By Dezan Shira & Associates
Legal Editor: Steven Elsinga
China tax authority, the State Administration of Taxation (SAT) issued an announcement on March 18, in which it outlines a number of transfer pricing transactions which would no longer be eligible for tax deductions. The decision is effective immediately.
The move follows an investigation into transfer pricing that first started in July 2014. The SAT requested local bureaus to gather information on the practice of transfer pricing for the purpose of launching a new policy. With the release of these new guidelines, tighter scrutiny of multinational companies is expected.
The new policy aims specifically to exclude service payments to overseas related entities for functions that aren’t actually performed, the bearing of risk, or business activities that are not in fact carried out by the overseas entity. Even prior to the release of the new policy, Chinese tax authorities have been paying close attention to large payments to related entities in low-tax jurisdictions. In practice, corporate groups often set up entities in low tax jurisdictions specifically for the purpose of decreasing tax, while no business activity in fact takes place there. These transactions are now no longer deductible.
Richard Cant, Dezan Shira & Associates North American Regional Director, comments, “This is yet another attack by the Chinese revenue authorities on the perceived ‘transfer pricing’ by foreign groups operating in China by inter group service & royalty arrangements. It appears the onus is on the taxpayer to ensure that payments to offshore group companies are not covered by the new provisions. Having regard to the recent ‘heavy hand’ of the tax authorities in such TP matters, we predict that this will become another tough area for foreigners operating in China in 2015 and beyond.”
RELATED: China’s Transfer Pricing Obligations
Services rendered to the China-based entity by the overseas related party must enable the China-based entity to directly or indirectly gain economic benefit. If this is not the case, these expenses may not be deducted.
Specifically, these include:
- Services irrelevant to the operations of the company
- Services such as control, management or supervision that are rendered for the purpose of protecting the interests of the company’s shareholders. As the China-based entity is not the beneficiary of these services, these transactions do not comply with the arm’s length principle and are therefore not deductible.
- Services provided by the related party, that the China-based entity has already bought from another party or has performed itself.
- Services by the related party that have already been paid for in previous affiliated transactions.
- Benefits that the China-based entity enjoins as a consequence of being part of a group of companies, but that does not constitute a service rendered by the overseas entity. An example would be that the China-based entity is able to secure better terms for financing by virtue of it being part of a larger group of companies, which would increase the lender’s confidence.
- Other services that do not provide the China-based entity with any economic benefit.
In addition, the new policy sets rules for the deduction of royalties payments to related parties. When a China-based company intends to make royalties payments to a related party, it needs to ascertain to which degree that related entity has contributed in the creation of that intangible asset. If the related entity only holds the property rights to the intangible asset, but did not play a role in its creation, the royalties payment will not comply with the arm’s length principle. Therefore, these payments will not be deductible. Instead, the China-based entity needs to pay the related parties that were involved in the creation of the intangible asset, to the degree that these parties contributed to the intangible asset.
One way to reduce tax is for a group of companies to set up an entity in a jurisdiction with little to no tax on royalties. The group then transfers all the royalties to that entity. This entity charges the group companies for the use of royalties, for which the entity will then pay little to no taxes. The stipulation described above intends to curb this practice.
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