China: Transfer Pricing of IP and Intangibles

Transcription

1 Tax Services China: Transfer Pricing of IP and Intangibles Jeff Yuan PricewaterhouseCoopers, Shanghai The recent high-profiled transfer pricing ( TP ) disputes have demonstrated tax authorities increasing focus on relatedparty intellectual property ( IP ) transactions. This article summarises the TP issues of IP transactions in China, addresses the main TP developments under China s new Corporate Income Tax ( CIT ) Law (that is, legislation of the Cost Sharing Arrangement), and provides general TP recommendations in relation to IP transactions for multinational corporations ( MNCs ) doing business in China. Part 1: Snapshot of transfer pricing of IP transactions in China IP is not a specifically defined term under China s current tax regime. Nevertheless, China s general tax law and TP regulations incorporate a broad concept of IP that may cover IP and other intangible properties, including patents, technology knowhow, trademarks, copyrights, land use rights 1 and goodwill, etc. Tax implication of related-party IP transaction in China In China, there are two types of common IP transactions between related parties: transfer (sales) and licensing. Transfer of IP (sales) When an enterprise sells intangible assets, it has to record the difference between the proceeds and the book value of the intangible assets disposed of. The tax implications for the transfer of IP in an asset deal acquisition are straightforward under 1 Land use right is classified as an intangible assets according to China s IP law. In this article however, we will not focus on the TP issues related to the land use right. Instead, we will mainly focus the TP issues of royalties / licensing in China.

2 the Chinese tax law. Business Tax ( BT ) will be imposed on the seller or transferor on any transfer of IP. Stamp duty of 0.05% will be levied on both the buyer and the seller for contractual documents of the IP transfer. At last, CIT will be imposed on the transferor for any capital gains on the IP transfer. IP licensing Licensing is another commonly used method of IP transaction between related parties (i.e. through an exclusive or a non-exclusive licensing agreement). Under the Chinese tax law, outbound royalty payment is normally liable to 10% withholding income tax ( WHT ) 2 and 5% BT. The BT paid can be deducted for the WHT purpose, which results in an effective tax rate of 14.5%. According to Circular Caishuizi [1999] No. 273, royalty income derived from technology transfer, technology development, provision of technical consultation and other technical services related to the aforementioned technology transfer / development can be exempted from BT. However, royalties relating to trademark licensing could not qualify for the BT exemption treatment. If such amounts are included in a technology transfer agreement without being separately or appropriately accounted for, a portion of not less than 50% of the total contract value will be deemed to be a trademark licensing fee and therefore subject to BT. In addition, royalties may also be subject to Customs Duty ( CD ). Chinese Customs has specific rules covering the treatment of royalties, license fees and other payments relating to imported goods. As stipulated in the General Administration of Customs [2006] No. 148, royalties satisfying the following conditions should be included in the imported goods dutiable value: Royalty is related to the imported goods; Royalty payment is a precondition for the seller to export and sell the goods inside PRC Customs border. Arm s length principle According to the CIT Law, in principle, an enterprise can deduct reasonable expenses (including royalties paid to its related party) that are actually incurred and are related to the generation of income for CIT purposes. Furthermore, China s TP regulations require the intercompany transaction to be conducted on an arm s length basis. The arm s length principle as specified in Article 2 of the Tax Circular Guoshuifa [1998] 59 / [2004] 143 ( Circular 59/143 ) states that prices charged between related parties for any inter-company transaction shall conform to the level that would have applied to the transaction taking place between independent parties. According to Article 41 of the CIT Law, if a related-party transaction is not conducted pursuant to the arm s length principle, resulting in the reduction of taxable income in China, the tax authorities shall make adjustment using appropriate methods. Transfer pricing methodologies China s TP regulations (i.e. Circular 59/143) do not provide specific guidance on how to determine arm s length price for related IP transactions, only requiring that related IP transactions conform to the arm s length principal. As such, general TP methodologies, namely, Comparable Uncontrolled Price ( CUP ) Method, Resale Price Method, Cost Plus Method, Profit Split Method and Transactional Net Margin Method ( TNMM ) applicable to tangible related party transactions could also be utilised in IP transactions. In practice, however, the following three methods are widely applied: Comparable Uncontrolled Transaction ( CUT ) Method If internal CUP / CUT is not available, benchmarking analysis will be usually performed to compare the price for IP transferred in a controlled transaction to the price charged for IP transferred in a comparable uncontrolled transaction in comparable circumstances. 2 Specific WHT rate is subject to the Double Tax Treaty ( DTT ) between China and other tax jurisdictions (e.g., Sino-HK DTT provides a reduced WHT rate at 7% for cross-border royalty payments). PricewaterhouseCoopers 2

3 As per Article 32 of Circular 59/143, the following factors of comparability should be evaluated between the comparable transactions and the related party transaction being analysed: development cost, condition of the transfer, market domination, degree and time period of the protection under the laws of relevant country, benefit to the transferee, investment and cost incurred by the transferee, and possibility and degree of substitution, etc. Residual Profit Split method The Residual Profit Split Method is commonly used to identify the residual profits to be split between / among related parties. In application of this method, functional routine returns are subtracted (i.e. for procurement, manufacturing, marketing functions) from the total operating profit from a specific segment / operating business where the intangible resides in associated enterprises. In the context of IP transactions, residual profit is then allocated between / among the associated enterprises, which economically own the IP, in compliance with the arm s length standard (i.e. profit allocation should be proportionate to contributions). Traditional valuation approaches (other reasonable methods) Circular 59/143 also allows the tax authorities / taxpayers to use other reasonable methods in determining the arm s length nature of related party transactions. Depending on the circumstance, taxpayer may also consider appropriate valuation approaches (e.g., the market-based approaches, cost-based approaches, and income-based approaches) to evaluate the reasonableness of the related IP transactions under review. 4. Economic analysis and benchmarking database Tax Circular Guoshuihan [2005] No. 239 ( Circular 239 ) stipulates that all tax bureaus should fully utilise the information databases of China s National Bureau ofstatistics and the Bureau van Dijk ( BvD ) database subscribed by the State Administration of Taxation ( SAT ) when conducting TP investigations and tax adjustment. Nevertheless, BvD database only contains the information relating to public companies, and it has limited sources of comparable intangible transactions from the TP perspective. As such, Circular 239 also encourages local tax authorities to collect relevant information from customs, banks and other authorities. In practice, other commercial databases such as LexisNexis Database can be employed by the taxpayers to search for comparable contractual arrangements of IP transactions. 5. TP audit on IP transaction In the past, most Chinese TP audits were focused on tangible goods transactions. However, with changes of investment landscape and increased sophistication of operations in China, foreign investment enterprises ( FIEs ) are now often involved in higher value-added operations, which may arise from localised R&D and marketing activities, increasingly complex manufacturing improvement process, and etc. Thus, IP transactions between related parties have recently become a more important part of TP audit in China. This trend can be evidenced by the newly released Tax Circular Guoshuihan [2007] No. 363 ( Circular 363 ), which requires taxpayers to disclose detailed information on potential intangibles and their respective amounts. In particular, we noted that the SAT has recently commenced a national joint tax audit focusing primarily PricewaterhouseCoopers 3

4 on royalty payments made by FIEs in China to their offshore parent companies. Recent audits not only demonstrate the increased attention of the Chinese tax authorities in questioning outbound royalty payments, but also show that where a TP adjustment is made, it can have significant impact on the profit of the whole business. As specified in Tax Circular Guoshuihan [2006] No. 901, where outbound royalties to overseas related party are disallowed as a TP adjustment, no adjustment 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. In the past, MNCs were reluctant to share IP with Chinese subsidiaries due to the high-risk IP environment (e.g., misappropriation of IP) and unfavourable tax treatment (e.g., business tax of 5% may be imposed on royalty payment and service fees). The CIT Law, undoubtedly, presents Chinese government s positive welcoming attitude of encouraging IP development and service sharing in China by legislating CSA, bringing good news for taxpayers who wish to apply this arrangement. Nevertheless, considering the following factors, there is still much ambiguity about the CSA implementation in China: Cost sharing basis (refund) of the WHT on the excessive payment should be made. It is therefore important that royalty amounts be set both on an arm s length and commercial basis. Furthermore, in the first successful Sino-Japan Mutual Agreement Procedure ( MAP ) case, both competent authorities agreed to eliminate double taxation through adjustments on royalties to be paid by a Chinese subsidiary to its Japanese parent on the domestic third party sales side. This indicates that the Chinese tax authorities are getting more experienced in dealing with complex TP issues relating to IP transactions. Part 2: Cost sharing arrangement transfer pricing development under the CIT Law For the first time, Cost Sharing Arrangement ( CSA ) is formally legislated in the CIT Law. Paragraph 2 of Article 41 of the CIT Law states that the cost of an enterprise and its related party incurred for jointly developing / assigning intangible assets or jointly providing / receiving services shall be allocated based on the arm s length principle for the calculation of taxable income. This not only provides a legal framework for CSAs, but also paves the way for China to attract more advanced IP and sophisticated services (e.g., R&D services and financial services) from overseas enterprises. In summary, CSA is an arrangement between two or more associated enterprises to share the costs and risks of As stipulated in the CIT Law, the related party shall conform with the arm s length principle in allocation of the cost relating to developing intangibles or jointly providing/receiving services. However, the CIT Law does not specify the acceptable practice and regulatory requirements for arm s length principle, such as cost base under the CSA, allocation method and allocation key. Based on international CSA practices and the principle that the shared cost should be commensurate to the benefit from the shared IP or services, the possibilities for allocation keys may include sales, units of goods or other items used/sold, gross or operating profits, headcount or employee compensation, capital invested and etc. In this regard, separate detailed rules are expected to be released by the SAT to provide specific guidance on CSA. Tax treatment WHT and BT Since related party participants share resources and risks as well as potential benefits from a R&D or service project, technically speaking, there should be no WHT and BT applicable under a CSA, on the basis that the participants are engaged in the activities on their own, rather than jointly purchase intangibles (e.g., royalty payment) or services (i.e. service fee). Furthermore, the relevant expenditure incurred by the participants should be deductible for CIT purposes. The SAT tends to agree that CSA should not be subject to WHT and BT according to the Tax Circular Guoshuihan [2004] No. 470 (a private ruling). However, it is still uncertain whether this will be accepted by the Chinese tax authorities after the implementation of the CIT Law. PricewaterhouseCoopers 4

5 Implementation effectiveness Though CSA is encouraged by the current legislation, special attention should be paid regarding the practical implementation effectiveness in the near future, as China does not have much experience in this field up to now. As such, it is expected that CSA will be concluded and scrutinised by the tax authorities (potentially more from the local level) under the APA framework. 4. Documentation Based on our understanding of the CIT Law, the CSA participants should prepare documentation (e.g., CSA agreement) to justify that the cost allocation is in compliance with the arm s length principle, i.e. each participant s proportionate share of the overall contributions to the CSA should be consistent with the participant s proportionate share of the overall expected benefits. However, it is still unclear whether the SAT will clarify other sophisticated CSA issues such as buy-in payments, balancing payments and periodic adjustments after the CIT Law takes effect. Despite the ambiguity and difficulties existing around the implementation of CSA in China, we have certainly sensed Chinese tax authorities willingness in introducing this particular topic starting soon. Part 3: Transfer Pricing Recommendations for Related IP Transactions under the CIT Law Exploitation of new tax incentive policies The CIT Law adopts the Predominantly Industryoriented, Limited Geography-based tax incentive policies, a significant deviation from the existing Geography-based policies. The new policies focus on high/new technology which is believed critical to China s future success. Under the CIT law, qualified high/new-tech enterprises are entitled to a preferential income tax rate of 15%, far lower than the normal tax rate of 25%. Moreover, Super Deduction of R&D expenses for new technology and products is still available. Production FIEs and Exportoriented FIEs in general industries, however, cannot enjoy preferential tax treatment under the CIT Law. These enterprises may have to devise TP arrangements in terms of IP transactions to enjoy the new tax incentives. For instance, FIEs may leverage intercompany IP migration to raise the high/new-tech content of their products or technology in order to meet the requirements of a high/new tech enterprise. Alternatively, FIEs may consider applying for a CSA to achieve super deduction of R&D expenses. Establishment of supporting documentation Since Chinese tax authorities are stepping up TP audits on IP transactions, Taxpayers should have inter-company agreement and TP documentation for IP transactions in place to demonstrate that the related party transactions are dealt at arm s length. To take an inter-company licensing arrangement as an example, taxpayers should carefully determine the terms and conditions of intercompany agreements, such as duration, exclusive or non-exclusive character, limitations on geographic area, possibility of sub-licensing, and charge rate. Taxpayers, meanwhile, may find that an IP policy that is stated clearly in TP documentation through economic analysis or valuation report is essential to any defence. APA & CSA - possible management tools To further mitigate future TP risks and potential challenges from the tax authorities, taxpayers (especially high/new-tech enterprises) can think about entering into APAs with the tax authorities, ensuring that taxpayer s internal IP transactions will be accepted by the tax authorities. For example, entering into an APA for the company s existing CSA can be regarded as an effective tool to enhance the group s tax efficiency and avoid potential disputes in the area of related IP transactions in China. This article is reproduced from its original publication entitled China: transfer pricing of IP and intangibles in the March 2008 issue of BNA International s Tax Planning International Special Report Transfer Pricing Aspects of IP and Intangibles. Copyright 2008 by The Bureau of National Affairs, Inc. Reprinted with permission. Jeff Yuan may be contacted by at: jeff.yuan@cn.pwc.com pwccn.com 2008 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.