On 18 March, 2015, China State Administration of Taxation ("SAT") released one important regulation regarding outbound payments by Chinese entities to overseas related parties - Announcement of the State Administration of Taxation Regarding Corporate Income Tax ("CIT") Matters on Outbound Payments to Overseas Related Parties ("Announcement 16").
With the aim to further standardize and strengthen the transfer pricing administration on outbound payments to overseas related parties, Announcement 16 specifies the service expenses which cannot be deductible for corporate income tax purpose as well as the relevant supervision procedures to be carried out by China tax authorities. This will directly impact the daily operation of Chinese taxpayers. Announcement 16 is also issued as a proactive response to the Base Erosion and Profit Shifting ("BEPS") action plans, one of the major tax initiatives launched by the Organization for Economic Cooperation and Development ("OECD") recently.
This alert provides an in-depth analysis of Announcement 16 mainly from the perspectives of tax authorities' supervision. The full text of Announcement 16 can be found in the appendix of this alert.
Target of supervision: Five types of non-deductible outbound payments
Announcement 16 specifies the following scenarios of outbound payments as nontax- deductible for the Chinese taxpayer:
1. The overseas recipient of the payment lacks business and operational substances;
2. Evidence on the authenticity of the transactions can't be provided;
3. Service transactions have not, directly or indirectly, benefited the Chinese domestic entity;
4. Royalties paid to the overseas related party who claims legal ownership of the intangible asset yet has made no contribution to its value creation; and
5. Royalties paid to the overseas related party in compensation for incidental benefits arising from overseas financing or listing activities.
The first scenario cited above merits special attention. Prior to the release of Announcement 16, substance of outbound payments was scrutinized more on the transaction level. With this new Announcement, however, the scrutiny will be extended to the fee recipient itself – whether it undertakes functions, bears risks and has substantial operations. In some real world cases, service fees or royalties are paid to related parties in low-tax jurisdictions of the group. In the context of Announcement 16, such payments could be disallowed for tax deduction in China, if the overseas receipts fail to prove their business substance.
Scenario 3 and 4 are detailed in the later section of this alert, while Scenario 5 is most relevant for Chinese businesses with outbound operations.
Supervision procedures: Multiple opportunities to detect tax avoidance
Announcement 16 stipulates that tax authorities are empowered to scrutinize and adjust the payments to overseas affiliates that are not in compliance with the arm's length principle, granting tax authorities more opportunities and channels to detect tax avoidance under outbound payments.
1. During remittance: In-charge tax authorities may require the Chinese entity to provide relevant documents for outbound payments
2. Post-remittance: Under the "foreign remittance filing mechanism", in the event that transfer pricing issues remain unidentified by tax authorities during outbound remittance, the payments not in compliance with the arm's length principle could still be retroactively disallowed for deductions even after the payments are made. Announcement 16 also sets 10 years as the statutory limitation for such retroactive investigations.
3. Annual transfer pricing filing: Though not reiterated in Announcement 16, Annual Related Party Transactions Filling forms for submission since 2009 include the "Form Nine", for "Outbound Payments". Following the unveiling of Announcement 16, "Form Nine" will be used by tax authorities as another effective means to collect information on outbound payments and screen potential targets for further review.
Requirements for documents
Announcement 16 sets forth the following documents to be submitted during outbound payment:
- Contracts or agreements concluded with overseas related party
- Relevant documentation verifying the authenticity of the transaction
- Relevant documentation proving the arm's length nature of transaction
Whether the aforementioned "Relevant documentation proving the arm's length nature of transaction" is the equivalent to routine transfer pricing contemporaneous documentation is worthy of particular attention and deliberation, and the answer may vary under different circumstances. In practice, contemporaneous documentation tends to analyze, only from the whole entity level, the arm's length nature of the entity crossing the legal threshold, therefore leaving service fee or royalty inadequately analyzed at the transaction level. In this case, adhoc documentation on these particular transactions is likely to be required.
The benefit principle for service fees
Announcement 16 introduces for the first time to China the benefit principle as a key criterion in determining the reasonableness of service fees payments to overseas affiliates. We will use different examples to illustrate the benefit principle stipulated by Announcement 16 –
Services not relevant to the function and risk profile of, or compatible to the current operation of the Chinese entity
Example: Theoretically speaking, a contract manufacturer should not undertake the functions and risks related to marketing; accordingly, if the contract manufacturers pay marketing fees to its overseas affiliates, such payments are very likely to be defined as irrelevant to its functions and risks and therefore be denied income tax deduction at the Chinese corporate level.
Services (including control, management and supervision activities) conducted to ensure the investment interests of direct or indirect investors
Example: Financial audit services in line with the group's accounting standard are rendered to subsidiaries, and each subsidiary is charged with service fee. Such service is very likely to be categorized as shareholder activities conducted to safeguard the interests of the parent company, rather than the local subsidiary. In this sense, such service fee may not be tax deductible in China.
Intra-group services that have already been rendered by a third party or have been performed by the recipient entity itself
Example: An entity has engaged a third party vendor to provide human resource outsourcing service, and paid human resource service fees to its overseas related party at the same time. Services provided by the related party can be deemed as duplicative and therefore non-deductible for income tax purpose.
Incidental benefits realized by the local entity for its affiliation to the group, without receiving any specific services from the group
Example 1: The group charges its subsidiaries various fees incurred at the group headquarter based on certain allocation method. Such type of "allocation method" has always been frequently challenged by China tax authorities. Announcement 16 further emphasizes that only service fees paid for "specific services" performed for the Chinese enterprise can be deducted for income tax purpose. Allocated expenses for services of a more generic nature may not qualify for such deduction.
Example 2: The Chinese subsidiary of a big global client of a group voluntarily becomes the client of the Chinese entity of this group. In this case, although the Chinese entity does receive commercial benefits due to its affiliation to the group, no specific services have been rendered by the group to this Chinese entity. As such, service fee paid by the entity, if any, may not be deductible for income tax purpose.
Services that have already been remunerated by other intercompany transactions
Example: An overseas entity purchases raw materials from a third party supplier and resells to its Chinese manufacturing affiliate. The overseas party has added a markup in the sales price to China and, in addition, charges the Chinese entity a service fee for the material sourcing support. Under such a circumstance, China tax authorities may deem that the overseas party has already been remunerated for the sourcing support by way of the mark-up in the sales price, and therefore deny the Chinese entity tax deductibility of the additional service fee.
As a summary, Chinese entity shall take into consideration various factors -- such as the benefit nature of the services, the overall entity profile as well as the correlation between the service transaction and other intercompany transactions – when planning its future outbound cash repatriation strategy in the context of Announcement 16.
Economic ownership of intangibles
Legal ownership of intangibles is normally achieved and certified by legal registration, while economic ownership recognized through the actual development and maintenance of such asset as well as bearing the costs.
Announcement 16 introduces, for the first time to China, the concept of economic ownership of intangibles and stipulates that "royalty paid to related party who is the legal owner but who has not contributed to the creation of the intangibles is not arm's length, and therefore shall not be tax deductible."
For example, an overseas related party has the ownership to the group's brand while the Chinese entity conducts marketing activities in the domestic market and bears the relevant marketing expenses. Chinese tax authorities may, in all likelihood, assume that the overseas related party has the legal ownership of such brand while its economic ownership is shared between the overseas related party and the Chinese entity. If the Chinese entity still pays royalties to the overseas related party with respect to the brand, whether such royalty is tax deductible and if yes, to which amount, would become debatable.
The same logic may implicate sublicensing activities whereas the royalty paid by the Chinese entity to the sublicensor may be denied tax deductibility, since the sub-licensor may technically be excluded from both the legal ownership and economic ownership to the intangibles.
Method and consequence of Adjustment, and impact to Chinese Entity
By law, a formal transfer pricing investigation shall undergo an integral procedure of target identification, case registration, audit investigation, negotiation, final adjustment and postaudit monitoring – all steps under the supervision of China SAT. That is why in practice a formal investigation often lasts for long and consumes significant resources of the tax authorities.
In contrast, Announcement 16 borrows the flexibility of general tax audit while retaining the severity of transfer pricing audit in terms of statutory limitation. The stipulation of "non-deductibility for income tax purpose" means the assessment of outbound payments can be more readily and effectively implemented. As such, it may be fair to speculate that more tax officials specialized in the antiavoidance discipline will more frequently participate in the routine scrutiny of outbound payments for service fee and royalty, under Announcement 16.
Therefore, taxpayers shall raise alertness to outbound payment arrangements following the unveiling of Announcement 16. Otherwise, they may suffer a double loss where the payment is denied income tax deductibility while the turnover tax and withholding tax paid during repatriation are not refundable under other legal stipulations.
How can Grant Thornton help you?
Our seasoned supply chain and transfer pricing advisors leverage our in-depth understanding of Chinese tax regulations and over fifteen years' first hand, real world experiences, when tailoring standalone or comprehensive solutions for different businesses under different circumstances.
1. Transfer pricing and tax planning
Given the scrutiny of Announcement 16 on payments to overseas related party, planning in advance is no doubt more effective than rectification post-event. We can assist you in transfer pricing and tax planning to optimize the overall tax structure in the boundary of business feasibility.
- Structure related party transaction in a proper manner based on the nature of overseas payment:
- Substantiate the business substance of outbound payment as well as the service fee recipient
- Ensure that the transaction between related parties comply with the benefit principle
- Enhance the economic ownership of the party who licenses intangibles to China
- During planning, attention should also be paid to supply chain structure to accommodate the overall characterization of the entity as well as other types of related party dealing.
2. Advice on and preparation of supporting documents
We can assist in preparing supporting documents specified by Announcement 16 for outbound payment to overseas related party including:
- Contract or agreement concluded between the Chinese enterprise and its overseas related party
- Relevant documentation verifying the authenticity of the transaction
- Relevant documentation proving the arm's length nature of transaction
Regarding the relevant documents proving the compliance of transactions with the arm's length principle, we can assist you to judge whether the existing transfer pricing contemporaneous documentation is adequate and proper as supporting documents to be submitted to tax authorities. In case not, we can also help you to prepare new supporting documents to justify the compliance with the arm's length principle. During this process, we will rely on professional databases endorsed by Chinese tax authorities, such as BvD Osiris and RoyaltyStat, to conduct benchmarking analysis on specific service fees and royalties.
3. Assistance in outbound payment Procedure
Following the unveiling of Announcement 16, we anticipate that communication and explanation on the part of taxpayers with the tax authorities will be more extensive when making outbound payments. We are vastly experienced to assist you during the whole process, from preparing or reviewing supporting documents, submitting contracts or agreements of related party transactions to the communication and negotiation with various authorities including tax offices, foreign exchange administration and banking institutions.
Announcement of the State Administration of Taxation Regarding Corporate Income Tax Matters on Outbound Payments to Overseas Related Parties
Announcement of the State Administration of Taxation  No.16
In order to further standardize and strengthen the transfer pricing administration on outbound payments to overseas affiliates, in accordance with relevant provisions in the Corporate Income Tax Law of the People's Republic of China (CIT Law) and its Detailed Implementation Regulations (DIRs), the relevant transfer pricing issues in relation to outbound payments to overseas related parties are specified as follows:
1. Under Article 41 of CIT Law, payment to overseas affiliates shall comply with the arm's length principle. Otherwise, the tax authorities may make adjustments thereto.
2. Under Article 43 of CIT Law, where an entity pays fees to its overseas affiliate, the in-charge tax authority may require the entity to file for record the contracts or agreements concluded with the affiliates as well as the supporting documents that affirm the authenticity and compliance of the transaction with the arm's length principle.
3. Fees paid for services received from an overseas affiliate that are not relevant to the function and risk profile, or have no business substance, should not be deducted when calculating the taxable income.
4. Where an entity pays fees to its overseas affiliates for the services rendered, such services shall help the entity gain, direct or indirect economic interests. The fees paid by an entity to its overseas affiliate for the following services shall not be deducted in calculating taxable income:
1) Services not relevant to the function and risk profile, or compatible to the current operation of the Chinese entity
2) Services (including control, management and supervision activities) conducted to ensure the investment interests of direct or indirect investors
3) Intra-group services that have already been rendered by a third party or have been performed by the recipient entity itself
4) Incidental benefits realized by the local entity for its affiliation to the group, without receiving any specific services from the group
5) Services that have already been remunerated by other intercompany transactions
6) Other services which cannot bring direct or indirect economic benefits to the entity 5. Where an entity pays royalties to its overseas affiliates for using an intangible asset provided thereby, it shall determine the economic interests to which each affiliate is entitled by taking into account the degree of contribution made by each affiliate to the value of the intangible asset. Royalties paid to entities that have legal ownership of intangible assets but do not contribute to the value thereof, are not in compliance with the arm's length principle and shall not be deducted when calculating the taxable income.
6. Where holding companies or finance companies are set up overseas by the local Chinese enterprise for listing and financing purpose, royalties paid to overseas affiliates for incidental benefits of such listing and financing activities shall not be deducted when calculating the taxable income.
7. Under Article 123 of Implementation Regulations for CIT Law, where service fees paid to overseas affiliates are not in compliance with the arm's length principle, the tax authorities reserve the right to make special taxation adjustment within 10 years from the tax year in which the transactions occurs.
8. This Announcement comes into effect as of the date of release.
This Announcement is hereby given.
State Administration of Taxation
March, 18, 2015
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.