China: Integrated Regulations on Special Tax Investigation and Adjustment are coming!

Published on April 28, 2017

Following the new transfer pricing (”TP”) reporting requirements (”SAT Public Notice [2016] No.42”) issued by the Chinese State Administration of Taxation (”SAT”) in 2016, the TP legislation in China has recently taken an important step forward. On March 28, 2017, the SAT issued the Public Notice on Administrative Rules for the Special Tax Investigation and Adjustment and Mutual Agreement Procedures (”SAT Public Notice [2017] No.6 – The Public Notice”) in response to the OECD’s BEPS actions and also the effective implementation of double tax treaties, agreements or arrangements that China has signed. The Public Notice will be effective from May 1, 2017. The Public Notice integrates the previous regulations including Guoshuifa [2009] No.2, Guoshuihan [2009] No.363, SAT Public Notice [2014] No.54 and SAT Public Notice [2015] No.16, whose key points are summarized as follows:

Self-Adjustment

The Public Notice regulates that enterprises are entitled to make self-adjustments and pay overdue taxes by themselves if they have received risk warnings on special tax adjustments or if they have discovered their own potential risks in this regard. In this case, enterprises shall fill in the new form of ”Self-payment of Overdue Taxes Regarding Special Tax Adjustment”. Enterprises should notice that even if the self-adjustment was made and overdue tax was paid, tax authorities can still carry out the special tax investigation and adjustment according to relevant regulations. If an enterprise requires tax authorities to confirm its pricing principles and methods for transactions and other issues regarding special tax adjustment, tax authority shall start the procedure of special tax investigation.

Guidance of Special Tax Adjustment Procedures

The special tax investigation and adjustment includes transfer pricing, thin capitalization, foreign controlled enterprises and unreasonable business planning (general anti-tax avoidance).

The Public Notice clarifies the detailed procedures and methods of special tax investigation, the requirement on documents/data, relevant timeline etc.

The Public Notice clarifies the recognized transfer pricing methods which is in accordance to the OECD guideline, including the original 5 methods, i.e. comparable uncontrolled price method (CUP), resale price method (RP), cost plus method (CP), transaction net margin method (TNMM), profit split method (PS), and 3 newly added methods, i.e. cost method, market method and profit method. The value contribution allocation method previously proposed in the draft TP regulation is not adopted.
The Public Notice clarifies the disputing questions in previous TP investigation cases, including:

Tax authorities shall have the right to deem the taxable income for the enterprises that do not provide relevant information on special tax investigation or provide false or incomplete Information.
Regarding the database selection for comparability analysis, tax authorities are committed to use the public database information as priority.
Tax authorities specify the statistical methods of comparable scope. According to the actual situation, enterprises may select the arithmetic average method, weighted average method or quartile method and other statistical methods to calculate the average profit or price or interquartile range of the comparable enterprise for each year or several years respectively. In the course of transfer pricing investigation, tax authorities shall test and adjust the related parties’ transactions of investigated enterprise year by year according to the comparable profit level or price. In addition, the Public Notice still continues the provisions in the previous Guoshuifa [2009] No. 2 that if the actual profit level of enterprises is lower than the median profit margin, in principle, it should be adjusted to the value which is no less than the median.
Capital adjustment is only applicable to processing trade and the adjustment range on profit level cannot exceed 10%.
The Public Notice clarifies that the party with relatively simple functions shall be selected as the tested party in an attempt to tackle the tendency to simply select Chinese enterprises as tested parties.
Regarding the interest penalty, it should be noticed that tax authorities can levy the overdue tax and interest penalty, when enterprises reach the threshold of preparing contemporaneous TP documentation, but fail to provide the documentation to tax authorities according to the regulation.

Others

The Public Notice continues the testing specifications regarding arm’s length of related service transactions stated in the Public Notice [2015] No. 16, which should pass the tests of profitability and rationality. However, there seems to be a slight loose in the relevant wording:

service payments from enterprises ”without business substance” no longer necessarily lead to ”non-deductible before tax”. If the transaction is in accordance with the arm’s length principle, for example, if enterprise without business substance purchases relevant services from service suppliers with business substance and charges relevant cost compensation to the group, the transaction could be accepted by the Chinese authority.

Concerning the intangible assets, the Chinese tax authorities refer to the basic content of OECD’s guidelines and state that an enterprise that only has the ownership of intangible assets and does not contribute to the value of intangible assets should not participate in the allocation of profit generated by the intangible assets. During the formation and use of intangible assets, if an enterprise only provides funds without actually performing the relevant functions or bearing the corresponding risks, it should only get a reasonable return on capital costs. In addition, the Public Notice reiterates that both parties should regularly check whether the value of intangible assets has fundamental changes, which means that enterprises can pay the royalties only if intangible assets bring profits.

Furthermore, the Public Notice clarified the issue whether enterprises with single function should prepare TP documentation even in the case of loss. These enterprises, regardless whether they reach the threshold for preparing the contemporaneous TP documentation or not, should prepare the local TP file for the period in which the loss occurred.

Remedies

For the special tax adjustment performed by tax authorities, taxpayers can adopt following remedies: administrative reconsideration, administrative litigation and mutual agreement procedures. It should be noted that the above mentioned measures are only applicable, when the Chinese tax residents have paid taxes and the fact of double taxation is constituted.

Our Observation

The content of the Public Notice is roughly the same as the OECD guidance and clarifies common disputes in the previous TP investigation. It should be noted that Chinese tax authorities do not accept any capital adjustment except for processing trade, which is not in accordance with OECD’s guidelines and should cause the enterprises’ attention.

The Public Notice reiterates the view of Chinese tax authorities on intangible assets and related service transactions. It both refers to the OECD’s guideline and continues the position of Chinese tax authorities on whether the payments for intangible assets can bring benefits to Chinese enterprises and the Six-Step Test. Therefore, in formulating the relevant transfer pricing strategies, the group should pay close attention to the requirements stated in the Public Notice, for example, whether the related parties’ transactions will lead to the risk characteristics focused by tax authorities, whether the value contribution and taken risks of each parties are fully considered during the pricing, in order to make the tax planning in compliance with the laws.

The Public Notice also clarifies the supervision and administration on enterprises with single function in loss, which was not stated in the Public Notice [2016] No. 42. For enterprises engaging in processing trade or feeding processing trade for overseas related parties or engaging in distribution or contract R&D business in a loss situation, the contemporaneous TP documentation should be timely prepared according to the requirements in order to avoid the interest penalty. Furthermore, if the transaction volume is close to the threshold of preparing TP documentation, enterprise shall check its related parties’ transaction according to the requirements of TP documentation to avoid potential risk of interest penalty.

The Public Notice clarifies the remedies that could be adopted by taxpayers to the special tax adjustment performed by tax authorities, which provides taxpayers a legal basis for further defense after the final adjustment decision is made by the tax authorities. However, the mentioned remedies only apply to the situation that the Chinese tax resident has already paid taxes or the fact of double taxation does exist. This may still be a great economic burden to the taxpayers.