On 17 September, 2015, China State Administration of Taxation (SAT) released the Discussion Draft for the Implementation Measures for Special Tax Adjustments ("Discussion Draft"), as a complete revamp to the existing trial version of the Implementation Measures, i.e., Circular 2.

Circular 2 has been serving as a backbone transfer pricing ("TP") ruling in China ever since its issuance in early 2009. The current systematical revamp of this ruling marks the new epoch of China TP legislation, under which the tax authorities may carry out TP administration and investigations with higher level of legal clarity and a more standardized approach.

The current main features can be noted from the Discussion Draft:

Comprehensive: On the framework of Circular 2, the Discussion Draft integrates a series of other TP rulings issued in recent years. It will therefore become the new fundamental ruling of TP for China.

Up-to-date: In the context of globalization, cross-border intercompany transactions are omnipresent and becoming ever more complex. In recent years, the Organization for Economic Cooperation and Development ("OECD") has launched a series of action plans to address Base Erosion and Profit Shifting ("BEPS Action Plan"), an initiative of anti tax avoidance vis-à-vis such intercompany dealings.

The Discussion Draft is clearly inspired by the BEPS Action Plan. Aside from enriching the existing stipulations of Circular 2, the Discussion Draft introduces three new chapters, addressing intangible assets, service transactions and profitability monitoring respectively. It also incorporates or addresses certain key practical developments as well as topics of controversies of recent years that have not been addressed by Circular 2.

Stringent: On one hand, the Discussion Draft brings forth higher demand of compliance and disclosure to the taxpayers, such as the expansion of TP contemporaneous documentation into a three-tier package; on the other hand, it clarifies several issues of ambiguity that has in the past years troubled tax authorities and taxpayers alike, such as the profit allocation in the context of intangible assets.

This alert summarizes all the fundamental changes of the Discussion Draft and analyzes their implications for taxpayers. More in-depth interpretation of each of the key specific topics will be presented in our future technical alerts.

Revision or expansion of key Concepts

"Related party" and "related party transaction"

Related party: Clarify and expand the criteria for determining a related party relationship, e.g. newly add the formula for judging related party with loan relationship; illustrate the concept of senior management, and etc.

Related party transaction: Financial assets transfer, cash pooling and equity transfer are now formally included as types of related party transactions.

Deemed related party transaction: Attempt to conceal related party transactions by way of agency, trust and etc, could be looked through by tax authorities. Such transactions can anyway be labeled as related party transactions in view of true economic substance.

Supplementation to the five traditional TP methods

Define the other TP methods in addition to the five traditional TP methods –

  • Value contribution method: The total profit of the supply chain shall be apportioned among the group entities of different countries under the basis of their respective contribution to the value creation.

    This method is normally applicable to cases in which it is hard to obtain information of the comparables while the total profits and contribution created by value-creating factors can be reasonably assessed.
  • Asset valuation method: It consists of cost method, fair value method, and income method.

    This method is normally applicable to the assessment of intangible assets transaction and equity transfer between related parties. It is foreseeable that such types of transactions shall become new focuses of tax authorities in addition to the traditional transactions, e.g. transaction of tangible assets and services.

Expansion of compliance obligation

Three-tiered TP contemporaneous documentation package

The Discussion Draft also clarifies other compliance obligations of enterprises, e. g.

  • Country-by-Country (CbC) reporting form: Qualified enterprises are required to fill out this form when submitting "Annual Reporting Forms of Related Party Transactions for PRC Enterprises".
  • CbC report: Where an overseas ultimately controlled enterprise fails to prepare or the Chinese authority is unable to obtain the report via information exchange, tax authority shall request the domestic enterprise to provide the CbC report during special tax adjustment.

For detailed analysis of this topic, please follow our later TP Alerts.

More Thorough approach of investigation and adjustment

More standardized investigation procedure and further clarification to adjustment methods

Investigation procedure: Further define the investigation authority, investigation and evidence-gathering process, e.g.

  • Submission of information via paperwork or paperless, electronic medium.
  • Submission of CbC report by certain enterprises.

Adjustment method: Further clarify special tax adjustment methods, e.g.

  • Reasonable statistical methods other than interquartile range method, e.g. simple average, weighted average, and etc; Single sample possible for comparable analysis, provided the comparability of this sample is highly satisfactory;
  • Where an investigated enterprise is engaged in toll manufacturing business for its related parties, the value of the consigned materials as well as equipments shall be added back into the cost base, and a capital adjustment up to 10% is allowed.
  • During review and assessment, tax authorities shall consider regional special factors, e.g. location savings and market premium, and use reasonable methods to determine the extra profits created by such factors for the local enterprise.
  • Where an enterprise provides simple production / distribution or contractual R&D for its overseas related parties, it shall not assume any risk and loss associated with decision making, under-utilization, sluggish sales, R&D failure, etc. and shall keep a reasonable level of profits.
  • Where an enterprise makes payment to its overseas related parties who does not undertake any related function, risk, or substantial business activities, tax authorities shall carry out special tax adjustment and the payment is not tax deductible in China.

Post audit monitoring period: The statutory limitation of five years removed, meaning the tax authorities can prolong such monitoring indefinitely.

The Discussion Draft also made reference to "second adjustment", a much disputed topic since its inception in GuoShuiHan [2006] No. 9012. The Discussion Draft stipulates that an enterprise shall pay tax within the period determined by tax authorities and adjust accounting record correspondingly. Where no adjustment is made, the increased taxable income shall be deemed as dividend repatriation and be subject to China tax in this nature.

For detailed analysis of this topic, please follow our later TP Alerts.

Intangible assets and service Transaction

The Discussion Draft introduces these two new chapters and addresses specifically some hottest as well most challenging issues of these two topics.

Intangible assets

Definition: Define the concepts of intangible asset, legal ownership, economic ownership, earnings from intangible assets, and etc.

Assessing principle: Clarify the principle that the distribution of earnings from intangible assets matches with economic activity and value contribution. Worthy of note is that instead of classify regional special factors (such as location savings and market premium) as a type of independent intangible asset; they are treated, together with other valuecreating factors, e.g. group cooperation effect, as considerations in assessment.

Calculation method: Comparable uncontrolled price method, profit split method, value contribution distribution method, asset valuation method etc.

Royalty payment not in line with arm's length principle: Echo provisions in SAT Announcement [2015] No.163, such royalty payment can't be deducted for Corporate Income Tax ("CIT") purpose.

Service Transaction

Assessing principle: Payment between related parties for service rendered shall meet both of the following conditions:

1. The service is beneficial to the service recipient;

2. The service fee is in line with arm's length principle.

What is a beneficial service: Service that can bring direct or indirect economic benefit to the service recipients; or that an independent party shall be willing to purchase such service or carry out such business activities by itself under similar conditions.

Meanwhile, the Discussion Draft also defines services that are not beneficial, echoing the provision in SAT Announcement [2015] No.16.

Pricing method: Service between related parties shall be priced on the basis of reasonable cost plus reasonable profit.

Where it is impossible to attribute the relevant cost to each individual service recipient and service item, it shall be apportioned among service recipients under the basis of total cost plus reasonable profit and according to reasonable allocation keys.

Services that are not beneficial, or beneficial services that, nevertheless, are not in line with arm's length principle: Payment made is not eligible for tax deduction, echoing provisions in SAT Announcement [2015] No. 163.

For detailed analysis of this topic, please follow our later TP Alerts.

Other key changes

Advance Pricing Arrangement (APA)

  • Remove the threshold for application for APA;
  • Clarify the procedure for application for APA;
  • Clarify cases in which tax authority may grant "priority processing" to an application or "turn down" an application, e.g.
    • "Fast-tracking of application": The application has sufficiently taken into account of the regional special factors, such as market premium and location saving, and the proposed pricing criteria and methods are reasonable.
    • "Rejection of application": The applicant is already under special tax adjustment audit; the applicant's original APA adopts the interquartile range method and its weighted average profit level is lower than the median during the implementation of the APA; failure to prepare TP contemporaneous documentation as required.
  • Clarify the period that an APA is rolled back for the same or similar related party transactions during the previous years, that is:
    • The period length from June 1th of the year following the end of the year during which such related party transactions occurs back to the date on which tax authority serves an enterprise a notice for meeting cannot exceed 10 years.

Cost Sharing Agreement

  • Echo the provision in SAT Announcement [2015] No. 454, reflecting the transition from "preapproval" to "follow-up supervision" for cost sharing agreement;
  • Emphasize the principle that cost be shared/allocated based on the expected returns. Also, countryspecific or regional-specific factors shall also be considered when determining the cost to be shared.
  • The critical assumptions for expected returns shall be aligned with the specific characteristics of intangible assets or service transactions.

Controlled Foreign Corporation

  • Clarify concepts such as "singly hold over 10% share with voting right in an foreign enterprise", "actual tax rate is lower than 50% of the tax rate specified in paragraph 1, article 4 of Corporate Income Tax Law", and etc.
  • Newly introduced concept of "attributable income" (defined as the portion of profits from controlled foreign corporation ("CFC") attributable to its parent company as a Chinese resident enterprise) and its calculation method. Revise the conditions under which attributable income may be retained by CFC:
    • Retained earnings of the current period is less than RMB 5,000,000;
    • Attributable income is less than 50% of the current income of CFC; and

    • For purpose of reasonable business needs, such as invest the profits into substantial production and operation activities or financial investment.

Thin Capitalization

  • Extend the scope of bond investment between related parties. Newly add:
    • Bond investment obtained from group cash pooling;
    • Current liabilities, long-term liabilities or deferred payment between related parties on which interest has accrued.
    • Expand the scope of interest expense. Newly add:
    • Interest re-characterized during special tax adjustment;
    • Financing cost for financial leasing;
    • Nominal interest rate of financial derivative instruments or protocols related with bond investment between related parties;
    • Exchange gain or loss arising from bond investment between related parties.
  • Debt-equity ratio between related parties is calculated per each transaction instead of per month.

For detailed analysis of this topic, please follow our later TP Alerts.


While the final version of this new TP ruling will almost certainly incorporate changes from the current Discussion Draft, such changes will not be significant nor fundamental. We make such a professional judgment out of the recognition that the current Discussion Draft has reasonably covered, almost to the extent possible, the most up-to-date international standards and initiatives such as BEPS Action Plans, as well as China-specific practical issues of the recent years.

According to our latest intelligence, the final ruling will be released by the end of 2015 and become effective in early 2016, posing challenges to taxpayers starting 2016 with a retroactive effect. In this context, taxpayers may naturally want to familiarize themselves with this latest key development of China TP legislation and implement sensible changes to their TP philosophies or systems as soon as practical.

Out of all these challenges, an imminent one shall be the new threetiered documentation package that might be required starting fiscal year 2015, along with the conditional obligation of CbC report. Taxpayers may find themselves short of lead time in terms of information collection, risk assessment and etc. to satisfy this brand new requirement of disclosure.

Tax planning in the context of the new ruling also warrants extra deliberations, especially when the related party dealings involve intangible assets, service transaction, financial assets transfer, equity transfer, and etc.

Also, for taxpayers with existing or contemplated overseas investments, the revised CFC provisions as well as the latest stipulations of overseas intangibles could directly affect the sustainability of your group TP practices.


1 Circular of the State Administration of Taxation on Enhancing the Monitoring and Investigation of Cross-Border Related-party Transactions (Guo Shui Han [2009] No. 363)

2 Circular of the State Administration of Taxation on the Relevant Issues Concerning the Tax Administration of Transfer Pricing for Transactions between Related Enterprises (Guo Shui Han [2006] No. 901)

3 Announcement of the State Administration of Taxation on Enterprise Income Tax Issues concerning the Disbursement of Expenses by Enterprises to Their Overseas Related Parties (SAT Announcement [2015] No.16)

4 Announcement of the State Administration of Taxation on Regulating the Administration of Cost Allocation Agreements (SAT Announcement [2015] No.45)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.