BEPS 2.0: What will it mean for China?
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BEPS 2.0: What will it mean for China?

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Intensive work at an international level to erect a new architecture for international tax rules by 2020 will have deep implications for businesses. Conrad Turley and Sunny Leung explore what this might mean for China’s burgeoning digital economy.

In last year's eighth edition of China – Looking Ahead, A Sisyphean task? – Tax playing catch up with the fastest moving digital economy in the world tackled trends in the digital economy (DE) and provided an overview of the various proposals to update international tax rules. These proposals had emerged from debates at the Inclusive Framework on BEPS (IF) during the course of 2018.

In 2019, the IF's work crystallised into an IF programme of work. The IF is working intensively towards global consensus on a new architecture for international tax rules by early 2020, with the detail of the rules to be ironed out in the course of the year. While it is still not certain that consensus will be reached on this timescale, we can already start to consider the impact such rules would have on multinational enterprises (MNEs) operating cross-border into and out of China. In doing so, it must be noted that while much of the initial focus of the global efforts was on so-called highly-digitalised enterprises, the proposals being taken forward have a much wider sweep of application, capturing a wide variety of industries and sectors.

Whatever rules do emerge will have to be reconciled with an increasingly complex international picture. Numerous countries have announced or adopted unilateral measures to tax digitalised businesses, with impacts on China's increasingly globalised DE players, and it remains to be seen if these rules will be suspended and rolled back following agreement on a global solution. The parallel long-running challenges, presented by Chinese domestic tax rules to structuring and operating new forms of digital business models, are dealt with in the separate article, We need to talk about platforms: Ongoing tax challenges in China.

Emerging global tax framework

Last year we explained how the UK, US and India had all advocated in 2018 for different approaches to modifying existing international tax conventions on nexus and profit attribution to address the challenges of digitalisation; so-called pillar one of the strived-for global consensus solution. These different approaches were subject to public consultation in March 2019.

The UK emphasised the importance of user participation and contributions, such as for transport, accommodation, and e-commerce platforms and for online advertising business models built around free services (for instance search and social media).

The US advocated for a broader scope for new rules, recognising that digitalisation is an aspect of a larger process of 'intangible-isation', whereby intangible assets are more predominant in the value creation processes of MNEs. In line with this, new rules should capture all large businesses whose business models have marketing intangibles at their core, including luxury goods, autos and consumer branded products alongside highly digitalised businesses.

India sought a still broader solution. While the UK and US proposals suggested that user contributions/intangible assets drove super-normal profits, and that therefore just this element of MNE profits should be allocated to user/market countries, India argued that market countries should have a share of all MNE profits. They argued that digitalisation enabled foreign enterprises to have a sustained, ongoing relationship with their customer/user base in a country without the need for physical presence. Consequently, both physical and remote distribution arrangements would need be subject to the same level of tax in the market country to preserve a level playing field. They suggested that MNE profits, both from routine activities as well as the 'residual' profits, be allocated to markets using fractional apportionment methods.

While there was no consensus on any one of these different approaches, by themselves, the commonalities of the approaches allowed for a programme of work to be drawn up (issued in May 2019), and for working parties (WPs) under the IF to commence detailed work from June 2019. More recently, in October, the Secretariat set out a proposed 'unified approach' for public consultation drawing on these commonalities. In particular, all approaches provided that:

  • The traditional threshold for a market country to assert taxing rights over foreign business, the physical presence permanent establishment (PE) threshold, would have to be supplemented by a new nexus rule, a 'remote taxable presence' threshold. Under this, a company could have a taxable presence in a market on the basis of its revenue from the market, perhaps supplemented by other factors showing engagement with the local customer/user base (for example, data collected, advertising spend, etc.);

  • The allocation of profits to the market/users jurisdiction would be made out of MNE group consolidated profits. This would be a step away from the historic reliance on the transactional arm's-length approach to transfer pricing (TP), which focuses on entity-to-entity transactions within the MNE group. Indeed, the nexus assessment would also occur at the MNE group level, having regard to all the interactions between various MNE entities and the market/user country. This compromises the separate entity principle at the heart of the existing international tax system.

  • The new rules would be simplified to the highest degree possible, to facilitate adoption across all of the 135 IF jurisdictions. Many of these have limited tax administrative capacity and would already struggle with highly complex new rules; as do many more developed countries and MNEs at present with the existing TP framework. This indicates that simplified ratios and metrics are likely to be used for calculating MNE residual profits, and for calculating the proportion of this to allocate to market/user countries.

Drawing on these commonalities, and in parallel to the work of the WPs, the IF steering group (SG) has worked with the OECD Secretariat on developing a unified approach. The SG includes the most significant global economies – China, the US, Germany, France, UK, Japan and India – as well as representatives of a number of smaller developed open economies and developing countries. It is tasked with finding the political compromises to guide the technical work of the WPs.

The chair's statement from the G7 finance ministers' meeting in July gave some indications of the possible shape of this compromise, involving trade-offs between the Europeans and the US. It was indicated that broader scope rules, capturing businesses heavily reliant on marketing intangibles, would be pursued – in line with the US approach – but that ways would be explored to adjust the allocation of taxing rights to markets to reflect the high degree of digital engagement that some highly-digitalised business models have with their customers/users; namely, the use of ratios/metrics that recognise the European position that users/data play a key value creation role. The Secretariat unified approach proposal sought to concretise this compromise by setting out an approach involving three 'amounts' of profit which may be allocated to a market country. Amount A is the allocation of residual profits using formulaic metrics. Amount B is a floor on the return attributed to 'baseline' physical marketing and distribution activities. Amount C uses standard TP rules to allocate further amounts to the market for functions beyond the Amount B 'baseline'.

Amounts A, B, and C are all noted to need strong dispute mechanisms, such as arbitration, International Compliance Assurance Programme (ICAP) or multilateral advance pricing agreements (APAs). Business line/regional segmentation are to be further explored. These new profit allocation rules would co-exist with traditional TP rules. It remains to be seen whether compromise can be built around these proposals over the coming months.

In parallel with this, under pillar two, rules to establish a global minimum tax are being developed. These would subject low-taxed controlled foreign companies (CFCs) in an MNE group to a 'top up' tax, so that the effective tax rate (ETR) on overseas income of the MNE rises to a globally fixed minimum rate.

To achieve this, residence countries would apply income inclusion rules, along the lines of the US global intangible low tax income (GILTI) rules, and market/source countries would apply base erosion rules. The latter could take the form of withholding taxes or a denial of deductions for outbound payments, and would need to be coordinated with the income inclusion rules of residence countries to avoid double tax (income inclusion rules would likely take priority).

France and Germany were the original advocates of this proposal, and the US appeared open to it from an early stage given they already apply GILTI. While other developed countries had earlier expressed scepticism, in July the G7 finance ministers agreed in principle to the minimum tax. It remains to be seen whether other IF countries can be brought on board; many observers consider it likely that while pillar one may become a minimum standard, with adoption across IF jurisdictions, pillar two may simply be set as a best practices recommendation, open to adoption by countries who wish to do so.

China – external pressures

China is a SG member and a key player in the IF process. Given that China will in 2019 have the world's largest retail market, and given the rapid expansion of Chinese DE enterprises overseas, the impact of any new rules on China are being closely scrutinised by Chinese tax policymakers. A number of considerations come to the fore.

First off, an increasing number of countries, particularly in Europe and across Asia-Pacific (ASPAC), but increasingly also in Latin America and Africa, are adopting unilateral measures to tax products and services delivered through digital channels. In Europe, France, Italy, Hungary and Slovakia have all instituted different measures, while Austria, Spain, UK, Czech Republic, Poland, Belgium and Slovenia are at different stages of progress with proposed rules. Many of these take the form of digital service taxes (DSTs), levied on online advertisers and intermediaries as gross basis turnover taxes; these generally follow a design developed by the EU Commission in 2017.

Not being covered by tax treaties, these would necessarily lead to double taxation, and impose a high effective tax burden for low margin or loss-making businesses. In ASPAC, India, Taiwan (China), Australia, Vietnam, Malaysia and Pakistan have adopted measures, while Indonesia, Thailand, Korea and New Zealand are all developing proposals. Many of these jurisdictions have deferred implementation/enactment of their unilateral measures pending the outcome of the IF process. If the latter fails to obtain a consensus solution in line with the ambitious time plan set out, these jurisdictions have indicated their intention to proceed with their unilateral rules.

These measures have the potential to have a very disruptive effect on Chinese DE players' overseas expansion plans. They come at a time when these companies are also grappling with the new VAT/GST rules, being adopted by many countries, which make platform intermediaries jointly or wholly liable for the VAT/GST obligations of third-party merchants transacting through the platforms. They also emerge as Chinese DE players are just coming to terms with strict new data privacy and handling requirements in many jurisdictions (for example, the EU's General Data Protection Regulation (GDPR)).

As such, from a policy perspective, reaching a global consensus solution, which sees the suspension and rollback of unilateral measures, would appear to be in the interests of China Inc. Even though this will involve additional tax registration requirements for these enterprises in their markets, and a requirement to allocate part of their residual profits – where a new treaty framework is in place and the rules are universally adopted, tax would apply solely to net income and double taxation should be limited.

It is also noted that the aim of the US and other leading countries is that the new rules should provide for a 'modest' additional allocation of taxing rights to market countries, so limiting disruption.

A second point is that given that the pillar one rules may even go wider, to cover branded consumer and luxury goods, the impact on Chinese exporters requires evaluation. In a listing of the world's top 100 brands compiled by Forbes, only one Chinese company was included (Huawei). Indeed, the inclusion of branded consumer and luxury goods enterprises within the scope of the pillar one rules does appear more likely to affect US and European firms than Chinese businesses. At the same time, Chinese companies are leading global exporters of various consumer goods including apparel, personal computers, household appliances and tools, and furniture. To the extent these are caught within the scope of the rules they would need to register taxable presences in their market countries and calculate and allocate a proportion of their global residual profit.

It will therefore be crucial, at the detailed rule development stage, to see how the scoping rules are defined. The exclusion of companies exporting generic goods, and of contract manufacturers producing for brand owners and other such B2B sales, would remove a large number of Chinese enterprises. Excluding companies on the basis of metrics showing limited reliance on intangible assets could exclude many low margin companies which would otherwise find the compliance costs very burdensome. Furthermore, scoping out smaller scale businesses, such as those with global revenue under the €750 million ($826 million) country-by-country reporting (CbCR) threshold, could also limit China enterprise exposures further.

From a China inbound perspective

A third important consideration is that from the Chinese inbound perspective the rules will interact with China's status as the world's biggest retail market. It is, after all, a huge cross-border e-commerce market with B2C imports expected to make up 12% of Chinese online retail by 2020. China is also the world's largest market for a number of product categories, including automobiles, spirits, luxury goods, and mobile phones, where it accounts for in excess of 30% of global consumption. The new rules could result in further foreign branded and luxury goods MNEs having taxable presences in China, and needing to allocate part of their global residual profits to China.

Beyond consumer and luxury goods, many of the global DE giants have more limited engagement with China on regulatory grounds, meaning that the outcomes of the new rules would be mixed. For example, in consequence of firewall restrictions, Facebook and Google have minimal users in China (although they do earn substantial revenues from Chinese advertisers to overseas customers). As such, the new rules would likely not treat them as having a remote nexus to China. For other DE players such as Amazon, which is heavily engaged in China, the rules would likely apply.

However, whether the new rules would result in additional tax revenues being allocated to China is an open question. In Chinese TP enforcement practice, concepts of local market intangibles and market premium (as a location specific advantage) have long been used to make adjustments to the profits allocated by foreign MNEs to China. These adjustments have been particularly relevant for luxury goods, such as handbags, jewellery and cosmetics, and high-end automobiles. Foreign MNEs in these sectors have in many cases been able to command prices well in excess of those prevalent in other markets and, as noted above, China now accounts for the largest element of global demand for many such goods. The BEPS TP amendments did not change this, but rather were leveraged by the Chinese tax authorities in support of their local market intangibles arguments.

It seems quite possible that, insofar as the new rules would allocate a proportion of MNE residual profits to market countries, the quid pro quo would be that countries using TP concepts of market premium and local market intangibles (such as China and India) would be expected to moderate their usage. At the same time, the impact of the shift to the new model may differ for China and for India, given the different product mixes being sold into the two countries and different consumer profiles.

Such matters would be expected to be part of the global negotiations, alongside the proportion of residual profits allocated to market jurisdictions, the role of dispute prevention and resolution mechanisms, and the setting of a floor on returns to physical marketing and distribution activity.

Looking ahead

At the implementation level, both Chinese MNEs going out and foreign MNEs active in China will have significantly increased tax compliance and risk management obligations, such as:

  • New types of accounting records may be needed to segment MNE group profits into separate business lines. These will then be assessed for whether they exceed nexus thresholds, and will be used as the starting point for residual profit calculations. Allocation of central costs could be extremely challenging.

  • New types of data will need to be collected to apply the scope, nexus and profit attribution rules. These may include statistics on data collection and user activity in different markets, advertising spend directed at various countries, and data tracing product sales through intermediaries to final consumer markets; another very challenging task.

  • New types of filing may be needed, such as enhanced CbCR, remote taxable presence filings, third-party distributor/intermediary returns.

  • Given how tax authorities will need to become more 'joined up' on information exchange, multilateral tax risk assessment, joint audit, and dispute prevention and resolution, MNE tax departments will similarly need to adopt more joined-up firm-wide tax risk management, and work closely with business line and IT teams to generate the data for new records and filings. Advisors will need to move in lockstep with this.

  • One particularly challenging area may arise in ensuring that treaty relief is available. While the new rules determine nexus and profit allocation at the MNE group (or business line level), relief from double tax will still need to be applied at entity level. Clearly, any new rules for attributing new market tax liabilities to particular MNE entities as the 'taxpayers' will require multilateral frameworks under which tax authorities can agree profit allocations.

  • Another challenging area is reconciling the market profit allocations under the new rules to existing TP rules. The new rules will 'pull profits out of the system' and adjustments will therefore be needed to the 'system profits' allocated to various MNEs entities on an initial arm's-length basis.

  • MNEs may consider undertaking business restructurings, whether to eliminate redundant principal/IP holding structures, align entity structures with the business line segmentation used for profit attribution, and pro-actively manage challenges with scoping or nexus thresholds. Economic and tax modelling is likely to be a crucial part of such exercises.

The impact of pillar one will need to be assessed alongside the impact of pillar two, if this is part of the final global consensus solution and is anticipated to be widely adopted. The impact on effective tax rates (ETRs) for Chinese MNE overseas profits could lead to restructuring to eliminate intermediate holding company entities, though the interaction with pillar one would be key. For pillar two, the impact of the rules turns to a great degree on the minimum rate set, the existence or absence of scope and substance exclusions, and the use of worldwide or jurisdictional blending under the rules.

Clearly, whatever the shape of the rules, there will be high complexity for MNEs in terms of new accounting records, ETR calculations, the operation of the coordinating mechanism between income inclusion rules and base erosion rules, and managing dispute prevention and resolution mechanisms.

Specific challenges may also arise in a China context, given that China does not provide for group consolidated filing for CIT purposes, and the complex interaction of China's foreign exchange control rules with tax administration. As the global proposals become more granular, Chinese policymakers will have to turn their attention to the resolution of these matters.

Conrad Turley


Partner, Tax

KPMG China


Tel: +86 10 8508 7513

Fax: +86 10 8518 5111

Conrad Turley is a tax partner with KPMG China and heads up the firm's national tax policy and technical centre. Now based in Beijing, Conrad previously worked for the European Commission Tax Directorate in Brussels, as well as for KPMG in Ireland, the Netherlands and Hong Kong SAR.

Conrad has worked with a wide range of companies on the establishment of cross-border operating and investment structures, restructurings and M&A transactions, both into and out of China. He is a frequent contributor to international tax and finance journals including ITR, Tax Notes International, Bloomberg Tax and Thomson Reuters, and was principal author of the 2017 IBFD book, A new dawn for the international tax system: evolution from past to future and what role will China play?. He is also a frequent public speaker on topical China and international tax matters.

Conrad received a bachelor's degree in economics and a master's degree in accounting from Trinity College Dublin and University College Dublin, respectively. He is a qualified chartered accountant and a registered tax consultant with the Irish Taxation Institute.

Sunny Leung


Partner, Tax

KPMG China


Tel: +86 21 2212 3488

Sunny Leung is KPMG China's national technology, media and telecommunications (TMT) sector tax leader. She has assisted various local tax authorities to perform studies on common China tax issues that have emerged in the new digital economy, possible solutions, and the potential impact of BEPS.

Sunny has been extensively involved in advising clients on setting up operations in China, M&A transactions, and cross-border supply chain planning. She has been providing China tax advisory and compliance services to domestic and multi-national companies in the TMT, as well as traditional manufacturing and service industries. Sunny has also been providing tax due diligence and tax health check services in China.

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