On the international stage, the Chinese central tax authority, the State Administration of Taxation (SAT), issued a report, "China Country Practices", in 2012, published in the UN's Practical Transfer Pricing Manual for Developing Countries (the UN manual). The SAT's contribution to this manual is intended to illustrate the views of the SAT on the challenges facing China's transfer pricing management. These include limitations of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD guidelines) when discussing certain issues of developing countries, and the impact of location advantages on the profits of multinational enterprises operating in China, affecting the application of the arm's-length principle. More specifically, the limitations of applying the transactional net margin method (TNMM) in developing countries, location-specific advantages (LSAs) as well as local contributions to intangibles were also highlighted.
The SAT's contribution to the UN manual reflects China's increasing efforts to contribute to and define aspects of the international TP framework. In particular, it is a call-out to the OECD regarding the need to consider additional factors affecting companies' profits in China (and potentially other developing countries) which, to date, have not been taken into account by the OECD guidelines, which were overwhelmingly written by developed countries.
China maintains its appetite for pursuing advanced pricing agreements (APAs), though one needs to be judicious when considering the strength of a particular APA application. As of December 31 2012, China was involved in about 180 APAs at various stages. This illustrates that APAs are continuing to gain in popularity, taxpayers are increasingly interested in APAs as a feasible TP risk mitigation strategy and that tax authorities are willing to consider these applications. It is worth noting, however, that a substantial number of APAs – especially bilateral APAs of which there are more than 100 – are still in the pipeline.
Recently, we have also seen certain breakthrough transfer pricing cases in China including the signing of the first cross-regional unilateral APA on intra-group services. The APA covers multiple legal entities, provinces and (district) tax authorities. Another audit case has brought the application of LSAs by the tax authorities resulting in additional tax assessment.
Looking ahead to potential changes to the Chinese transfer pricing regulatory framework, the SAT has been collecting feedback from local tax officials, who have, in addition to their usual responsibilities, also been asked to collect, review and provide feedback as to the quality of transfer pricing documentation reports for the past few years, on the existing TP regulations set out in Implementation Measures of Special Tax Adjustment (Provisional) Circular 2 (Circular 2). Discussions have been conducted about the administration of transfer pricing investigations, cost sharing arrangements, the efficiency of administration of equity transfers, and the adequacy of transfer pricing documentation requirements. It is likely that the SAT will issue a new comprehensive circular to replace Circular 2.
Application of the arm's-length principle in China
Similar to the OECD Guidelines, China also follows the arm's-length principle in its transfer pricing regulations and administration. However, there are differences in the detailed application of the principle due in part to data constraints, particularly under the TNMM. According to China's laws and regulations:
- Tax authorities may adjust to the median of a set of comparable data for any given year in which the Chinese entity's taxable profit level is below the median profit level indicated by the comparable companies.
If all countries had similar requirements, then each year taxpayers would be subject to adjustment in one jurisdiction or another: it is impossible to predict, and then achieve during a fiscal year, what will be the median result of a set of comparable companies after year-end. The OECD guidelines address this problem by specifying that results falling within a range based upon comparable data should be considered to be at arm's-length. While the SAT has given oral guidance publicly that generally speaking being within the interquartile range, and only sometimes below, sometimes above, should not typically lead to an adjustment, the written regulations to date offer no such protection for taxpayers.
- "Single-function" entities should maintain reasonable (and positive) profit levels and not bear market risk or other risks related to decisions they cannot control; this message was later reiterated in Circular Guoshuihan  No. 363 (Circular 363), which stipulates that entities with limited functions and risks should maintain an appropriate (positive and stable) level of profits.
- In practice, Chinese tax authorities rarely accept any loss-making comparables when assessing an arm's-length profit range using the TNMM regardless of the change/trend of the market.
Consistent with these principles, the SAT has been taking an industry-specific approach by targeting low-profit industries, multinational enterprise (MNE) groups and market leaders, and studying operating models that industries adopt to minimise tax costs. Though there is no formal safe harbour rule in China, in practice, minimal expectations for profitability also exist for some industries, such as processing of electronic components, and manufacturing of home appliances.
With the publication of the UN manual, the SAT formally expressed its views on the transfer pricing implications related to unique market characteristics in developing countries, such as LSAs and local marketing intangibles, which are expected to serve as arguments for retaining additional "non-routine" profit within China and will have a further impact on the application of the arm's-length profit range locally. With a lack of reliable local comparables, Chinese tax authorities are making adjustments for LSAs to comparables from other jurisdictions.
Location specific advantages
As outlined in the UN manual, LSAs refer to the net cost savings derived by MNEs through the establishment of operations in low-cost jurisdictions. Location savings are commonly realised from the cost advantages in raw materials, labour, rent, transportation and infrastructure, as well as government industry policies and tax incentives.
China has been asserting LSAs exist for many years and requiring additional remuneration for local cost advantages in audit and APA negotiations. In the past, it has demanded the application of higher mark-ups to low-margin or contract service providers using location savings arguments. Recently, it has been testing a more systematic mechanism in assessing the advantage attributed to local cost savings. The main challenges comprise demonstrating empirical evidence regarding the existence and measurability of such savings, and determining how to attribute accurately and effectively the savings to the respective parties involved in the context of the arm's-length principle.
In a recent transfer pricing audit case, Chinese tax authorities applied a factor analysis approach to assess location savings related to a local R&D facility of a large electrical MNE group. In that case, officials maintained that:
- The main reason for the MNE group to relocate its R&D facility from the home country to China was to take advantage of low operating costs in China, i.e., an LSA exists.
- Under the contract R&D service arrangement, the MNE group's overseas related parties had been enjoying the benefits of lower R&D costs, as the LSA generates additional profit.
- The local R&D facility was therefore under-remunerated based on the cost plus method.
Reviewing the R&D service costs breakdown in detail, Chinese tax authorities selected a number of cost items such as labour, rental, utilities and maintenance for a cost comparison analysis. The degree of location savings was then calculated based on the cost differentials sourced from open market data as well as company-specific information. Relevant dissaving factors, such as differences in working efficiency, additional relocation expenses incurred due to the start-up of local R&D facilities and training provided to the locally hired R&D team were also considered, and quantified, to arrive at the net location savings. However, a potentially contentious issue in this case was the allocation of savings between the home and host countries, which were all allocated to, and taxed in (presumably for a second time), China.
Another local advantage is related to the concept of market premium. The term usually refers to the surplus profit obtained by sales of product at a higher price and/or volume due to differences in market conditions. Due to the fast-growing China market demand and preference of Chinese customers for foreign brands, China has asserted that MNE distributors in China are likely to earn a profit in excess of comparable distributors in developed countries. To account for this, a market premium may be allocated reflecting the success of local marketing efforts. Large investments in local advertising, marketing and promotion (AMP) aimed at Chinese customers may also result in higher profitability for Chinese affiliates. In cases regarding royalty arrangements, this argument has also been relied upon by authorities to discount the contributions of foreign intangibles and question royalty rates charged to Chinese affiliates.
It should be noted that tax authorities in other jurisdictions may not concede that LSAs exist in a particular instance; or that LSAs lead to substantially greater profits for a group, even if they exist. For example, for competitive reasons and the structure of the market or that an arm's-length arrangement is to leave all of those profits in China, as the UN manual seems to suggest the SAT feels is appropriate, even when LSAs exist and lead to increased profits. As the concepts related to LSAs may be controversial and potentially result in local transfer pricing adjustments significantly deviating from the traditional application of the arm's-length principle under the OECD framework, disputes may arise between competent authorities and negotiations on bilateral and multilateral APAs under a mutual agreement procedure (MAP).
As China's status as a low-cost country is slowly diminishing, some MNEs for which labour costs are a substantial portion of total manufacturing costs (for example, textiles companies) are now seeking to transfer their manufacturing activities to lower cost jurisdictions. Already a number of examples of manufacturing operations are being relocated within China which have led to transfer pricing adjustments, and given the emphasis on LSAs and local intangibles, it is possible that China may also pursue on a widespread basis substantial exit charges, just as certain developed countries already do.
Emerging transfer pricing issues for MNEs in China
Inference of related-party transactions (RPTs) based on substance and control
Following the logic of India's recent court case LG Electronics India Pvt Ltd v ACIT, China is also seeking to impose adjustments in several cases by inferring or deeming related-party transactions between affiliates. The features that lead to deemed RPTs typically involve:
- Fast-moving consumer goods (FMCG) companies with a domestic supply chain
- Limited overseas related-party transactions undertaken by the domestic entities (that is, minimal buy-sell transactions since most if not all raw materials are locally sourced and finished goods are substantially sold within China)
- The entire Chinese supply chain has been operating at a loss over the long-term (sometimes as long as 10 or 20 years)
- The distributor that sells to third-party Chinese customers may pay a brand royalty to the overseas brand owner
- The distributor also incurs a significant amount of AMP expenses annually.
In the past, it would have been rare for an in-charge tax authority to pursue a transfer pricing investigation due to the lack of material cross-border transactions. However, similar to the LG case, we see instances where it is argued that a third party would not conduct its overall operations earning long-term losses as observed by subsidiaries in China, and that it is the decision-making of the overseas related party that is leading to the losses of the China entity(ies). It may be further argued that the losses in China are due to the creation of brand intangible licensees (for an overseas headquartered company) through excessive AMP expenses of the distributor licensee, and as such, it should be compensated by the brand owner for this service.
In terms of investigating, as a first step, the in-charge tax authority may request and scrutinise documentation relating to the marketing activities undertaken in China, including meeting minutes, organisation charts and contracts. This documentation may provide some evidence to suggest that the decision-making and final sign-off of key decisions are made by the overseas company, even if in fact the final sign-offs may only be rubber-stamping, which can form the basis to question the reasonableness of the local entity bearing associated risks.
As a result, tax authorities may challenge the losses incurred in China and claim that the overseas brand owner should bear the AMP costs associated with building up and maintaining the brand in China since the owner is performing the majority, if not all, of the strategic decision-making associated with the marketing and advertising activities in China. We would like to note that these loss-making entities may be considered too complex to qualify for treatment as entities assuming limited functions and risks under Circular 363, described above.
This challenge by the tax authorities regarding AMP expenses of FMCG companies in China may lead them to mimic the approach taken in the LG case and benchmark the level of routine AMP expenses. As discussed, excess spending on AMP is an incremental, measurable increase in expenses of the loss-making licensee; whereas the potential benefits of such spending are much harder to quantify. Presuming the comparable companies selected are from the greater Asia Pacific region, the results of this type of analysis may include companies operating in markets where lower AMP expense intensity could be attributable to market factors (for example, a number of brand rivals) and/or differences in the cost of media production relative to China. If so, the benchmark range of the appropriate level of AMP expenses may be lower than their Chinese counterparts. In such a case, taking into account the disadvantages faced by the tested party in China, an adjustment would need to be made to the comparable data, one which would lead to a higher level of routine AMP expenses. Detailed analyses would be needed to understand and quantity differences in AMP expense intensity; and taxpayers need to keep in mind that while such an analysis is theoretically consistent with the SAT's treatment of LSAs in general, the result would lead to a smaller tax adjustment in China in the example above, and local tax authorities might be reluctant to easily accept this reasoning.
The use of deemed RPTs, when combined with Circular 363, suggests an environment in which loss-making entities are likely to be challenged aggressively. Circular 363 already states that certain, simple entities should not incur losses under almost any circumstances. However, China has been encouraging the expansion of more advanced, value generating activities such as R&D, which bear the risk of potential losses or revenue shortfalls due to increasing investment spending, R&D risk of failure or inefficiency and market risks for newly developed products. The adjustments imposed in these cases, nonetheless, illustrate the commitment of the Chinese tax authorities to pursue loss-making companies: while the China footprint of group companies may clearly be more than that of single function low risk entities, these more complex operations – sometimes spread across multiple entities – may still be challenged with the assertion that they have limited decision-making ability in some sense, and on that basis, argue they should be insulated from losses by related parties (even when there is not an obvious related-party transaction between them to adjust for this purpose).
China is also expanding its audit scope to include local marketing intangibles, arguing that local marketing activities create excess profit, which should also be taxed in China. However, there is a question of how to treat such marketing intangibles: if deemed transactions on AMP are concluded to have occurred in China, the local subsidiaries would presumably not be entitled to any further profit related to marketing intangibles, since they have already been compensated for their development. The question of how this may play out is yet unanswered. We believe that this trend will likely continue and that Chinese tax authorities will expand their audit scope to other industries where they believe LSAs may exist, especially related to marketing, such as luxury retail brands. It will be important for taxpayers in these industries to follow progress in this and other industries as well, as it will likely also affect the concurrent dialogue regarding the assessment of LSAs presented by the SAT in the UN manual.
China recently released administrative procedures for the remittance of cross-border payments. However, it is not relaxing its attention on service fees charged from overseas related parties from a transfer pricing perspective. Arguments that may arise from the assessment of service fees include:
The substance of the service, including demonstration both of its existence as well as benefits for the China entity(ies):
China's focus on intra-group service arrangements begins with substantiating the existence of the service. Taxpayers have to prove that services between related parties were actually provided and that if so, the party receiving the services benefited and that the charges were reasonable. If a taxpayer fails to show a service was conducted due to the lack of clear guidance or criteria, then no deduction will be considered. Local officials often request substantial supporting documents from service agreements, and even as deliverables. Even if the service activity exists, it is still necessary to show how the services benefit the China entity, that is, that profit increases as a result of this service.
Calculation of a reasonable service fee
If a taxpayer can show the service took place and that China entity(ies) benefited from it, the next question is the reasonableness of the service fee. Cost and fee computation schedules may be requested. If the service is not one to one, for example, it is an allocation made by an offshore shared service centre, then the allocation method may be a point of considerable contention. Effectively, the burden of proof is with the taxpayers and the failure to provide relevant supporting documents can result in corporate income tax being non-deductible. As for fees remitted outside of China, there is also a risk of it being deemed a royalty fee (most common for certain IT-related services) or dividend payments, in which case other taxes, such as withholding taxes, may be levied.
Cost sharing agreements
As Circular 2 has formally introduced the concept of a cost sharing agreement (CSA) into the China TP regime, in assessing the overseas services charges, it is conceivable that a tax official may ask whether it is allocated into China as part of an offshore CSA. In particular, any sales and marketing, procurement, R&D and technical support related services may be inherently linked with CSA which shall be reported and registered up to the SAT level.
Though it is clear that the difference between a CSA related cost and a shared service agreement relies upon the creation and sharing of intangibles, in practice, the boundary is vague partly because of the lack of a clear definition of intangible assets under China's tax and transfer pricing framework. Tax authorities have, in some cases, argued that sales, technical and development related activities create intangible assets, for which China should be due additional compensation in the future. In such cases, the deductibility of the allocated cost may also be questioned since the tax authority may take the view that the (deductible) cost should be apportioned according to the expected future benefits associated with the arrangement. Many tax authorities do not have extensive practical experience with this type of analysis, so such discussions can be resource intensive. However, CSAs are themselves a topic of increasing interest in China, they are likely to play an increasingly relevant role for taxation in China and taxpayers should expect such issues to arise more frequently.
China has also seen a breakthrough in transfer pricing related to intra-group service arrangements in early 2013 with the signing of the first unilateral APA on services. In the future, APAs on services may be a worthwhile approach for taxpayers with complex service arrangements or service arrangements spanning multiple companies and districts to consider due to the potential efficiencies across tax and non-tax aspects of remittance procedures in China. Additionally, APAs typically involve more senior, experienced officials who may be able to provide extra insight into issues of substance, benefits, reasonable calculation mechanisms, and others about these types of fee arrangements.
As an active player on the international stage, China is making itself heard and establishing a proactive approach to protecting domestic tax revenue, and is even driving the dialogue on the treatment of complex tax issues for developing countries on an international scale.
We also note an increasing trend for companies headquartered in China to be facing challenges in overseas jurisdictions regarding their transfer pricing arrangements on outbound investments. These companies often try to adopt policies and internal control mechanisms consistent with the OECD guidelines, similar to companies headquartered in the US and Europe which have considerable experience in navigating these issues. Implementation of arm's-length arrangements is likely to be an increasing area of focus for these China headquartered companies as their overseas (non-China) operations continue to grow. We predict that the future landscape of China transfer pricing will likely involve clarifying the SAT's position on situations in which Chinese entities face issues, reversing the fact pattern of those being contended, such as when China headquartered companies seek to compensate overseas subsidiary losses or receive compensation from their foreign subsidiaries for services rendered.
More broadly, taxpayers and their service providers will need to remain cognisant of the constantly evolving transfer pricing landscape in China. We expect that new approaches with little precedent outside of China, such as the application of formulary apportionment that was mentioned in the UN manual as an alternative to the more traditional transactional or profits-based methods for companies, will be applied in audits and APA applications.
National Transfer Pricing Leader
Based in Shanghai, Cheng Chi is the partner in charge of KPMG's global transfer pricing services for China and Hong Kong SAR [Special Administrative Region]. He has led many transfer pricing and tax efficient value chain projects in Asia and Europe, involving advance pricing arrangement negotiations, cost contribution arrangements, pan-Asia documentation, controversy resolution, global procurement restructuring and headquarters services recharges. His clients include those in the industrial markets such as the automobile, chemical, and machinery sectors, as well as the consumer market, logistic, communication, electronics and financial services industries.
A native Chinese, Chi started his transfer pricing career in Europe with another leading accounting firm, covering many of Europe's major jurisdictions while based in Amsterdam, before returning to China in 2004.
A frequent speaker on transfer pricing and other matters, his analyses are regularly featured in tax and transfer pricing publications globally. Chi has been recommended as a leading transfer pricing adviser in China by the Legal Media Group since 2009.
Irene Yan is a partner in KPMG China's global transfer pricing services group and is responsible for the Northern China region. She joined KPMG in Beijing in 1993. With more than 19 years experience with the firm, she has a broad knowledge of PRC taxation, particularly corporate income tax, indirect tax and individual income tax.
Irene has conducted research and has been actively involved in the PRC inter-company transfer pricing practice since the late 1990s. She has extensive experience in operational transfer pricing, business model tax optimisation, contemporaneous transfer pricing documentation, transfer pricing due diligence and risk assessment, controversy resolution, unilateral advance pricing arrangements (APA) and bilateral APAs.
Her rich experience covers industrial markets, the information, communication and entertainment markets, consumer markets, property and infrastructure, energy and resources, and financial institutions. Her clients include a number of multinational enterprises with investments in China as well as large domestic enterprises with overseas investments covering diverse industries.
Brett Norwood is a tax partner and PhD economist with KPMG's global transfer pricing tax practice. Before joining KPMG in Shanghai, he held transfer pricing positions first in New York, and more recently in Beijing for nearly six years.
Brett has led the documentation efforts for companies with several dozens of entities across China, advised a variety of taxpayers regarding their transfer-pricing audits in China, and also advised multiple state and privately owned China-based companies expanding their operations overseas. In the US and China, he has served clients in a variety of industries including financial services, consumer goods, manufacturing, automotive, advertising and marketing services, and others, analysing cross-border transactions in Asia, Europe, and North and South America.
He frequently speaks at industry events, tax forums and in webinars; gives presentations in Chinese to the tax authorities on topics such as cost sharing agreements, valuation of intangibles, valuation of equity and international aspects of transfer pricing including tax efficient supply chain management, using written materials in Chinese; and regularly leads regional and China national training programmes.
Michelle Sun is a director in KPMG's global transfer pricing services (GTPS) group in Guangzhou. She has been working in the transfer pricing practice since 2003. Before joining KPMG, she worked for another Big Four accounting firm where she started her career in transfer pricing and acquired extensive experience in this area.
Michelle is actively involved in various transfer pricing projects, including risk reviews, documentation, transfer pricing planning, supply chain management/planning. She also has experience in solving transfer pricing disputes with the PRC tax authorities as well as bilateral advance pricing agreement applications.
Michelle's clients include a number of multinational and domestic enterprises in a wide range of industries, including consumer markets, electronics, petrochemicals and real estate. Further to the analysis on tangible goods transactions, Michelle also has experience in the assessment of the value of intangible goods, such as the provision of services and planning for royalty charges. Michelle also has experience in establishing group shared service allocation mechanisms.