On January 9 2009 the State Administration for Taxation (SAT) released "Implementation Measures for Special Tax Adjustments" (Final STA Measures). The Final STA Measures contain 13 chapters and 118 articles. What is new and compelling to multinational investors in the regulations include dealing with the significant compliance burden of the new documentation requirements and tapping into the opportunities provided by cost sharing.
What are special tax adjustments
It may be helpful to start by clarifying the term "special tax adjustments" under which the transfer pricing regulations have been issued. Special tax adjustments" (te bie na shui tiao zheng) refer to "tax avoidance" associated with:
transfer pricing;
use of tax havens via controlled foreign corporations (CFCs); and
sham arrangements entered into solely for tax evasion.
Policies designed to crack down on these policies are known in China as "anti-avoidance". So transfer pricing adjustments are a subset of special tax adjustments.
The documentation requirement – the essentials
The most anticipated aspect of the STA Measures was the documentation requirements and the biggest guessing game was the threshold level. Under the Final STA Measures, taxpayers must prepare contemporaneous documentation for 2008 by December 31 2009 and are also required to submit nine intercompany disclosure forms as part of the tax return due by May 31 2009. Enterprises whose tangible transactions are less than Rmb200 million ($29.3 million) and other related-party transactions are less than Rmb40 million are exempted.
The SAT dials back
The Final STA Measures are in line with draft measures circulated in March 2008 for comments, but obviously alarmed by the financial crisis, the SAT has dialled back the requirements. Most importantly, the documentation threshold was raised significantly from the draft value of Rmb20 million and the deadline for preparing 2008 documentation was extended to December 31 2009. There has also been some simplification in information required and one of the disclosure forms has been dropped.
But boxes in the taxpayer (with a novel approach to arm's length)
Stepping out ahead of other tax authorities, the SAT has boxed in the taxpayer by narrowing the room for economic gaming. As is well-known, creative transfer pricing economists can justify a remarkably wide range of financial results under the arm's-length rubric.
The SAT takes dead aim at two of the most powerful tools in the economist tool kit – the inter-quartile range and capital intensity adjustments. In an audit, says the SAT, the target's profit should be adjusted to the "median" value and capital intensity adjustments can be used only with SAT approval. Taken at face value, these constraints would mean that enterprises would be boxed in to generating "acceptable profits" (for example, 5% to 10%).
Is the door really closed?
First, it should be noted that the SAT positions are discussed in contexts of an audit not documentation. In other words, these instructions are to tax officials who are conducting an audit not to taxpayers preparing documentation.
Second, at other places, such as in discussing the transactional net margin method, the SAT acknowledges that it is reasonable to make adjustments. Thus, it may be possible for the taxpayer to use adjustments and ranges in preparing documentation recognising that there may be a challenge if and when they are audited.
Capturing the impact of the financial crisis
The SAT recognises the impact of the financial crisis and multinationals – especially significant job-creators – should take advantage of this to support their position. They should provide information on their globally declining profits, as well as 2009 quarterly data on comparable companies. They can also share negative and impending industry developments, such as bankruptcies, declining sales, and so forth.
Technology cost sharing – useful for the minority
In the Final STA Measures, the SAT has finally come out in favour of cost sharing. For a minority of companies this could be a very useful way to minimise global taxes. We are speaking of multinationals who are in loss in their home markets but profitable in China. These companies could have their Chinese entities do a cost-sharing "buy in" of pre-existing technology thereby shifting profits and cash out of China and back home.
Service cost sharing – a possible opportunity
The difficulty of paying a service fee out of China (without taking a tax hit) is a common complaint by global tax directors. The Final STA Measures endorse the concept of service cost sharing (for group marketing and procurement services). This could be the best news to come out of the Final STA Measures, but unfortunately one crucial area has not been clarified: the business tax and corporate income tax treatment associated with a service cost sharing payment. Service fees paid out of China are subject to such taxes if a permanent establishment exists and the question is whether a cost sharing payment would be exempt from such taxes. Multinationals should stay tuned as to this important matter.
More and more developed
The Final STA Measures come at an interesting time. China needs taxes as the country seeks to pay for its $585 billion economic stimulus plan (a staggering 15% of GNP). But at the same time, the message from the highest levels is that the number one priority is job creation and growth. We believe China will continue to maintain its investor-friendly attitude and that tax inspectors will take a balanced and reasonable position. The Final STA Measures impose significant burdens on multinationals but these can and should be handled in a practical and cost effective manner. On balance, the Final STA Measures are a necessary step forward and signal that China is acting more like an advanced economy.
Glenn DeSouza (glenn.desouza@tpmc.com.cn), managing director, Transfer Pricing Management Consulting in Shanghai, which has an exclusive strategic alliance with Baker & McKenzie in China.
