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UN China chapter: Issues raised on contract R&D

The inclusion of the China country practices chapter, as part of the UN Practical Manual on Transfer Pricing for Developing Countries (draft version) indicates a great leap in the transfer pricing (TP) administration of the State Administration of Taxation (SAT). Han Jin Ping, tax manager at Siemens, China, discusses the importance of the chapter and the international message it conveys on contract R&D.

While endorsing the arm's-length principle, the SAT addressed some unique issues in its TP administration and in its unique approach, which may be considered controversial. Among them, the topic of contract R&D has been repeatedly mentioned related to several topics such as location savings, intangibles and alternative methods.

Location savings

Location savings are one of the location specific advantages (LSAs) that arise from the use of assets, resource endowments, government industry policies and incentives, etcetera, existing in specific localities. SAT recognises that location savings are net-cost savings by considering savings on lower expenditure items such as raw materials, labour, rent, transportation and infrastructure, together with dis-savings on additional expenses incurred due to the relocation, and increased training costs in return for hiring less skilled labour, etcetera.

SAT suggests taxpayers adopt a four-step approach on the issue of LSAs:

  1. Identify if an LSA exists;
  2. Determine whether the LSA generates additional profit;
  3. Quantify and measure the additional profits arising from the LSA; and
  4. Determine the transfer pricing method to allocate the profits arising from the LSA.

Location savings have been raised and used in audit cases by various Chinese tax authorities. However, in the active audit cases in China, rarely do we see that the four steps are strictly followed. The tax authorities usually directly ask the taxpayers that are under audit to quantify the locations savings by themselves. And usually Chinese tax authorities take the approach of adding the location savings quantified to the Chinese taxpayer's taxable profit directly, which assumes that all the location savings generated should be retained in China. As a matter of fact, Chinese officials have stated on several occasions that non-routine profit, generated from the location specific advantages arising from Chinese economic development and business environment, should belong to its creator (Chinese taxpayer).

Han Jin Ping notices how the Chinese authorities are gearing-up to take their fair share from profits
In several cases that I have seen, location savings are mostly derived from low cost labour. On a general level, the wages of the production worker in developed countries might be several times higher than that of their counterpart in China. For example, the average hourly wage in the European Union is €23.5 ($30.5) according to the statistics published by a German research institution, Destatis, while the average hourly wage for Chinese workers is usually €2 to €3. The location advantage can be demonstrated in a labour intensive industry. But for a capital intensive industry, where only limited labour force is used, such as digital factories, the advantage will not be significant. For other factors of location savings, due to a lack of a direct comparable cost base for benchmarking in most cases, a lot of assumptions have to be used in the quantification. For example, a production line may not exist anymore after it moved from a high cost jurisdiction to a low cost one. Therefore, there are certain limitations when a comparable cost base for benchmarking is not available and therefore the analysis has to be based on assumptions and adjustments.

Intangibles and alternative transfer pricing methods

In the China chapter, SAT states that the contribution of developing countries on contract R&D is often underestimated. The transfer pricing method commonly used to reward R&D activities performed by a subsidiary of an MNE in China is cost plus. Remuneration on contract R&D typically used by Chinese subsidiaries of multinationals is cost plus 8% to 10%. Chinese tax officials have clearly indicated in several cases that their expectation for contract R&D is more than 15% according to their benchmark.

SAT also challenged the "high and new technology status" (high tech status) if it is obtained by a Chinese company that conducts contract R&D activities. In a number of cases, the Chinese entity has obtained the high tech status in Chinese law and therefore enjoys tax incentives on the basis of its ownership of valuable core technology.

However, on the other hand, it also claims to be a contract R&D service provider with no valuable intangibles. The Chinese tax authorities hold the view that a Chinese entity which has obtained "high and new technology status" cannot claim itself to have "no valuable intangibles" elsewhere, for example, in its contemporaneous documentation. The Chinese tax authorities have indicated that they will start to do comprehensive document reviews to find out such circumstances. In the last two years this point has been emphasised to taxpayers when the local tax authorities review the quality of the contemporaneous documentation.

In addition, SAT notes that the Chinese affiliate has improved a manufacturing process or technology provided by the parent company and the Chinese affiliates may even be entitled to a return on the intangible that they have developed and shared with the group companies. In such cases, an alternative method such as profit split method should be used to determine a proper return for the Chinese affiliates.

In my view, these situations are usually complicated in reality once R&D activities are involved. As a matter of fact, some of the companies that conduct contract R&D activities also are involved in local R&D activities for themselves. Therefore, every case needs to be analysed in detail, without forcing them to fit a certain model.

For example, as a common practice, a lot of products need to be specifically modified for a specific local market. Therefore, the improvements and modifications for the Chinese market by the local company are recognised as valuable intangibles and held by the local companies. The high tech status is granted based on the intangibles generated and held by the local companies. However, these local intangibles are also developed and modified based on the basic intangibles or R&D platforms held by the parent company. From this perspective, the company could not overstate its functions and risks in its R&D activities if looking from a whole value chain.

On the other hand, the local IP could be important to local manufacturing but may only relate to the local market. These intangibles might not be useful for other locations and may not be shared by other group companies. In this case, the issue of an extra return on the intangible, based on the profit split method, might be less concerned, after careful analysis, on the actual situation.

This is different from providing two versions of a description to different government authorities, for example, fancy or exaggerated descriptions to be entitled to the high tech status and other tax preferential treatment, and at the same time claiming to have few valuable intangible assets to be applied to the cost plus method.

Another situation might be that the locally developed intangibles have contributed to the improvement of the original technology held by the parent company and shared with other group entities. And, at the same time, if the contract R&D activities are considered by Chinese tax authorities to be not adequately compensated by the parent company, the Chinese tax authority might argue the Chinese entity should have partial ownership of the locally developed intangibles and question whether the Chinese entity should be entitled to an additional profit or a deduction of royalty.

Companies that do fall within this category – or other similar situations that SAT specifically mentioned in the China chapter – may need to carefully examine their transfer pricing policy, consider adjusting their current transfer pricing models and building precautionary measures.

Implementation by local tax authorities

It could be predicted that, in the foreseeable future, the SAT and tax authorities at all levels will prefer to adopt the concepts and methods that might be favourable to developing countries. However, the implementation in future practices might not be on the same level for different regions.

In China, there is an obvious discrepancy in economic development levels across the country. The transfer pricing experiences and practices of Chinese local tax authorities also vary significantly. Under the highest level of tax authority, SAT in Beijing, there are 34 provincial level tax bureaus. And the next tier is comprised of many local tax authorities. It is commonly recognised that the tax authorities in Beijing-Tianjin area, Yangtze River Delta Region and Pearl River Delta Region are more experienced and they are more willing to discuss with taxpayers from a technical point of view. It is anticipated that the tax authorities in those areas could follow the concepts and methods raised in the China chapter more closely.

However, in second and third tier cities, tax authorities are generally less experienced and relatively hard to negotiate with, especially if they come with a revenue target. Under such circumstances, there may be concern about how these concepts can be actually implemented in Chinese audit practices, especially when the concepts and methods themselves are considered to be potentially controversial between tax authorities and enterprises, developed countries and developing countries.

But one thing that is for certain is that Chinese tax authorities are ready to take their "fair share" of global taxes in line with China's contribution to global profits.

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