China’s new transfer pricing guidelines and BEPS
The highly significant changes to transfer pricing guidance planned for under the SAT’s public discussion draft on ‘Special Tax Adjustments’ (yet to be finalised at the time of writing), and the impact of these changes in the light of evolving Chinese transfer pricing enforcement practice is the focus of this chapter by Chi Cheng, John Kondos, Simon Liu, and Kelly Liao
The Base Erosion and Profit Shifting (BEPS) initiative aims to enhance the integrity and fairness of the international tax system by realigning jurisdictional taxing rights with the location of value creation and where business activities are actually conducted. On October 5 2015 the OECD publicly released its 2015 Deliverables under the BEPS initiative, corresponding to the original 15 actions of the 2013 BEPS Action Plan work programme and following the 2014 Deliverables. Beyond simply implementing these deliverables, China tends to pursue a selective approach to the BEPS measures, leveraging BEPS guidance to apply a unilateral approach to key issues, a trend we already remarked upon in last year's edition of China Looking Ahead.
That China adopts such a selective approach has been confirmed by the contents of the long-awaited public discussion draft guidance on the implementation of 'Special Tax Adjustments' (the Draft), released by China's State Administration of Taxation (SAT) on September 17 2015. The Draft explains that China will not adopt all BEPS proposals and will naturally tailor them to China's circumstances.
The Draft is a substantial document, comprising 16 chapters and 168 articles. It encompasses an expansive range of source materials including:
the existing transfer pricing (TP) guidance in SAT Circular 2  and other records of the SAT's TP views, particularly in the UN TP Manual;
the evolution of the TP enforcement approach of the Chinese tax authorities observed in recent years; and
the proposals emerging from the BEPS process.
Below, we explore the TP issues to which multinational enterprises (MNEs) in China may want to pay special attention. Other BEPS measures which have been localised for China in the Draft or in other recent regulations are dealt with in the separate chapter in this volume, China in the forefront of global BEPS implementation.
Location specific advantages (LSAs)
The references to LSAs in the Draft do not appear to be at odds with the discussion on location savings and local market features in the BEPS TP report. However, the discussion on LSAs in the Draft is far less detailed than in the BEPS intangibles report, and latitude is left for local authority interpretation and application. Notably, while the BEPS paper discusses how location savings may ultimately dissipate, being passed on to independent customers or suppliers, the Draft makes no such observation.
Neither does the Draft indicate, as the BEPS report does, that where there is availability of reliable local market comparables, with other companies in the market having access to the benefit of equivalent location savings or local market features, then the need for making any LSA comparability adjustments may be dispensed with. Furthermore, while the BEPS report does not indicate that the presence of LSAs could lead to application of a non-comparables based TP method, the Draft indicates just that.
In the BEPS TP report, the OECD urges restraint on the part of taxpayers and tax authorities in rejecting potential comparables. However, the SAT has frequently taken the position that the existence of unique Chinese LSAs may deprive available potential comparables of their validity (reliable adjustments being argued to be not possible) and local tax authorities have been actively using this rationale as a basis for pushing for the profit split method (PSM) to be used. The LSA references in the Draft now provide a useful reference point for tax authorities when making such challenges, and may also be leveraged in pushing use of the new value contribution apportionment method (VCAM) in the future.
The Draft sets out a 'DEMPEP' approach, including a final 'P' for promotion alongside the BEPS DEMPE (Development, enhancement, maintenance, protection and exploitation) factors. This reinforces the historic Chinese emphasis on the importance of China market promotion and Chinese consumer-product-awareness building as value drivers for foreign brands, supported in the past by the Chinese local marketing intangibles concept. This emphasis is bolstered by a further statement on the key importance of taking into account market factors and product localisation in determining contributions to intangible value.
The Draft DEMPEP approach and the description of 'important functions' as those typical 'middle value chain activities' frequently carried out by MNEs in China (for example, manufacturing and trial production) as well as China market-building activities, could readily lead to a divergence between profit attributions from intangible assets by Chinese and foreign tax authorities, with the potential for double taxation this brings. It is also quite possible, drawing on past China enforcement practice and the practical absence of references to 'control' in the Draft, that the Chinese tax authorities will focus on the performance of DEMPEP functions, to a greater degree than on their control (the preference of the OECD).
The Chinese tax authorities are expected to leverage the open wording of the Draft, concerning the circumstances in which ownership of intangibles (or contribution to their value creation) by transacting related parties might invalidate use of one-sided methods, to push for more use of PSM and VCM. This would be in line with, and further support, the frequent current assertions by the Chinese tax authorities in TP audits that local intangibles (in the same way as LSAs) render potential comparables unusable and beyond reasonable adjustment. The use of the term 'significant intangibles' could, for example, include local marketing intangibles, which might not be considered 'unique and valuable' by the OECD but might readily be argued by the Chinese tax authorities to be 'significant'.
The identification by the Draft of an 'economic owner' of intangible assets is not expected to have a major impact on TP outcomes. However, it remains to be seen whether the concept might also be used, outside the TP space, by other tax authority departments, leading to further complexity (for example, withholding taxes on transfer).
The clarifications on deductibility of royalties paid to overseas related parties may be viewed as positive, and may assist in securing deductions for payments to overseas IP holding companies (in danger with the previous (mis)reading of Announcement 16). Still there is a pressing need for more clarification on the required level of 'substance' in overseas entities.
Value contribution apportionment method
The Draft introduces the VCAM as one among the 'Other TP Methods'. Under this method MNE profits are to be allocated across the value chain based on analysis of how value creating contributions have been made to group profits, with reference being made to assets, costs, sales and number of employees. It is stated to be appropriate to use where comparability information is difficult to obtain and where, at the same time, the consolidated profit for the MNE and value creating factor contributions can be reasonably determined.
With the explicit introduction of the new VCM method, it remains to be seen whetherthe Chinese tax authorities will be even more inclined to dismiss potential comparables, on grounds of LSAs, local intangibles or other factors, and use the absence of comparables to push in the direction of using this new method.
In addition to VCM, the value chain analysis requested in the TP documentation local file is further evidence of SAT's ardent support for the value chain theory. Moreover, the Draft requests that, regardless of the TP method selected, the enterprise shall state its contribution to the overall profit or residual profit of the group in the local file documentation.
Special tax adjustment provisions
The Draft introduces a re-characterisation provision, among other key changes. The re-characterisation rules provide that if a contract for transaction between related parties would not have occurred under equivalent economic circumstances between unrelated parties then the transaction may be deemed not to have occurred or may be re-characterised by the tax authorities. Furthermore, where the functions conducted/risks borne by a related party for another related party are more than that which an independent party would have been willing to do then compensatory arrangements will be made.
The exact application of the broadly worded re-characterisation provision remains unclear. It would be preferred if the Chinese tax authorities would allow for regard to be had to the relevant BEPS guidance in negotiations with taxpayers over whether re-characterisation should be applied.
Adopting the SAT's position, as set out in the UN manual, on adjustments which need to be made to calculate appropriate profits for toll manufacturers, the Draft provides that the tax authorities may make adjustments for the value of materials and equipment legally held in the ownership of the offshore principal when determining the appropriate profit for a toll manufacturer.
The Draft explicitly sets out that, in cases where a foreign company transacting with a Chinese taxpayer is low-tax and has a limited function/risk profile, then the foreign company can be used as the tested party in a TP audit. There is a danger that a reverse transactional net margin method (TNMM) approach could be applied which awards a limited return to an overseas company for its functions, with the entire residual profit in the global value chain being allocated to China.
The Draft also sets out that, before an enterprise which engages in cross-border transactions is deregistered with the tax authorities, they can conduct special tax adjustment risk analysis targeting the enterprise and focus on whether it has transferred lowly priced or non-priced intangible assets to overseas entities. If any transactions are found not to comply with the provisions herein, special tax adjustments and investigations should be carried out.
SAARs and GAAR
The existing Circular 2, while it deals primarily with TP matters, also extends to dealing with the Corporate Income Tax (CIT) Law's Special Anti-Avoidance Rules (SAARs), including controlled foreign company (CFC) rules and thin capitalisation (thin cap) rules, as well as the PRC General Anti-Avoidance Rule (GAAR), and these are now updated by the Draft. A significant change for both the GAAR as well as the SAARs is that the statute of limitations for these measures has now been extended to 10 years. This had always been the case for TP cases but the extension of the time limit for the other rules will have a significant impact on tax risk management for MNEs. The chapter in this volume, China at the forefront of global BEPS implementation, probes into the proposed changes to CFC.
For thin cap rules, debit balances under cash pooling arrangements and interest-bearing current and long-term liabilities (including interest-bearing trade payables) are now considered to be related-party debt investments. Furthermore, the calculations for related-party debt and equity are revised; this may become highly complicated if a taxpayer engages in a cash pool, as its debit balance is different on a daily basis, but the rules are likely less to be prone to manipulation in the future. The SAT has declined to introduce the earnings stripping or group limitation rules proposed by the BEPS interest deductions draft. It is understood that this may be partly because an update to the CIT Law itself would have been necessary to facilitate the roll-out of these measures, and the SAT was disinclined to push for such a change.
As much as China continues to adhere to the internationally accepted arm's-length principle and OECD-sanctioned "benefit test" (that is, a service payment made must be one which an independent enterprise would also have willingly made), the brand new Chapter 7 of the Draft demands an examination of the 'direct or indirect economic benefit' of a given service for a service recipient and takes a very strict view on determining whether and to what extent outbound service fee payments can be deducted for CIT purposes. Such language and rationale are basically aligned with what has been detailed in previous SAT Announcement  No 16 (Announcement 16).
More importantly, the Draft indicates that for a positive assessment to be reached that a service has generated a direct or indirect benefit for the service recipient, a Chinese entity may have to demonstrate a connection between the service fee payment and an incremental marginal profit. This approach would go beyond what the equivalent OECD rules would demand to see. As a result, taxpayers may find it hard to reconcile China's approach to intra-group services with other countries' approaches. The risk of double taxation is very real.
As a supplement to the direct or indirect economic benefit test, the Draft also provides the detailed documentation requirement in the Special Issues File regarding intra-group services. Extensive recording and reporting of information on the pricing of related-party service transactions is also provided for under the services chapter, with a separate services section in the local file as part of the TP documentation also now required.
The Draft also integrates the guidance in Announcement 16 on payments to 'low function entities'. This denies outright deductions for service fee payments to such entities, a harsher approach than envisioned under OECD rules. The SAT also chose not to integrate the safe harbour, proposed by the OECD BEPS work, for low-value adding services on the basis that all intra-group services are high-risk transactions.
Nonetheless, it remains to be seen what evidence would be deemed sufficient to substantiate direct or indirect economic benefit in practice. An implicit incremental profit approach could make it very challenging for MNEs to support their deductions for outbound service fees. Taking this together with the local file value chain analysis and the country-by-country reporting (CbCR) information, service fee payments are now at higher risk of scrutiny like never before.
With reference to the BEPS report on Action 13, Guidance on TP documentation and CbC reporting, the Draft creates a new TP documentation structure composed of master file, local file and special issues file. Meanwhile, the CbCR requirements have also been incorporated as part of related-party transaction disclosures in filing the annual CIT return for certain taxpayers who met the criteria/threshold set out in the Draft.
The Draft formally expands the scope of parties obliged to prepare the master file and local file from those with more than the existing Rmb200 million ($31 million) (buy-sell transactions) or Rmb40 million (other transactions) transactions thresholds, to also cover entities with limited risk and function profiles but suffering operating losses regardless of their related-party transaction amount. This requirement is a slight modification from Circular 363 , which provided that single-function entities incurring losses shall prepare TP documentation.
The master file requirements, which include an organisational chart and information on and a description of a MNE's business, intangibles intercompany financial activities, financial and tax positions, are in line with the BEPS action plans. The Draft includes only one additional requirement: the name and the location of the legal entity preparing and filing the CbCR for the group. Obviously, a MNE's Chinese taxpayers may find it difficult to prepare the master file on its own since the preparation requires extensive information and profound understanding of the group's operation/business, value chain and core competitiveness. On the other hand, the higher standard for the quality and scope of analysis in connection with related-party transactions indicates the value chain analysis of the intra-group transactions may not be easy to prepare.
As for the local file, the Draft's requirements include:
Company profile (including management team, business lines, and industry profile);
Comparability analysis; and
Selection and use of a TP method.
Throughout the description of the contents, the Draft sets out in finer detail than is done in the BEPS Local File description, what precise details must be set out. This being said, at least in respect of (1), (2), (4) and (5), the detail does not significantly expand on what could reasonably be expected to be included in the BEPS local file (though there is a requirement to set out the effective tax rates of related parties similar to the documentation requirements under existing Circular 2, which is not included in the BEPS Local File).
Where the Draft does depart significantly from the BEPS local file (and this is also additional content which had not been required under Circular 2) is the value chain analysis segment within (3) Related party transactions. This requires significant disclosure of information on a MNE's value chain relevant to the Chinese taxpayers.
In particular, the transaction, goods and funds flows within each value chain in the MNE group must be set out in the local file. A MNE must also provide an overview of the attribution of its global profits to the different countries within its value chain, both in terms of how profits are allocated across the value chain and also in terms of the actual amounts of profits earned by each value chain participant. What is more, it also demands that standalone and consolidated financial statements for every entity within the MNE value chain be retained in the local file. Depending on how such requirements are applied by the tax authorities in practice, this could go well beyond the requirements of BEPS CbCR, which is much more summary in nature.
The rationale for the inclusion of such extensive requirements for value chain information in the local file was provided by the SAT panel in a recent seminar releasing the BEPS Chinese language reports. The panel said the information being requested in the value chain analysis' segment of the local file is what is typically sought during a TP audit. Based on the SAT's TP audit experiences, existing TP information was frequently seen as inadequate. Thus, it had been planning to include a requirement for such value chain information in the Chinese TP documentation requirements of the revised Circular 2, before the BEPS work commenced. The initiation of the BEPS project led the SAT to adapt their original proposals so that the BEPS TP documentation framework was adopted; nonetheless, the SAT chose to preserve the requirement for the value chain analysis segment of the local file.
The inclusion of value chain analysis in the local file demonstrates that the SAT is conscientious about ensuring that the Chinese taxpayers are allocated their fair share of MNEs' global value chain profits, and that any potential mismatches can be easily identified in the local file. It also provides the fuel for the Chinese tax authorities to apply PSM and VCM TP methods.
As a very interesting addition to the above master file and local file, taxpayers engaging in intra-group services arrangements, cost-sharing arrangements (CSAs), or falling under thin-cap requirements are required to prepare a special issues file without a transactional threshold.
Subject to the above, MNEs are advised to evaluate their capability in preparing the files, set-up an effective system to collect information and better allocate resources. Meanwhile, they should also consider reviewing and updating the group's TP policies without further delay so they can adapt to the new requirements set forth in the Draft.
Advance pricing arrangements
Refinements have been made to guidance on advance pricing arrangements (APAs), providing that priority will be given to applications from taxpayers who provide thorough value chain analysis and/or have duly considered LSAs such as market premium and location savings, and who plan to adopt appropriate TP mechanisms.
The concept of median is further reinforced in the APA provisions. The Draft provides that the tax authorities may adjust the pricing or profitability to the median of the agreed range if the pricing or profitability falls outside the agreed range in any particular year during the APA. The tax authorities may also adjust the weighted average pricing or profitability to the median of the agreed range if it is below the median of the agreed range (even if within range). The Draft also provides that tax authorities may turn away applications for extensions from taxpayers whose weighted average pricing or profitability fell below the median of the agreed range (even if within range) during its in-force APA period.
The Draft also made changes to the administrative proceedings. The notable ones include the requirement to provide the application materials with the submission of the letter of intent" and the abolition of anonymous pre-filing meetings.
The issuance of the Draft was timed to coincide with the release of the 2015 Deliverables of the G20/OECD BEPS international tax reform project and integrates elements of the BEPS proposals for TP. However, , in parallel, it also formalises many of the novel China TP concepts which the SAT has developed in recent years, thus localizing the BEPS TP work in a China context.
The Draft is a highly significant document, clarifying the Chinese approach to TP investigations and analysis, introducing new TP methodologies, and significantly expanding TP documentation requirements. The guidance spells out, more clearly than ever, the types of transactions and the nature of the TP adjustments which the PRC tax authorities consider themselves entitled to investigate and make, respectively. At the same time, the Draft gives great latitude to local tax authorities to apply the often broadly drafted rules. Ultimately it remains to be seen in practice what precise effect the new guidance will have. Incidents of double taxation for MNEs may be set to increase in the future, and MNEs may in many cases be compelled to adjust their existing business models and/or TP policies.
The authors would like to thank Conrad Turley and Mimi Wang for their contributions to this chapter.
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Based in Shanghai, Cheng Chi is the partner-in-charge of KPMG's global transfer pricing services for China and Hong Kong SAR. Before returning to China in 2004, Cheng started his transfer pricing career in Europe with another leading accounting firm based in Amsterdam. He has led many transfer pricing and tax efficient supply chain projects in Asia and Europe, involving advance pricing arrangement negotiations, cost contribution arrangements, Pan-Asia documentation, controversy resolution, global procurement structuring, and headquarters services recharges for clients in the industrial market, including automobile, chemical, and machinery industries, as well as the consumer market, logistic, communications, electronics and financial services industries .
In addition to lecturing at many national and local training events organised by the Chinese tax authorities, Cheng has provided technical advice on a number of recent transfer pricing legislative initiatives in China. He has been recommended as a leading transfer pricing adviser in China by the Euromoney Legal Media Group since 2009 and as a tax controversy leader by International Tax Review.
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John leads the KPMG Hong Kong transfer pricing team and has 20 years experience in tax and transfer pricing advisory. He has extensive experience in transfer pricing documentation, planning, controversy and audit resolution, including competent authority matters.
John has completed a large number of advance pricing arrangements (APAs) as well as transfer pricing audit defence and controversy management in China, Japan, Korea and across the Asia Pacific region, and has worked globally with tax authorities in the US, UK, Germany, Canada and other key jurisdictions.
Having lived and worked in Asia for more than 15 years, John has extensive experience in transfer pricing issues across the region with respect to Japan, Korea, Hong Kong, Singapore, Taiwan, China, India, Indonesia, Philippines, Vietnam and Australia and is up to date on the different transfer pricing systems. John also has built up an extensive network within KPMG across the Asia region, which assists in coordinating work around the region.
John works with global and multinational Fortune 500 companies as well as with new emerging businesses across a wider range of industries, such as insurance, asset management and financial services, retail and consumer markets, transport and logistics and information and communication and telecommunications.
John is a frequent speaker at seminars and for professional organisations, and has published articles on transfer pricing.
John holds a bachelor of commerce degree and a master's degree in commerce & business administration fromKobe University in Japan.
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Simon Liu is a tax partner in KPMG's Beijing office. He has been involved in providing various China tax and transfer pricing advisory, and compliance services to multinational corporations and PRC domestic companies since 2003.
Simon has been actively involved in advising clients on various issues such as M&A, corporate restructuring and market entry feasibilities, based on PRC state regulations and special local rules, policies and practices. He is experienced in delivering creative and practical solutions, and planning ideas which not only cover tax but also regulatory, customs, and foreign exchange issues. He also has extensive experience in transfer pricing and of cost sharing arrangements.
His technical expertise covers transfer pricing documentation, planning, and investigation defence; cross-border tax structuring; tax-efficient supply chain management and economic valuation for intra-group restructuring.
Simon has bachelor degrees in engineering and commerce from the University of Melbourne, and is a certified management accountant.
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Kelly Liao is a partner in KPMG China, based in southern China. Kelly started her professional career in 1999. She has extensive working experience in China, Hong Kong and Finland.
Kelly became specialised in transfer pricing in 2004. She has been actively assisting multinational companies in transfer pricing dispute resolution, value chain planning, rationalising transfer pricing policies, formulating cost recharging policies, applying for advance pricing arrangements and preparing transfer pricing documentation in China.
Kelly's clients include a number of multinational enterprises in a wide range of industries, including infrastructure, chemical/oil & gas, consumer goods, retail, electric and electronics, property development, pharmacy, machinery, finance and e-commerce.
She is a Chinese certified public accountant, Chinese certified tax agent and a Hong Kong certified tax agent.