China: 2016 will bring an increased focus of authorities on transfer pricing and tax-avoidance

As ECOVIS Ruide was covering last year in our March issue of the our newsletter, on March 18th, 2015 the State Administration of Taxation (SAT) announced a new regulation concerning Enterprise Income Tax (EIT) Issues. Specifically the Disbursement of Expenses by Enterprises to Their Overseas Related Parties also known as transfer pricing was regulated in the document No. 16 [2015].

Transfer pricing is the way of defining a price for products and services that are sold between related legal entities like subsidiaries and a mother organization, i.e. legal entities that are being part of one enterprise. Part of one enterprise means any branches and firms that are wholly owned or, owned in the majority by the mother organization. The cost of products and services that a parent then pays to its subsidiary, branch or the majority-owned enterprise is the so-called transfer price. Transfer pricing is a way of calculating a multinational enterprises’ profits or losses before tax in the countries where it is operating. In setting the prices between divisions the transfer price should be the market price that any independent buyer would pay to another seller. However, transfer pricing can in this way be a major tool of corporate tax avoidance if those prices are manipulated and enterprises artificially lower profits in one or more divisions located in countries with high income taxes. And, to raise profits in a country that levies only low income taxes.
Beginning in 2009 China’s tax rule started to significantly differ from those of other countries. Tax guidelines were made for instructing field offices how to conduct transfer pricing examinations and adjustments. At the same time those factors that are to be investigated differ by transfer pricing method. Document No. 16 in 2015 was an extended measure on the topic of handling transfer pricing issues.

According to the announcement, the State Administration of Taxation cannot forbid enterprises from paying all kinds of fees to the overseas related party. However, it is possible to exclude remittances from enjoying any deductions in terms of corporate income taxes.
The starting point of Document No. 16 [2015] is to judge whether there is a substantial foreign-related party connected with the respective transaction, and to identify whether the firms are complying with the independent transaction principle.

The process of how to identify and judge the respective situation will inevitably cause more tax disputes, and the taxpayer should be fully prepared for them.

Within a period of 10 years as of the tax year in which disbursements occurred, tax authorities have the right to make special tax adjustments should they find evidence of violations against the independent transaction principle, tax avoidance and wrong tax declarations. In 2016 the crackdown on compliance with this and other laws related to transfer pricing is expected to be serious. We therefore want to revisit which four types of of cross-border payments could not be deducted from taxable income:

1. Disbursement of expenses to an overseas related party failing to perform their functions of for example R&D, marketing etc. or fail to bear the investment risks and that have no substantial operating activities.
   This also means that paying fees to operating shell companies overseas (especially such companies registered in tax havens) are ineligible for corporate income tax deductions in China.

2. Six types of service charges without bringing any direct or indirect economic benefit to subsidiary branches and firms;
3. Disbursement of royalties by the branch or subsidiary to related parties overseas that only have legal ownership of intangible assets but make no contributions to above mentioned value creation;
4. Disbursement of royalties from a local enterprise to an overseas related holding company or financing company that was created for the major purpose of financing and listing for spinoff benefits arising from the relevant financing and listing activities.

With respect to the mentioned six types of non tax deductible service charges, it should be noted that those include:

1. Services that have no relation with the functional risks to be assumed by, or the operations of the local enterprises in China.
2. Services such as the control, administration and supervision on the local subsidiaries or branches carried out by the related overseas parties for the protection of the investment interests of the enterprises’ direct or indirect investors (for example personnel sent with a dispatch contract).
3. Services that are rendered by the related parties overseas but that already either were provided and completed by the Chinese subsidiary itself or, that were rendered by third parties and paid for by the local subsidiary.
4. Services to subsidiaries and branch offices in China who enjoy those services being within a worldwide active MNC enterprise / worldwide active group of companies.
5. Services that already were disbursed in other related transactions;.
6. Any other services that cannot, directly or indirectly, bring economic benefits to the respective subsidiary or branch.

Our observations and suggestions

In short it is possible, that enterprises already completed the payment of costs to related parties overseas, and that they therefore may have paid VAT or Business Tax, Withholding Tax and IIT according to the regulations already years ago.

However, within a period of 10 years the tax bureau can revoke an earlier tax amount paid as incorrect and deny the independent transaction principle being fulfilled. Such a decision would then result in the recollection of EIT. Overall this means, transfer pricing would finally increase the tax burden for remittances if such remittances are then decided by tax authorities shall not be deductable from taxable income.

Additionally it shall not be forgotten, that Document No. 16 issued in March 2015 came at a time when just a little bit earlier in mid-2014 Xi Jinping started his lasting and well-orchestrated campaign of anti-corruption within the communist party as well as in the country as a whole with the goal for more transparency. Since then, awareness and inspections as well as numbers of investigations increased. These increased numbers of tax investigations are the reason why we kindly want to draw attention to the necessity to be well prepared for the regulations stipulated in announcement No. 16 [2015].

We suggest keeping relevant contracts, invoices, tax vouchers and payment evidences of each payment advised properly on file. In order to deal with the tax inspections and explanations that may be needed in the future.

As always: Our professional consulting team and personnel in Shanghai and Taicang can offer you consulting service for both of the above mentioned policies and practices.
German, English, Chinese: Ms Katharina Siegrist, katharina.siegrist@ecovis.cn
English, Chinese: Ms Pingwen Hu, pingwen.hu@ecovis.cn