 July 2015, Chinese enterprises that have entered into a CSA with a related party must submit a copy of the CSA to the competent tax authority within 30 days of signing of the agreement and include in the related-party transaction form with the annual tax return (Announcement 45/2015). However, a review of the CSA by the tax authorities is no longer required.
If there is a mismatch between the shared costs and the actual benefits, the tax authorities will require a compensation adjustment to be paid by the enterprise, and if not paid, the authorities will begin the special tax audit and adjustment process.
Furthermore, SAT Announcement 42 of 13 July 2016 introduced a specific reporting Form for CSAs.
The government has clarified that for service fees to be considered at arm's length, the service must provide a direct or indirect economic benefit to the service recipient, the price must reflect the fair price for transactions between unrelated parties in same/similar circumstances, and the service must be one that an independent party would be willing to pay for or perform itself.
Any expense paid to a foreign related party will not be deductible if the foreign party undertakes no functions, no risks, and no substantial business activities.
In regard to service fees paid to foreign related parties, the fees paid will not be deductible in any of the following cases:
- The services are not relevant to the Chinese company’s functions, risks, or business activities;
- The services are for the control, management and supervision of the Chinese company in order to protect the interests of the company’s direct or indirect investors;
- The services are duplicated, i.e., already supplied by a third party or carried out by the company itself;
- Although the company received additional benefits due to services being provided in its group by related parties, no specific services were provided to the company itself;
- Compensation for the services was paid through other related-party transactions; or
- Any other case where the company did not receive any direct or indirect economic benefits from the service.
The tax authorities have clarified that adjustments will be made to royalties paid to related parties, where:
- The value of the intangibles has changed substantially;
- There should have been an adjustment as per standard business practice under the license agreement;
- The functions performed, risks assumed, and assets used by the related parties have changed during the use of the intangibles; or
- The licensee has contributed to the development, enhancement, maintenance, protection, exploitation, and promotion (DEMPEP) of the intangibles but has not been compensated.
It is also clarified that in respect of royalties paid to a related low-function entity that has only contributed funds to the development of the intangibles, the payment will only be partially deductible (a financing return). If no contribution to the development has been made by the low-function entity, no deduction for the payment will be allowed.
In regard to royalties paid to a foreign related party for the use of intangibles, it must be considered how much each party has contributed to the creation of the value of the intangible property, and the payment made accordingly. If royalties are paid to a related party that holds the title to intangible property but does not contribute to the value of the property, the royalties paid will not be deductible.
It is further clarified that the allocation of benefits of intangible assets among related parties must be based on the economic activities and value of the contribution of each party. In determining the allocation, the following factors will be taken into account:
- The functions performed for the development, enhancement, maintenance, protection, exploitation, and promotion of the intangibles (DEMPEP);
- The risks assumed; and
- The contribution of capital, manpower, and other resources.
In determining the benefits, an overall analysis of the global business operations of the group should be performed. This includes taking into account the interaction between the intangibles and other global business functions, assets and risks, market premium, cost savings and other regional factors, and value creation factors resulting from synergies within the group.
If a Chinese company establishes a foreign holding company or financing company for the purpose of an initial public offering and royalties are paid to a foreign related party after benefiting from the public offering, such royalties will not be deductible.
Based on Article 123 of the CIT Law, if expenses paid to a foreign related party are found to be non-compliant with the arm’s length principle, a special tax adjustment may be applied for up to 10 years following the year in which the transaction occurred.
Companies engaged in simple manufacturing activities based on orders from related parties, as well as trading companies, and contract R&D service providers, must earn a stable rate of return and should not be expected to bear the risks or suffer the losses associated with excess capacity, product obsolescence and other such factors.
All loss companies with limited functions and risks are required to prepare and submit contemporaneous documentation to the tax authorities, regardless of whether the amount of related party transactions exceeds the materiality thresholds.
Transfer pricing audits and their outcome in China are usually settled through negotiation. And although the conduct of the taxpaying enterprise should not affect the outcome, a friendly working relationship with the tax authorities is to the taxpayer’s advantage, as Chinese tax authorities have broad discretionary powers.
When an enterprise under audit receives an initial unfavorable assessment, it may provide written explanations and documents supporting the reasonableness of its transfer prices. Additional discussions and negotiations may continue until a conclusion is reached and the tax authority issues a written notice of audit assessment in the form of a ‘Special Tax Adjustment Notice’ or a ‘Special Tax Investigation Conclusion Notice’. Once the notice is issued, the decision is final and further negotiation is not possible.
If the taxpaying enterprise disagrees with the final notice, both administrative and judicial appeal procedures are available for resolving tax disputes.
The taxpaying enterprise may appeal to the tax authority at the next higher level within 60 days for an administrative appeal, and a decision on the appeal must be made within 60 days. However, the enterprise is still required to pay the taxes, interest levy, and any fines and surcharges prior to proceeding with the appeal process.
If the taxpaying enterprise is not satisfied with the administrative appeals decision, it may start legal proceedings in China’s People’s Court within 15 days upon receiving the written decision. However, legal proceedings related to transfer pricing are rare in China, and the outcome typically favors the tax authorities.
For related party transactions between China and a treaty country, mutual consultation between the SAT and the competent authority (CA) of the treaty country is available to taxpayers to resolve double taxation issues resulting from transfer pricing adjustments.
Chinese law allows for corresponding adjustments in the case of a transfer pricing adjustment to avoid double taxation. If the corresponding adjustment involves an overseas related party resident in a country with which China has a tax treaty, then upon application by the taxpayer, China tax authorities will initiate negotiations with the tax authorities of the other country based on the mutual agreement procedure article of the treaty. Application for the initiation of the mutual agreement procedures should be submitted simultaneously to China’s State Administration of Taxation and the local tax authorities. Corresponding adjustments are subject to a statute of limitations of three years; any application after three years will not be accepted.
Where payment of interest, rent, or royalties to overseas related parties was disallowed as a result of a transfer pricing adjustment, no refund is available for excessive withholding tax paid. This may result in double or even triple taxation for multinational companies in some cases.
If the original adjustment is imposed by an overseas tax authority, then the Chinese enterprise can submit a formal application for a corresponding adjustment to the Chinese tax authority within three years of the overseas related party’s receipt of notice for transfer pricing adjustment.
Corresponding adjustments are not available in cases of income taxes assessed on deemed dividends resulting from non-deductible interest expenses under the thin capitalization rules.
Taxpayers should be aware that these corresponding adjustments are available as a way to resolve prior-year double taxation issues and an important supplement to bilateral advanced pricing arrangements.
Permanent Establishment (‘AOA Approach’)
Under the Authorised OECD Approach (AOA), the OECD has published guidelines for the allocation of profits to permanent establishments. In its tax treaties, China does not follow Article 7 of the OECD Model Tax Convention 2010 for attribution of profit to the permanent establishment.
Transfer pricing audits typically will focus on companies with the following characteristics:
- Significant amount or numerous types of related party transactions;
- Long-term consecutive losses, low profitability, or fluctuating pattern of profits/ losses;
- Profitability lower than those in the same industry, or with profitability that does not match their functions/risks;
- Business dealings with related parties in tax havens;
- Lack of contemporaneous documentation or transfer pricing-related tax return disclosures; or
- Other situations clearly indicating a violation of the arm’s length principle.
In addition, China has been conducting both nationwide, and industry focused audits. In a nationwide audit, companies within a multinational group are simultaneously audited, while in industry audits focus is on companies in specific industries. Examples of targeted industry include the automotive, real estate, pharmaceutical, shipping, and freight forwarding, telecommunication, trading, services, finance, and retail industries.
A transfer pricing audit (or a special tax investigation) procedure is typically comprised of the following steps:
- Desktop review and selection of transfer pricing audit targets by the tax authority;
- Notification to the taxpaying enterprise of a transfer pricing audit and field investigation by the tax authority to raise inquiries, request accounting records, and conduct on-site verification;
- Information request to the taxpayer under investigation, its related parties, or other relevant companies for relevant documents;
- Negotiation and discussion with the taxpayer under investigation and the tax authority;
- Initial assessment notice issued by the tax authority;
- Further negotiation and discussion between the taxpayer and the tax authority, as needed;
- Final assessment and issuance of ‘Special Tax Adjustment Notice’ if there is an adjustment or ‘Special Tax Investigation Conclusion Notice’ if the related party transactions under investigation are considered to be at arm’s length;
- Settlement of underpaid taxes and interest levy; and
- Post-audit follow-up management by the tax authority.
In addition, adjustments may be made on a retroactive basis for up to ten years as a result of a special tax investigation.