China: Transfer Pricing under the New Income Tax Law Regime

Transcription

1 Tax Services China: Transfer Pricing under the New Income Tax Law Regime Jeff Yuan PricewaterhouseCoopers, Shanghai Prior to 1990, Chinese tax authorities had already started conducting tax audits of a transfer pricing nature on foreign investment enterprises ( FIEs ). During the 1990 s and in early 2000, the emphasis was on FIEs manufacturing activities since such activities are also the focus of the country s economic development. In recent years however, with China s market opening up, the country s transfer pricing focus, together with the country s other economic developments, has broadened from the traditional export manufacturing model to more of local marketoriented business model. In the future, transfer pricing regulations will be even more strictly imposed, and the burden of proof will lie with the taxpayer. Under this environment, China s new Corporate Income Tax ( CIT ) Law, the most profound tax reform of the decade, takes effect on January 1st, The new law merges the Enterprise Income Tax Provisional Regulations (which currently applies to PRC domestic enterprises DEs ) and the Foreign Enterprise Income Tax Law (which currently applies to FIEs and foreign enterprises FEs ). At the same time, it also brings in new transfer pricing concepts and further strengthens transfer pricing enforcement in China. The objective of this article is to address the main transfer pricing developments under the new CIT Law, and explore the implications of these developments under the new CIT Law for multinational corporations ( MNCs ) in China.

2 Key Aspects of the CIT Law Affecting TP Enforcement The new CIT Law aims at establishing an income tax regime that reflects four main themes: Simplified Tax System, Wide Tax Base, Low Tax Rate, and Stringent Administration. Key aspects of the CIT Law affecting transfer pricing enforcement are summarised below: Tax resident The CIT Law introduces two new concepts, Tax Resident Enterprise ( TRE ) and Non-tax Resident Enterprise ( non-tre ), to determine tax status of corporate income taxpayers. In China, TREs are liable for paying income tax based on worldwide income, whereas non-tres are only liable for paying tax on its income generated in China. In judging a TRE, the CIT Law adopts a combination of criteria including registration location and effective management. According to this provision, domesticinvested enterprises and FIEs registered in China are unaffected by the change since they are taxed in China either way. However according to the new legislation, FEs will also be regarded as TREs if they have their effective management based in China. This move towards taxing enterprises based on residency status improves consistency between China CIT regime and many other tax jurisdictions. The definition of effective management is currently not clear however will be specified in the Detailed Implementation Rules of the CIT Law ( DIRs ), expected to be released later this year. MNCs should therefore be aware of these concepts when considering undertaking more regional management functions within China (including regional headquarters) and should keep informed of further developments as they arise. Tax rate Currently, FIEs and DEs are subject to different enterprise income tax rates, while FEs are subject to a 10 percent withholding tax ( WHT ) rate. The CIT Law unifies an enterprise s income tax rate to 25 percent for both FIEs and DEs (the exception being qualified small and thin-profit companies which will be subject to a 20 percent rate). Non-TREs are subject to 20 percent WHT rate on their China source passive income. The CIT Law does not address whether the 10 percent WHT rate on passive income and the WHT exemption on FIE s dividends for foreign investors will continue. Tax preferential treatment The tax preferential treatments under the CIT Law mainly include: High / new-tech enterprises may enjoy a preferential income tax rate of 15 percent. Exemption or deduction of CIT is provided to: - agriculture, forestry and animal-husbandry, fishery projects - basic infrastructure projects - qualified technology transfer. The income derived from manufacturing products while fully utilising resources under the state industrial policies can be deducted when calculating taxable income. Venture capital enterprises may have part of their investment credited against taxable income. Super deduction is granted when calculating taxable income for the following: - R&D expenses incurred for the development of new techniques, new products and new craftsmanship - Salaries paid to handicapped staff and other employees encouraged by the State. A shorter tax depreciation life or accelerated depreciation is allowed for particular types of fixed assets due to technological advancement. A certain percentage of investment spent on acquiring specific equipment used for purposes such as environmental protection, energy and water conversation and enhancement of production safety may be credited against income tax payable. Preferential treatment currently available to Manufacturing FIEs and Export-oriented FIEs have been cancelled under the CIT Law, highlighting the tax incentive policy shifting from Geography-based to Predominantly Industry-oriented, Limited geography-based. These two types of enterprises in general industries may enjoy only limited incentives via qualifying R&D activities, capital investments, etc. Details are expected to be laid out in the DIRs and afterward rules and regulations. Grandfathering FIEs approved to be established before the CIT Law were entitled to preferential treatments in the forms of reduced tax rate. However beginning from January 1, 2008, the tax rate will gradually increase to 25 percent over the course of five years. These entities are also able to continue their unused tax holiday under the PricewaterhouseCoopers 2

3 grandfathering scheme set out in the CIT Law. FIEs established after the CIT Law was released have no such benefits. During this period of transition, FIEs should continue to ensure their profits are based on a commercially reasonable position and are not subject to tax manipulation. TP Implication under Chapter 6 Special Tax Adjustments Chapter 6 of the CIT Law is focused towards tax avoidance and transfer pricing issues. Key features of this chapter are described below. Transfer pricing adjustment methods Paragraph 1 of Article 41 states that if a transaction between an Enterprise and its related party is conducted not in accordance with the arm s length principle which results in the reduction of Taxable Gross Income or Taxable Income of the Enterprise or its related party, the tax authorities shall have the authority to make adjustment using appropriate methods. This provision is basically a reinforcement of the existing laws (e.g. Article 13 of the current Foreign Enterprise Income Tax Law and Article 10 of the current Enterprise Income Tax Provisional Regulations) regarding transfer pricing adjustments. China transfer pricing legislation currently specifies the following three basic methods for determining transfer prices in terms of buy-andsell transaction : 1. Comparable Uncontrolled Price ( CUP ) Method, 2. Resale Price ( RP ) Method, and 3. Cost Plus ( CP ) Method. The rules also permit the use of other reasonable methods, including profit-comparison method, profit-split method, and net profit method, which are generally consistent with the transactional profit methods specified in the Organisation for Economic Cooperation and Development ( OECD ) Transfer Pricing Guidelines, i.e., the Profit Split Method ( PSM ) and the Transactional Net Margin Method ( TNMM ). These methods will continue to be applicable under the CIT Law. However, taxpayers should be cautious in selecting their method for tax compliance purposes. According to China s Tax Collection and Administration Law and the new CIT Law, tax authorities in charge are empowered to select appropriate adjustment methods at their discretion in a transfer pricing audit (i.e. the Best Method approach is not available in China). The CIT Law does not state the preference / hierarchy of transfer pricing methods, placing uncertainty on the taxpayer for their tax compliance. Cost Sharing Arrangement ( CSA ) Chapter 6 contains a provision for CSAs, considered a breakthrough in China s transfer pricing legislation. This article models both the OECD Transfer Pricing Guidelines (Chapter VIII, Cost Contribution Arrangements) and US transfer pricing regulations. This not only provides a legal framework for CSAs, but also paves the way for China to attract more advanced intellectual property ( IP ) and sophisticated services from overseas enterprises. In summary, CSA is an arrangement between two or more associated enterprises to share the costs and risks of developing or obtaining IP, and/or providing or receiving services for an agreed-on scope in exchange for a specified interest in the project s results. IP related CSAs permit two or more companies to share the cost of developing IP and to share proportionally the revenue and profits resulting from exploiting the property. PricewaterhouseCoopers 3

4 Under the CSA, there is no need for participants to pay royalties for the IP developed under the arrangement since generally each participant will exploit the IP rights in its own territory. In response to the state policy of technological development, the CSA provision in the CIT Law focuses on the legal and economic ownership of IP. Therefore, we anticipate that high / new technology enterprises are most likely to benefit from the new CSA rules in the future. Advance Pricing Arrangement ( APA ) Before the CIT Law was promulgated, China already had rules and regulations relating to APA, namely: 1. Article 53 of Detailed Implementation Rules of Tax Collection and Administration Law, and 2. Tax Circular Guoshuifa [2004] No. 118 Implementation Rules on Advance Pricing Arrangements for Transactions between Related Parties. The CIT Law further consolidates the legislative foundation of APA practice in China. Article 42 of the Law states that an Enterprise may propose the transfer pricing principles and determination methodology for the transactions with its related party to tax authorities; and the tax authorities and the Enterprise may conclude an Advanced Pricing Arrangement after discussion and verification. This provision indicates uniform implementation guidelines and strong support from the tax authorities for the APA process. According to current enforcement in China, APAs are subject to final review and approval by the State Administration of Taxation ( SAT ). In general, the SAT has taken a supportive attitude towards the development of APAs to address complicated transfer pricing issues. Different forms of APAs arose after its formal introduction to China in Two bilateral APAs were concluded, one with Japan s tax bureau ( NTA ) in 2005 and another with the US tax bureau ( IRS ) in In December 2005, four subsidiary companies of a multinational group signed four APAs with their respective in-charge tax bureaus in different cities. This is the first successful multi-jurisdiction APA within China. Its covered transactions include royalties and service charges rather than transfer prices for transfer of tangible property alone, which was the primary subject of many previous APAs. In April 2007, an APA concerning Business Tax was concluded with the local tax authority. With the support of the CIT law, APAs are expected to become increasingly popular as a tool to minimise tax risks. Nevertheless, taxpayers still need to be aware that concluding an APA is anything but easy; there are hurdles to jump even before APA submission is accepted. Transfer pricing documentation Annual filing requirements of related party transactions According to paragraph 1 of Article 43, where an Enterprise submits its annual CIT return to tax authorities, it shall attach annual related party transactions report with respect to its transactions with its related parties. Under current practice, during annual filing FIEs and FEs should complete Form 13-A or Form 13-B to report their related party transactions. In February 2007, the SAT issued the Tax Circular Guoshuifa [2007] 156 which comprised of seven forms requiring detailed filings of FIEs and FEs related party transactions: Form A1301 (a summary of related party transactions), Form A1302 (buy-and-sell transaction), Form A1303 (service provision), Form A1304 (financing), Form A1305 (transfer of tangibles), Form A1306 (transfer of intangibles) and Form A1307 (other related party transactions). This circular, undoubtedly, brings forward more detailed guidance on documents that taxpayers should prepare for tax compliance purpose. Although the SAT did not require the use of these seven forms in the 2006 annual filing, it is expected that the SAT will enforce the use of the forms in the near future for disclosure of related party transactions. DEs transfer pricing filing procedure might also refer to these forms. Contemporaneous documentation requirements According to Paragraph 2 of Article 43, during a transfer pricing investigation, the Enterprise as well as its related party and other relevant enterprises are required to provide relevant information within a short timeframe. This provision is considered as paving the way for the release of the long-awaited Contemporaneous Documentation Requirements. Similar to the individual income tax self-reporting requirements issued at the end of last year, contemporaneous documentation requirements to be released in the near future will place significant tax-compliance burden on taxpayers (both FIEs and DEs). MNCs with significant operations in China must critically evaluate and assess their transfer pricing position and consider PricewaterhouseCoopers 4

5 ways to best manage their position. In principle, China does not allow group consolidation in filing income tax returns, therefore MNCs with multiple operations in China may find the proposed documentation rules particularly difficult to comply with, especially because documentation is expected to cover not only crossborder but also intra-china related party transactions. More than 650,000 FIEs and over 3,400,000 DEs exist in China today. The expected contemporaneous documentation will place tension not only on these taxpayers, but also on tax authorities. As such, it is doubtful whether the tax authorities have sufficient resources to implement and enforce the requirements. Special interest levy One of the most significant impacts of the CIT Law on transfer pricing is the imposition of a special interest levy on anti-avoidance tax adjustments proposed by tax authorities. The special interest levy mechanism is different from surcharge and penalty, which constitute the current punishment measures of tax collection. This is explained further below: Surcharge Article 32 of the Tax Collection and Administration Law issued in 2001 provides that if taxpayer fails to pay the tax due, the tax authorities shall impose a daily surcharge of 0.05 percent on the amount of the tax unpaid commencing on the day of default. Penalty A penalty has to be paid as a punishment for any violation of Article of the Tax Collection and Administration Law. These may include tax evasion, tax fraud, tax violence, and so on. Relationship between special interest levy, surcharge and penalty In brief, a special interest levy deals with tax avoidance while surcharge and penalty are forms of punishment for tax evasion in China. In the context of transfer pricing adjustment, the taxpayer will be subject to a special interest levy where a transfer pricing adjustment is imposed. A daily surcharge of 0.05 percent will be levied if the taxpayer fails to pay off the tax assessment within the time limit set by the tax authorities in the Final Transfer Pricing Adjustment Notice. In case the taxpayer has practices as specified in Article of the Tax Collection and Administration Law, it will also be subject to tax penalty. The implementation of special interest levy will significantly increase the financial cost associated with anyavoidance tax adjustment. This amount will be in addition to the transfer pricing tax adjustment. The proposed special interest will likely include a penalty component as well as a true interest component based on the time value of money. At time of publication, there are still some uncertainties relating to the newly proposed special interest levy: Interest rate and calculation methodology The rate of interest and the calculation methodology are to be determined by the State Council in the DIRs. Retrospective effect It is still unclear whether the imposition of special interest levy will have retrospective effect. If a retrospective interest charge is allowed, it may have a significant impact considering the statute of limitations for transfer pricing investigations can be up to ten years, pursuant to Chinese tax and transfer pricing regulations. Other Anti-Avoidance Rules Newly Introduced Controlled foreign corporation rule (Article 45) Under the controlled foreign corporation ( CFC ) rules, Chinese shareholders (i.e. TREs) may be taxed on their portion of undistributed profits as retained by their CFC established in jurisdictions where CFC s effective tax rate is substantially lower than 25 percent, if the profits are undistributed for reasons other than valid business reasons. It is believed that the DIRS will provide detailed guidance on items such as definition of CFC, valid business reasons, and substantially lower than 25 percent. Thin capitalisation rule (Article 46) Article 46 states that the ratio of debt investments to equity investments from related parties must follow the prescribed criteria, otherwise the interest from the excess debt would not be deductible for income tax purposes. The prescribed debt to equity ratio is expected to be provided in the upcoming DIRS. General anti-avoidance rule (Article 47) A general anti-avoidance provision empowers tax authorities to adjust taxable income where business transactions are arranged without reasonable business purpose. PricewaterhouseCoopers 5

6 New Challenges to MNCs in the Dynamic Market Challenge 1 - value chain transformation Under China s WTO commitment, China has removed restrictions on foreign investment in the wholesale and retail industries since 2004, leading to a full spectrum of trading and distribution vehicles available for MNCs to integrate their sales and marketing functions. With establishment of trading subsidiary in China, MNCs should consider the following transfer pricing issues: Entity characterisation and billing arrangement (e.g. service provider or risk-taking distributor) Market share strategies, such as market penetration plan Placement and/or migration of marketing intangibles China s current investment boom validates the speed at which China is moving up the value chain, from a simple labour-intensive manufacturing base to a higher end business generating base. Value chain transformation usually results in MNCs realignment of transfer pricing policy. To manage the tax / transfer pricing risks in the implementation of business restructuring, MNCs should take the steps to: Prepare and maintain sufficient documentation to justify the commercial substance / business reasons of the reorganisation as well as the arm s length nature of their new transfer pricing position. Phase in the change gradually particularly where the local tax authorities will lose revenue during the transformation. If possible, communicate the changes and convey the business motives and reasons to the tax authorities in charge using APA or informal advance communication to obtain buy-in from the authorities. Source: Oded Shenkar, The Chinese Century (Wharton School Publishing, 2004) knowledge economy (for example, service industries) Low-cost, high-tech branding design and manufacturing (for example, flat-screen TVs) Low-cost, medium-tech design and manufacturing (for example, home appliances) Low-cost, low-tech manufacturing (for example, toys textiles) OEM 1 CDM 2 OBM 3 Service-based China s progress 1980s 1990s 2000s OEM original equipment manufacturer 2. ODM original design manufacturer 3. OBM original branded manufacturer Source: Oded Shenkar, The Chinese Century (Wharton School Publishing, 2004) PricewaterhouseCoopers 6

7 Challenge 2 - IP issues The Chinese government, in its pursuit of sustainable growth, has made the development of technology-led sectors and high value-added capabilities its key policy focus. The government s recent five-year program, ratified in March 2006, focuses on the creation of a knowledge-led and innovationoriented economy supported by greater domestic consumption. As a result, MNCs may need to increasingly focus on IP value management strategies, which are ways to preserve IP value that go beyond legal means to involve the core operations of the enterprise. In a transfer pricing context, relevant issues in terms of IP development and migration may include Location savings Form vs. Economic substance CSAs Stock-based compensation IP valuation and migration (i.e. transfer pricing due diligence in M&A projects) To set up an effective transfer pricing management system in China for IP assets, MNCs should have proper inter-company agreements and relevant documentation in place. To be specific, the terms and conditions of inter-company agreements (e.g. licensing agreement) should be carefully determined, (e.g., duration, exclusive or nonexclusive character, limitations on geographic area, possibility of sublicensing, and charge rate). MNCs facing high transfer pricing risks of IP issues in China should also have a clear strategy for its IP policy and document the strategy in transfer pricing relevant documentation, which are important elements of tax defence. Furthermore, since IP issues are always complex and business-driven, it would be beneficial for management to take advantage of the opinions from the transfer pricing and valuation experts to settle IP disputes with the tax authorities. Challenge 3 increasing intragroup services Following the WTO accession, China has been progressively liberalising its market and offering tremendous business opportunities for MNCs. As previously indicated, more and more companies are moving their business functions such as marketing and R&D to China by establishment of regional headquarters ( RHQs ), Chinese holding companies ( CHCs ) and R&D centres. Meanwhile, MNCs in China continue to receive various services from their overseas affiliates and as a result, intra-group services (both cross-border and within China) are growing rapidly in volume while also becoming increasingly complex. Transfer pricing in this respect has become an ever-increasing focus for Chinese tax authorities. Tax Circular Guoshuifa [2002] No.128 provides guidance on intercompany services rendered by CHC to its subsidiaries in China in terms of tax and transfer pricing treatment. As a general approach, taxpayers could consider the following aspects in determining reasonable charges for intra-group services: Can the cost of intra-group services be recharged? This question is related to a benefit test and the characterisation of shared service provider and beneficiaries. To which parties the cost should be allocated? How to charge the relevant costs (i.e. direct-charge method or indirect-charge method)? Should a mark-up be added in determining the reasonable charge amount? Conclusion Get Prepared for the CIT Law The field of taxation is constantly faced with legal changes, some being insignificant while others, such as the new CIT Law for instance, giving rise to legal and economic impact of a much more profound degree. In view of this, it is crucial for business to be prepared and to mitigate various potential risks or challenges. PricewaterhouseCoopers 7

8 Advance planning With the new CIT Law coming into effect on January 1, 2008, it is recommended that taxpayers plan ahead and make early preparations to defend against various uncertainties and risks. Value chain transformation In order to increase profit, companies are often under pressure to improve efficiency, reduce costs and minimise risks by restructuring supply chain and operating structures. From a tax and transfer pricing perspective, tax profile shall be aligned with the restructured value chain. With the establishment of an integrated anti-avoidance regime under the new legislation (in particular Chapter 6 on Special Tax Adjustments ), the Chinese tax authorities have increased their scrutiny of any potential tax-avoidance acts. This may arise where an MNC shifts profit outside China by means of international tax planning arrangement, restructuring and/or related party transactions. Therefore, regional profit realignment should be supported and endorsed by its commercial substance, in other words, substance will become at least as important as form rather than form over substance as in the past. Transfer pricing policies In consideration of the increasingly stringent scrutiny on anti-avoidance behaviour and uncertainties during the implementation of the new legislation in the following several years, it is recommended for taxpayers to establish sustainable as well as flexible transfer pricing policies in China. Though it is generally a useful tactic for an FIE to maintain consistency with its global transfer pricing policy in order to manage local transfer pricing risks, sometimes local adaptation will be necessary to show a sound transfer pricing base, especially in a dynamic market such as China. On-going management From a management perspective, taxpayers should establish not only transfer pricing policies for its related party transactions, but also an effective mechanism to execute the policy and monitor its application. Documentation and periodical review are the key elements in this regard. Robust transfer pricing documentation Inter-company agreements and contemporaneous documentation should be in place to demonstrate to the tax authorities the reasonableness of the transfer pricing policy. Companies that have not properly documented their policies are likely to face severe problems in the context of an intensive transfer pricing investigation (e.g. national or regional joint audit). Periodical review and update The taxpayer shall conduct periodical reviews and updates of its transfer pricing position, and make necessary adjustments pursuant to its transfer pricing policies. The arm s length principle also requires that intercompany pricing must reflect the change of transaction substance as well as the business cycle. Generally, periodical reviews may result in transfer pricing self-adjustment. In this respect, year-end adjustments are usually difficult to make due to the timing and the magnitude of the amount. In practice, a lump-sum payment at the fiscal year-end may attract tax authorities attention and result in transfer pricing investigation / audit. PricewaterhouseCoopers 8

9 To avoid a one-off significant adjustment to be made at the yearend, the taxpayer should closely monitor its profit level and adjust its transfer prices on a monthly or quarterly basis (semi-annual adjustment examinations may be sufficient when the industry is stable). This way, the variance between the actual and targeted profit levels can be kept to minimum at the year-end. Dispute resolution Transfer pricing audits have become increasingly aggressive over the past few years. A recent Tax Circular (Guoshuihan [2007] No. 236) requires that enterprises with the sole-function of manufacturing maintain a certain level of profits and not sustain any losses. Moreover, the statute of limitations for transfer pricing investigations can be up to ten years as previously indicated. Recently, several transfer pricing audit cases have been settled in a tax assessment of more than U.S. $10 million. During a transfer pricing investigation, it is crucial that the taxpayer establish and maintain control of the audit process. A team of tax and operational staff should be assigned and a clear plan should be established to set out the anticipated progress and the strategy to deal with the audit. Taxpayers may suffer from double taxation resulting from a transfer pricing adjustment imposed by tax authorities in relation to its crossborder transactions. In this case, the taxpayer may apply Mutual Agreement Procedure ( MAP ) to initiate competent authority ( CA ) negotiation to mitigate double taxation. APA & CSA - possible management tools To further mitigate potential challenges from tax authorities in the near future, taxpayer can also consider entering into APAs / CSAs, which are effective tools to mitigate the future transfer pricing risks by ensuring that taxpayer s future profits will be accepted by the tax authorities. APA and CSA, now legislated in the CIT Law, can be regarded as promising ways to avoid potential disputes in the transfer pricing area. This article is reproduced from its original publication entitled China: transfer pricing under the new income tax law regime in the August 2007 issue of BNA International s TAX Planning International: Transfer Pricing. Copyright 2007 by The Bureau of National Affairs, Inc PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers refers to the China firm of PricewaterhouseCoopers or, as the context requires, the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.