Tax Insights from Transfer Pricing Tax Controversy and Dispute Resolution MNC intra-group outbound charges under spotlight of China SAT September 8, 2014 In brief Recently, the State Administration of Taxation (SAT) released the Notice of Anti-Avoidance Examination on Significant Outbound Payments (Circular [2014] No. 146, hereinafter referred to as the ‘SAT Notice’). In this SAT Notice, the SAT requests the local-level tax bureaus to launch a comprehensive tax examination on significant outbound service fee and royalty payments to overseas related parties of a multinational company’s (MNC) subsidiaries in China, with an aim to strengthen the tax administration on intra-group charges and prevent profit shifting out of China. The SAT Notice sets forth the key characteristics of suspicious intra-group outbound service and royalty charges that deserve special attention in the tax examination. The SAT urges the local-level tax bureaus to launch a formal Special Tax Adjustment Investigation on the MNC subsidiary in China where the tax avoidance suspicion is obvious. In detail What happened? Earlier this year, in response to the United Nation's (UN) request for comments on intragroup service and management fees, the SAT submitted an official Response1 to express its views and provide two recommendations to be included in the next update of the UN Transfer Pricing Manual. In the Response, the SAT reaffirmed its stance that service fees paid between related parties must be in compliance with the arm’s length principle. In regards to management fees, the SAT stated that these expenses, in general, relate to shareholder activities and shall not be deductible for China corporate income tax (CIT) purposes. It was reported that a senior tax official from the International Taxation Department of the SAT also delivered a strong message at an international conference that China’s tax authorities would vigorously investigate intra-group service charges. According to the news report, the official highlighted some tests that would be applied to determine whether such charges warrant a Special Tax Adjustment, including the (1) benefit test, (2) necessity test, (3) duplication test, (4) value creation test, (5) remuneration test, and (6) authenticity test.2 It appears that this SAT Notice is a follow-up action in accordance with the official positions expressed in the SAT Response as well as the public speech of the senior SAT official in relation to their concerns on the significant outbound payments to overseas related parties. Highlights of the SAT Notice The SAT Notice states that the reasonableness of outbound payments should be assessed based on the purpose test and substance test and lists out certain types of typical suspicious intra-group outbound service payments and royalty payments which deserve www.pwc.com Tax Insights special attention and thus possibly subject to Special Tax Adjustment Investigation. For example, fees paid for certain types of shareholder activities; centralized management of the group; duplicated services which have been compensated via other transactions; royalties paid to a tax haven entity, etc. The suspicious payments highlighted by the SAT Notice echo the SAT’s Response to the UN and this SAT Notice reaffirms the SAT’s increasing focus on intra-group charges. The SAT Notice also reminds the local-level tax bureaus to pay particular focus on payments of such nature to tax havens and low tax jurisdictions. The tax examination should be covering the period from 2004 t0 2013, a ten year span which is the legitimate transfer pricing investigations period. Following the SAT Notice, we are aware that local-level tax bureaus in certain regions have already formulated their own examination plans, starting from information collection from MNC subsidiaries/ service recipients. Some local-level tax bureaus are only collecting information on intra-group service fees and royalty charges exceeding a certain monetary threshold or a certain percentage of the domestic payer’s turnover value, while some other local-level tax bureaus are collecting information on all types of intra-group payments as well as dividends, interests, rentals, etc., without a minimum threshold. Given the huge volume of information to be collected in the examination, the local-level tax bureaus are likely to leverage on various resources (and technology) to screen and analyse these information in order to make the examinations more efficient and focused. 2 Impact on intra-group outbound service fee arrangement Local-level tax bureaus will likely follow the SAT’s position paper on intra-group service and management fees in verifying the authenticity and reasonableness of the intra-group charges. Inevitably, it is increasingly challenging for the MNC’s Chinese local subsidiary to justify the CIT deductibility for some intra-group charges. These Chinese local subsidiaries should prepare sufficient and valid documentation and evidence showing the authenticity of the intragroup charges; be able to justify why the services are needed by the Chinese local subsidiary; illustrate how the benefit is delivered from the perspectives of both the foreign service provider and domestic service recipient; show the value add from the services provided by the foreign service provider; verify that such services are not duplicative activities and neither was remunerated through the transfer pricing policies of other related-party transaction. Some of these items could easily be driven into lengthy debates as they hinge more on subjective judgment. We anticipate that this round of tax examination will likely give rise to many tax controversies between Chinese tax authorities and MNC groups. At first glance, the SAT Notice appears to tackle the CIT deductibility for the Chinese payer/service recipient, but it is not difficult at all for the Chinese tax authorities to expand their examination scope to the taxability issues of the foreign service provider where relevant, for instance, permanent establishment, services rendered onshore or offshore China (and deemed profit rate for services rendered onshore), or the nature should be active labour service vs passive royalty charges, etc. Such challenges initiated in China could result in serious tax consequences to not only local subsidiaries in China, but also headquarters and service providing affiliates in overseas jurisdictions, and may result in double taxation for the group. The takeaway Indeed, it is very obvious that Chinese tax authorities have bolstered their efforts to monitor intra-group outbound service payments and royalty charges. We consider that the following actions are critical in monitoring the tax risks of an MNC’s Chinese local subsidiary’s intra-group outbound payments: As a good starting point, a comprehensive tax health check is necessary to better understand the subsidiary and the group’s current intra-group outbound charges status. Take immediate actions to rectify any issues identified and build up a proper and sustainable structure and system which may involve both the overseas parent company/affiliates and Chinese local subsidiaries. Readiness for a potential tax investigation through proper documentation and adequate justification of intra-group outbound payments. Effective and efficient communication with local-level tax bureaus to proactively understand the purpose and anticipated outcome of the queries and/or investigations, and resolve any potential disagreements as early as possible so as to mitigate the potential risk of serious disputes. Sound ongoing internal tax risk control and update/improve the pwc Tax Insights intra-group outbound charging mechanism to ensure timely and effective tax compliance. In the case of unresolved disputes, proactively take actions and consider the available mutual agreement procedures to resolve the disputes and mitigate double taxation. Finally, based on our experience, we observe that a successful defense case will generally depend largely on the proactive actions taken and seamless cooperation between the headquarters, overseas service provider affiliate, and the Chinese local subsidiary. Endnote 1. 2. The Response submitted by the SAT is available on the United Nation website. Please refer to our PwC Tax Insights – Transfer Pricing issued in April 2014 for details of our observation. “Chinese Tax Auditors Challenging Fees, For Intragroup Services, SAT Officials Says”, Tax Management Transfer Pricing Report 2014, Bloomberg BNA. Let’s talk For a deeper discussion of how this issue might affect your business, please contact: Transfer Pricing and Tax Controversy Spencer Chong, Shanghai +86 21 2323 2580 [email protected] Jeff Yuan, Shanghai +86 21 2323 3495 [email protected] Qisheng Yu, Beijing +86 10 6533 3117 [email protected] Paul Tang, Shanghai +86 21 2323 3756 [email protected] Send Feedback SOLICITATION This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC does do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2014 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details. 3 pwc
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