Welcoming a liberal era for financial services firms in China
John Leightley, Xiaoli Huang and Samuel Gordon discuss how transfer pricing (TP) considerations will evolve for financial services firms as China takes calculated steps towards liberalising its economy.
For global financial services firms, the appeal of the Chinese financial services market is the size and growth of the Chinese economy and the increasing accumulation of wealth across Chinese society. China's business strategy and the presence of foreign financial service firms is evolving with the liberalisation of the Chinese financial services market.
In China's financial services market, where domestic financial institutions have significant competitive advantages, many foreign firms are relying on their cross-border business models connecting Chinese clients to products, know-how, counterparties, and capital through their global networks. This differentiates foreign firms from their domestic competitors.
Transfer pricing (TP) is part of the critical financial and tax infrastructure of these cross-border business models. This article addresses important TP considerations for financial services firms during this important period as the Chinese financial services markets are liberalised and as foreign financial services firms deepen their commitment more to the Chinese financial services market.
Enticing foreign investment
The most widely heralded aspect of China's market liberalisation is the relaxation of foreign ownership restrictions in the banking, securities, and insurance industries that allow foreign firms to take majority ownership of Chinese entities. To date many foreign firms have taken minority ownership stakes in Chinese businesses through joint venture arrangements. After receiving regulatory approval, some foreign firms are taking majority ownership in their joint venture businesses through a variety of transactions (e.g. capital injections, share purchase arrangements, etc.).
The liberalisation has also spurred foreign financial services to establish branches or subsidiaries in China. Beyond changes in ownership limitations, the liberalisation extends to the types of business that foreign financial firms can conduct in China. Obtaining licenses for these areas of business involves demonstrating various aspects of the business including governance, organisational structure, internal set-up, internal control and more.
The tax implications of foreign ownership
From a group tax perspective, taking majority ownership of a joint venture gives rise to the question of whether the legacy joint venture TP continues to be acceptable, or whether changing the TP to reflect consistent group TP methods is more appropriate. Additionally, the movement into other business areas introduces fresh TP requirements.
In an increasingly transparent global tax environment, foreign financial services firms frequently strive to apply consistent global TP methods at a transactional, product, or business unit level. The methods are applied as consistently as possible to reflect relative value of people, capital, and intangibles across the group of companies and branches.
In many instances, the TP applied to financial services firms' Chinese joint ventures has been an exception to the firms' global TP methods. The transactional net margin method (TNMM) has often been used to remunerate Chinese joint ventures based on a combination of the functional profile and business conditions. The use of TNMM also may be in part driven by the legal arrangement with the joint venture partner, which may make it challenging to apply other TP methods. A key feature of the TNMM is that it results in relatively stable operating profits for the recipient of the TP.
Upon taking majority ownership of Chinese operations when determining whether to apply globally consistent TP that does not guarantee the Chinese entity a relatively stable operating profit, management should carefully analyse any decision being or expected to be made in the majority-owned Chinese entity with respect to key economic risks.
Evaluating TP methods
When evaluating changing TP methods, changes in third party risk decision-making and changes to the ability of the entity to bear financial risk are more important than changes in ownership. A foreign financial firm will typically disclose planned business changes as part of any regulatory request to take majority ownership; or for expanding existing business or undertaking new business. Regulatory approval of changes in client contracting, corporate governance, entity organisation, risk management and/or regulatory capital may provide the clearest indicative basis for TP changes.
If the financial regulatory view and TP functional analysis views align and demonstrate that the Chinese entity should bear the risks of operating losses, are TP methods resulting in losses acceptable under Chinese TP regulations?
The Chinese TP methods are broadly consistent with the OECD methods, and the Chinese TP regulations do not preclude related parties from bearing operating losses. Accordingly, in principle, Chinese TP methods do not guarantee the Chinese entity an operating profit under all conditions, and where a Chinese entity bears key economic risk, it should also be able to earn returns in excess of a routine return as determined measured through the application of a TNMM.
Any potential change of TP method should take into consideration China's requirements to address location specific advantages, and China's position that returns for the unique Chinese market characteristics should accrue to Chinese entities. Under joint venture arrangements, where a TNMM based on benchmarking of comparable Chinese companies operating profit levels were used, an argument that the location specific factors are inherent in the geographic market comparability is a relatively straightforward documentation and audit defence position.
However, when changing to a consistent, global TP method that is not based on Chinese comparables, the new TP method may be subject to scrutiny or adjustment. Two important means of understanding and potentially mitigating this risk are cost analysis and product margin analysis.
Consider an example of changing the TP method from a TNMM based on Chinese comparables to a fee split for a banking business based on global comparable percentage splits. One type of corroborative analysis might compare the Chinese related party and foreign related party costs, and then the China entity's costs and cost structure of its peers to establish whether the fee split puts the Chinese entity at a disadvantage. This might also provide a basis for adjustment of a global comparable for a key location specific factor i.e. cost structure.
With respect to the other types of key location specific advantage (e.g. market premiums) foreign financial service firms have commonly taken qualitative positions that their market share is low relative to their domestic competitors, and they are unable to price products at premium due to intense competition for clients and deals. Going forward, if TP results in fluctuations of a Chinese entity's taxable margins, one best practice is to regularly review product margins to identify the presence or absence of a market premium and review this against TP results to strategise how best to prepare the documentation and any audit defence files.
Audits and adjustments
Even if the selected TP method is appropriately based on risk decision-making, capacity to bear risk, and location specific factors within the context of the Chinese TP regulations, the Chinese State Taxation Administration (STA) specifically outlines that businesses with fluctuating profits are subject to TP audits. Likewise, adjustments may be imposed if the risks were due to wrong decision-making by related parties. Given this, are there any mechanisms for addressing anticipated loss-making situations?
In various countries, clawback mechanisms are sometimes used to address loss-making situations. A TP clawback involves a contractual term and agreed upon calculation mechanism that allows for the offsetting of TP losses in one period against TP profits in another period. Clawback provisions are observable in third party contacts. Clawback arrangements are not seen in many TP arrangements in China, which is likely due to the prevailing use of returns linked to TNMM benchmarking and the fact that single year periods are typically used as the testing period in China. Multi-year testing periods, which would allow a clawback, are used occasionally. Care would need to be taken before implementing clawback mechanisms, although such a mechanism may be possible given the right circumstances.
Where losses are likely or expected due to market entry, product synergy, or even major business cycle downturns such as the COVID-19 crisis in various countries, certain contingencies (e.g. net cost plus floors, etc.) are built in the TP arrangement to mitigate the risk of loss. As best practices for employing these contingent arrangements, it is notable that:
They are reflected in inter-company agreements;
They are defined as being driven by business conditions more so than the functional analysis;
The rationale or benefit for the related party bearing the cost of the contingent arrangement is clear; and
On an ex-ante basis, the parties agree specific criteria or timeframes determining how or when a contingent arrangement is to be exited.
It is also relatively common in China to proactively engage with in-charge tax authorities when there is a change in the TP method or significant new transactions are entered into. Consideration should be given to whether engagement with the tax authorities could help mitigate transition risk. Frequently, this approach will be used where the TP would result in significant outbound payments from China.
When evaluating the move from TNMM to other methods (particularly those resulting in outbound payments), firms will have to give consideration to how China's foreign exchange administration regulations will impact the ability to make cross-border payments.
Changing TP methods requires consideration of whether to go with a document and defend strategy versus an advance pricing arrangement (APA). The important decisions will need to be made for both the year that the policy is changed, as well as the year when losses may first arise in the Chinese entity and it is possible that these could be on the same date.
A document and defend strategy will require comprehensive support, particularly if the business is changing the TP policy, but little else changes from the tax authority perspective. The financial service firms' regular tax authority will likely question a move away from a cost plus or similar approach, which may have provided stable and predictable tax revenues over many years.
Given that increased transparency and moving away from a TNMM will likely lead to questions, proactive engagement with the tax authorities should be considered, with careful risk analysis and simulation being completed beforehand. China has a developed APA programme, however the financial services sector has not had any completed APAs to date.
Deciding if and when to change TP is always difficult. The changes to business and ownership within China will likely present the best opportunity to make changes to appropriately remunerate the activities. Evaluating the degree of risk of operating losses after aligning TP policies should be grounded in the regulatory allocation of risk and representations made to regulators for the approval of majority ownership or business change and expansion.
In making changes, a clear position on the local market factors and the ability to demonstrate quantitatively that local cost factors are not at issue or adjusted for; or there are no market premiums, will be more important where TP methods rely mainly on global or non-Chinese benchmarks in particular.
Without always using a TNMM, losses are inevitable. Mechanisms like clawbacks and contingent arrangements for certain business conditions should be considered. While these mechanisms are less common in China than in some other countries, with appropriate support and demonstration that the mechanisms are consistent with third party behaviour, they help make the transition away from a TNMM smoother where appropriate.
Once the decision to change a TP method is made and the business considers the risk management strategy, i.e. document and defend or APA, it will need to think about whether the change can be clearly supported, the likelihood of losses during the initial years, and the financial services firms' existing relationships with the authorities.
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Samuel Gordon is a TP/financial services tax partner with Deloitte Tohmatsu Tax Co in Tokyo, Japan. He is the global TP leader for the financial service industry, and serves as regional or global lead TP advisor for clients across three major financial services hubs – Tokyo, Hong Kong SAR, and Singapore. He is a bilingual (English-Japanese) TP professional with more than 20 years of advisory and in-house experience.
Samuel focuses on TP for financial services industry clients and inter-company treasury issues of all types of clients. He brings to bear his prior in-house experience to help clients enhance their TP and overall tax management.
Samuel speaks regularly at TP and tax conferences in Tokyo, Hong Kong SAR, Singapore, New York, and London. He is active with several financial services industry associations and has contributed articles to publications. He is listed in Euromoney's Expert Guides for his TP work.
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Xiaoli Huang is the northern region's lead partner for TP at Deloitte China.
Xiaoli assists top multinational entities (MNEs), headquartered both in China and other countries, in managing their international tax business. This includes drafting and implementing TP policies, arranging cross-border transactions, drafting compliance documentations, defending TP audits, and working on mutual agreement procedures (MAP) and APA applications.
Before joining Deloitte, Xiaoli worked at the State Taxation Administration of China (STA) for 18 years. He made significant contributions to China's enterprise income tax law and also worked on the development of other regulations in the country such as TP, non-resident tax, controlled foreign corporations (CFC), the general anti-abuse rule (GAAR), and outbound investment tax management. He led bilateral APA cases including the first such arrangements with Japan, the US and South Korea.
Xiaoli has also worked as a delegate to OECD working groups representing Chinese tax authorities and was deeply involved in BEPS action plans in China.
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John Leightley is a senior manager in Deloitte China's cross-border tax team, specialising in TP. He has more than fifteen years of tax experience, working across a wide variety of clients on inbound and outbound tax and TP advisory services, including financial services industry clients, regional headquarters, and consumer and industrial goods multinationals.
John works with financial services clients within mainland China and Hong Kong SAR, focusing on banking and capital markets. His broader experience covers the full suite of TP services, including TP planning and advice, debt pricing, APAs, TP controversy and regional/global documentation.
Prior to moving to China in 2011, John was with Deloitte New Zealand's TP team.