On 17 September, 2015, China State Administration of Taxation ("SAT") released the Discussion Draft of Implementation Measures for Special Taxation 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.
Three chapters of the Discussion Draft are most relevant to special taxation adjustments (almost an equivalent to transfer pricing adjustment and general anti avoidance adjustment in a practical context), i.e., Chapter 5 on Special Taxation Investigation and Adjustment, Chapter 13 on Profit Level Monitoring and Chapter 14 on Corresponding Adjustment and Mutual Agreement.
The current revisions are inspired by the latest theoretical developments of OECD(in particular the Base Erosion and Profit Shifting action plan, or BEPS Action Plan), as well as by the practical experiences and observations of China tax authorities in transfer pricing audits of recent years. As a result, these chapters retain the fundaments of Circular 2 and its ensuing rulings, while expand the applicability of audit and adjustment, further clarify the procedure of audit and adjustment, and provide more options for comparable analysis as well as for other quantitative methods.
Obviously, these substantial revisions could have significant impact on the effective planning of the group's supply chain value allocation, and overall management of transfer pricing risk in China. MNCs may need to stand to the challenges of more frequent audit and investigation as well as more stringent post-audit monitoring measures, and further build up their strategies of tax compliance and risk control.
As one of the series of TP Alerts addressing the Discussion Draft, in this Alert, we will share with you our understanding and observation regarding the special tax investigation and adjustment. As for the discussion with regard to the Discussion Draft, you may refer to the previous TP Alert "A Brand-new Reporting Mechanism for Transfer Pricing Contemporaneous Documentation under Discussion Draft for the Implementation Measures for Special Tax Adjustments"; meanwhile, we will release more issues to discuss other key contents of Discussion Draft topic by topic. Please expect our upcoming TP alerts.
Target of audit
According to Article 37, enterprises with any of the following features can be targeted for transfer pricing audit:
- Have related party transactions in large amount, or in multiple types;
- Incur long-term loss, low profit or fluctuating profit;
- Have profit level that is lower than the industry norm;
- Profit level mismatch with function/ risk undertaken; or benefits received mismatch with costs allocated;
- Transact with related party in low tax jurisdictions;
- Fail to fulfill the obligation of preparing TP filing or contemporaneous documentation;
- Ratio of equity vs. debt investment received from related parties exceeds the prescribed ratio;
- Have controlled foreign corporation (CFCs) in low tax jurisdictions;
- Have transaction without reasonable business substance;
- Other circumstances that violate the Arm's Length Principle.
The Discussion Draft further expands the coverage of audit targets. In addition to large amount of related party transactions, profits fluctuation, consecutive losses etc., improper benefits received under cost sharing agreement ("CSA"), thin capitalization, CFCs and transactions without rational business substance generally regulated by general antiavoidance investigation, are newly included as the latest focuses of tax authorities.
It is worth noting that the title of Chapter 5 has been changed from "TP Investigation and Adjustment" from Circular 2 to "Special Tax Investigation and Adjustment" in the Discussion Draft, reemphasizing the fact that special tax investigation will not just limited to TP investigation but also applicable to the general anti-avoidance.
Generally speaking, tax authorities will undertake investigation under the following steps:
- Initial screening of data and information;
- Selection of investigation target (and formal notification to the client);
- Formal investigation and negotiation: information request (including original documents and electronic data), field investigation, on-site interview and etc.;
- Discussion of adjustment scheme;
- Conclusion of investigation;
- Accounting adjustment; and
- Post-audit supervision.
The Discussion Draft further revises certain procedural clauses of Circular 2, such as the delivery of documents, collection of evidence, applicable methods of investigation and etc. The amended provisions are stricter while at the same time more practical, with the following aspects warranting extra attention of taxpayers:
- Emphasize the risk managementoriented approach. The Discussion Draft establishes a risk managementoriented approach as the investigation work guidance, which stipulates that tax authorities shall strengthen information collection, database construction, risk level evaluation, contemporaneous documentation review and so on to better monitor the profit level of taxpayers, both before and after the investigation.
- Extension of deadline no longer possible for document submission: Unlike under Circular 2, the taxpayers would no longer have the right to request for deadline extension in terms of submitting documents and information, under the Discussion Draft. Given the practical challenge faced by taxpayers when it comes to the gathering of overseas information, the removal of time extension could add yet another obstacle to Chinese taxpayers.
- Newly added requirement for accounting adjustment: See below for details.
Information for submission
According to the provisions of Discussion Draft and our practical experiences, a targeted entity is generally required to provide the following information:
- Contemporaneous documentation. Enterprise that does not meet the statutory threshold for preparing contemporaneous documentation still has the possibility to be required to prepare such documentation by tax authorities, so that the authority can better understand its nature of related party transactions;
- Other business and financial information. Normally, an enterprise will be required to provide account book, expenses breakdown, and etc. The Discussion Draft has more strict requirements regarding the truthfulness and integrity of the information to be provided, for example, Article 41 and 42 newly requires that the enterprise need to provide the material with the signature of the provider and guarantee the provided copies of documents are the same as original version, and this rule also applies to the printed hardcopy of electronic data. Thus, the enterprise should be more cautious in the preparation of the documents required by tax authorities.
- Country-by-Country Report (CbC Report): Article 47 clearly listed the circumstances under which CbC Report shall be provided. Chapter 2 on reporting and filing of related party transactions stipulates that qualified enterprises shall fill the CbC reporting form. Thus, while inspired by the BEPS Action Plan No.13, SAT limits the provision of CbC Report within formal special tax investigation. Since some other countries are still in the process of codifying their domestic legislation regarding the CbC reporting mechanism, therefore, the points such as the extent of information to be disclosed, the down to the ground practices of CbC reporting in China are still to be observed.
Comparable analysis & adjustment method
For the core part of adjustment scheme, i.e., the comparable analysis and adjustment methods, the current revisions of the Discussion Draft are granting more technical leeway to the tax authority, and corresponding, a higher level of uncertainty to the taxpayers. Specifically,
- Single sample of comparable is now possible for comparable analysis, provided that the comparability of this comparable is highly satisfactory. Besides, the Discussion Draft retains the rights that tax authorities could use non-public information. Thus, the possibility has greatly increased that tax authorities may use some or even one secret comparable to calculate the adjustment on the targeted entity.
- Reasonable statistical methods such as simple average, weighted average or interquartile-range method etc. can be used to calculate the average or median of the selected comparables on individual year basis or multiple-year basis. The average or median can be regarded as the comparable profit level or comparable price.
- The investigated enterprise could be adjusted based on the comparable profit level or comparable price under year-by-year basis, or multiple-year average basis.
- Article 54 of the Discussion Draft stipulates that tax authorities shall make the adjustment to a level not lower than the median of the comparables. While this principle also exists in Circular 2, the current Article denies special consideration for exceptions for this aspect, which is allowed under Circular 2.
On one hand, the above additions or revisions of relevant provisions could bring a broader space for technical review and discussion between the taxpayer and the authority; on the other hand, however, level of uncertainties could rise considerably for taxpayers. They will potentially face more challenges and even dilemmas such as how to select proper comparables; how to elect the best statistical method which is both rational and beneficial to themselves; how to argue against the adjustment plan proposed by the tax authority and etc. These challenges will require more professional knowledge about transfer pricing, economics and tax. Thus the involvement of TP professionals to help with the defense and to gain more technical insights and edges in comparable analysis would be crucial for the final consensus to be reached between the taxpayer and the authority.
Investigation and adjustment method & negotiation procedure
The Discussion Draft revises the investigation and adjustment methods and the procedures for negotiation. The revised provisions are more thorough, precise and stricter. Specifically:
- Investigation and adjustment method. In addition to regular payment of additional taxes, the Discussion Draft newly adds the provision that tax authorities could deny or redefine the terms of related party transactions which are not in line with arm's length principle; besides investigations initiated by tax authorities, enterprises are also encouraged to conduct self adjustment and pay additional taxes.
- Results of refusing the negotiation. Article
64 stipulates that where an enterprise refuses to negotiate, tax
authorities shall directly deliver the Preliminary Special
Tax Investigation Adjustment Notice. If the enterprise disagrees with the notice but refuses to
negotiate with tax authorities, tax authorities shall directly
issue the Special Tax Investigation Adjustment
The above provision indicates that enterprises should cooperate with tax authorities in negotiation to avoid the risks of direct, deemed adjustment.
- Direct adjustment. Article 64 further
stipulates that where an enterprise disagrees with the notice, but
such opinion does not adopted by tax authorities, tax authorities
have right to deliver Special Tax Investigation Adjustment
To some extent, as the initiative or even decision-making right for deciding the final adjustment plan lies more with tax authorities, how shall enterprise negotiate with tax authorities will be crucial and more difficult.
Accounting record adjustment
Article 65 further clarifies the issue of "Accounting adjustment" mentioned in Circular of the State Administration of Taxation on Relevant Issues Concerning the Tax Administration of Transfer Pricing for Transactions Between Related Parties (Guoshuihan  Circular No.901) . It stipulates that after the payment of additional taxes regarding special tax adjustment, enterprises should adjust their accounting records accordingly. If no adjustment had been made, the adjusted taxable income shall be deemed as dividend distributed to shareholders, and be subject to income tax for such hypothetical transaction. Tax authorities would also have the authority to request the enterprises to remit the adjusted taxable income into their bank account within a specified time limit.
In practice, accounting record adjustment usually faces multiple challenges, for example, is it the adjustment on income or costs/expenses, or directly on taxable income? With respect to the former case, will it lead to the adjustment of turnover tax? Under which item will the remittance to be made? How to coordinate with the foreign exchange management system? After adjustment, whether the dividend paid to investors is eligible for relevant tax treatment or tax credit and etc. These issues are yet to be further clarified in the final draft.
- Regional special factors: Article 57 once again stresses regional factors such as location-savings and market premium, both of which shall be considered during special tax investigation and adjustment. Such factors are also mentioned for several times in other chapters of the Discussion Draft. As the defacto leader and representative of the developing countries, China has constantly emphasized the regional special factors that could bring benefits to the enterprises, such as location-saving or market premium. In practice, we have seen an increasing number of investigations related to location-saving and market premium. It could be reasonably expected that more cases regarding these factors will take place in the future.
- Stringent supervision over cash repatriation: Following Announcement of the State Administration of Taxation on Enterprise Income Tax Issues concerning the Cash Repatriation to Overseas Related Parties ( Announcement 16) issued in March, 2015, Article 60 and 67 further stipulates that tax authorities has the right to make investigation and adjustment on the outbound intercompany payment . Such payment made cannot be eligible for deduction purpose. Meanwhile, the paid withholding taxes on interests, rental and royalty cannot be deductable. Thus, enterprises should be more cautious in the outbound remittance arrangement to mitigate potential risks.
- Pre-deregistration check: The Discussion Draft illustrates for the first time that an enterprise with cross-border transactions shall be subject to anti-avoidance check, as one of the standard procedure during deregistration. It is worth noting that the "cross-border transactions" are not limited to "cross-border related party transactions". Thus for enterprise that is going to perform tax deregistration, special tax adjustment including general anti-avoidance investigation will be the focus of tax authorities.
- Limitation on capital adjustment: Circular 2 stipulates that when enterprise needs to apply for capital adjustment (i.e., adjust the profit differences between the investigated enterprise and the comparable enterprise due to different utilization rate of operating capital), such case shall be reported to the SAT for approval by levels. The Discussion Draft further limits the application of capital adjustment, i.e., it is only applicable for toll manufacturer.
- Retrospective period and postaudit monitoring period: Circular 2 specifies the statutory limitation of five years post-audit monitor period for investigated enterprises and they are obliged to prepare the contemporaneous documentation, in addition, the TP investigation in China can trace back up to ten years. The Discussion Draft retains the 10 year retrospective period but does not specify the postaudit monitoring period. It is our understanding that this does not mean the enterprise after special tax adjustment is no longer the main focus of tax authorities, Article 149 states that tax authorities shall supervise the investigated enterprises by monitor their manufacturing and operation, changes of related party transactions and profit level. Therefore, even though there is no clear regulatory deadline, enterprises should conduct stricter self-check and close monitor their business and profits in order to reduce risk of a second adjustment. Meanwhile, enterprises should prepare the contemporaneous documentation in advance to meet tax authorities' requirements timely. More specified provisions regarding retrospective period can be expected in the final draft.
- Interest and penalty. During special tax investigation, based on the magnitude of cases, enterprise may be subject to fine, profit adjustment and interest (including late payment surcharge). The Discussion Draft retains these provisions and further clarifies the payment of interest and late payment surcharge. That is, if an enterprise pays taxes before delivery of the Special Tax Investigation Adjustment Notice or repay taxes within the time limit set in the Notice, it shall pay interest calculated from June 1 of the year succeeding the year in which the tax is due, to the deadline for payment of back taxes; if an enterprise fails to pay the back taxes within the specified time limit, it shall pay interest calculated from June 1 of the year succeeding the year in which the relevant tax is due, and shall pay late payment surcharge from the succeeding day of the deadline for payment of back taxes. The interest rate will be the sum of an amount computed using the basic RMB lending rate (hereafter referred as "the basic lending rate") applicable to the same period as the back tax published on Dec 31st in the year to which the back tax is attributed by the People's Bank of China, with 5% additional charge. The daily interest rate will be calculated from the basic lending rate on a 365-day-basis (one year).
Based on Circular 2, the Discussion Draft further differentiates the interest charge and late payment surcharge, that is, an enterprise shall pay late payment surcharge only if it fails to pay the back taxes within the specified time limit. This will serve as a criterion for solving disputes and confusion in practice.
Issues to be further clarified
Though the Discussion Draft is more thorough compared with Circular 2, the following issues still needs further clarification:
- As mentioned above, compared with Circular 2, the Discussion Draft removes the deadline for enterprises investigated for providing required documents and application for deferred provision. We shall see whether this will be addressed in the final draft.
- Article 50 stipulates that special tax investigation shall not apply to transactions between domestic related parties. However, in practice, the actual tax rate among domestic related parties may still differ due to tax preferences, operating loss etc. We shall see whether this exclusion will be adopted in the final draft.
- Article 51 stipulates that where tax authorities hold that transactions between related parties are not in line with arm's length principle after examine relevant contracts, they may deny and redefine the terms of such transactions. If functions performed or risks undertaken by an enterprise exceed the amount of function or risk that an independent party is willing to undertake, the extra portion shall be reasonably compensated by related parties. However, the Discussion Draft does not specify what measures will be adopted after the transactions is denied; how to redefine the terms of transactions and how to reasonably compensate for the extra function or risk undertaken.
- Article 56 stipulates for profits differences between the investigated enterprises and the comparable enterprises due to different utilization rate of operating capital, tax authorities may make adjustment for the investigated enterprises within a 10% range. But the Discussion Draft does not clarify the rational for choosing 10% as the adjustment range and the adjustment target of 10%. They are yet to be clarified in the final draft.
- As mentioned above, executive issues related with accounting records adjustment are yet to be clarified.
Practical strategies for Taxpayers
Based on the above analysis, it could be expected that future TP administration in China will be much stricter. In particular, enterprises with any of the following characteristics shall pay more heed to the potential risks of special tax adjustment:
- Engaged in large amount of related party transactions and incurring loss;
- Engaged in large amount of service and intangible assets transactions with related parties;
- Domestic enterprises with investment in low tax jurisdictions;
- Enterprises transacting with related parties in low tax jurisdictions;
- Enterprises with thin capitalization issue;
- Enterprises in the industries affected by regional special factors, e.g. automobile, luxury and retail industry;
- Involved in the transaction that lacks business substance.
Based on our extensive experiences in controversy resolution, we are summarizing below the key practical tips for taxpayers in the event of special tax investigation and adjustment:
- Plan well ahead. With the increase of information disclosure and the development of global information exchange system, tax authorities will have better overview of the business arrangement of MNCs. Thus, prompt and effective planning of group supply chain and TP strategy will be the key to reduce investigation risk.
- Strengthen business substance. For either intra-group related party transaction arrangement or general business arrangements regulated by general anti-avoidance, the availability of rational business substance shall be focus of tax authorities in special tax investigation. Enterprise should strengthen the business substance of current crossborder transactions and retain relevant documents to lower the risk of formal investigation.
- Prepare relevant documentation. Contemporaneous documentation and relevant materials necessary for outbound remittance specified in  Announcement No.16 will continue to be a major source of information for tax authorities to understand related party transactions. Especially, under the new monitoring mechanism guided by risk control and featured by risk level evaluation and data management, the preparation of contemporaneous documentation and information disclosure will be more critical. For detailed analysis of documentation related discussion, please refer to our TP Alert-Issue 2 on contemporaneous documentation and TP Alert-Issue 4 on related party service and intangible assets transaction.
- Establish effective negotiation strategies: The more flexible investigation and adjustment approaches under the Discussion Draft, as well as the requirements on comparable analysis, post monitor of profit level, accounting record adjustment and etc., all raised both the importance and difficulties for enterprises to communicate effectively with tax authorities. Therefore, if the investigation is launched by the tax authority, the investigated enterprise should seek external support as soon as possible and response actively to tax authority in order to achieve a better result.
- Other planning opportunity. Qualified enterprises may seek pricing agreement with tax authorizes via advance pricing arrangement ("APA") or CSA to reduce the risk of second investigation and adjustment. It is worth noting that under Announcement of State Administration of Taxation on the Standardization of Cost Sharing Agreement Administration ( Announcement No. 45), the administration of CSA will be changed from pre-approval to follow-up supervision. This shows authorities' encourage and support on CSA practice.
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.