China has been a strong proponent of BEPS implementation, driving forward the BEPS rollout by, among other things, hosting meetings of the G20 and the Forum on Tax Administration in 2016. China has updated its transfer pricing rules and documentation in line with the BEPS deliverables and used the Multilateral Instrument to update its tax treaties. Later in 2017 and in 2018, China is set to issue a series of new regulations, with major effects for multinational companies.
China’s President Xi Jinping set the pace for China’s BEPS implementation efforts when, addressing the 2014 G20 Leaders’ Summit, he pledged China’s support for global cooperation on tax reform. Since then, the Chinese State Administration of Taxation (SAT) has assertively pushed forward on BEPS transfer pricing and treaty updates. These regulatory changes are augmented by stricter enforcement actions taken by the Chinese tax administration in recent years against perceived aggressive tax planning and closer scrutiny of cross-border related-party royalty and service payments.
Comparatively, some of the BEPS deliverables have less resonance for China due to its regulatory framework, which has limited the incidence of BEPS in some cases. For example, capital controls and foreign exchange controls curtail the use of hybrid instruments and debt planning. In other areas, China has been at the forefront in adopting anti-base erosion initiatives beyond the initial BEPS program, for example, on offshore indirect disposal rules. These rules are now central to the OECD BEPS follow-up work for developing countries.
Looking ahead, China’s extensive involvement in global tax thought leadership and policymaking is set to grow in coming years. China is a member of the Steering Group for the BEPS Inclusive Framework, has announced the establishment of an international tax policy research center for international tax policy design and research, and is investing substantial resources in providing tax technical assistance to developing economies, particularly countries covered by China’s Belt and Road economic strategy.
Several key BEPS-relevant tax regulation announcements and enforcement developments are detailed below, followed by a fuller consideration of the upcoming revised Chinese transfer pricing guidance.
The SAT Announcement on Special Tax Investigations, Adjustments and Mutual Agreement Procedures (’Announcement 6’), issued on 28 March 2017, leverages the BEPS transfer pricing work (Actions 8–10, 13) to support China’s existing approach to transfer pricing. Indeed, the SAT’s efforts were influential in having China’s transfer pricing concepts referred to and integrated in the updated OECD transfer pricing guidelines.
In particular, the Chinese tax authorities use the concepts of location-specific advantages and the contributions of Chinese entities to group intangibles as a basis to argue for allocating more profits to Chinese group entities. Such advantages include cost savings, which are considered to arise from low-cost China production, and market premium, which is considered to arise to foreign businesses selling to China’s burgeoning consumer classes at potentially higher prices than they could charge elsewhere.
Announcement 6 leverages the enhanced BEPS transfer pricing guidance on ‘local market advantages’ (an equivalent OECD concept) to formalize the concept of location-specific advantages in Chinese guidance. In practice, however, the Chinese tax authorities could push this concept further than the OECD intended by calling for transfer pricing comparability adjustments or the use of profit split methods.
Announcement 6 also leverages the BEPS framework on the development, enhancement, maintenance, protection and exploitation of intangibles for compensating group members for contributions to intangible asset value creation. China has adapted the BEPS intangibles framework to its own circumstances, adding (local) promotion. China emphasizes the contribution of manufacturers and marketers to the enhancement of intangible asset value and downplays the importance of high-level strategic planning and control of intangible asset development. Further, the new BEP transfer pricing guidance on risk and ‘delineation of the transaction’ was only integrated into Announcement 6 to a limited extent.
Announcement 6 could thus lead China and other countries to arrive at different conclusions about the relative contributions of international group members to intangibles value creation, leading to different profit attributions and potential double taxation. China’s position on intangible assets broadens the circumstances in which China may push for transfer pricing comparability adjustments and profit splits and seek to deny deductions for outbound payments for licensed intellectual property.
Announcement 6 takes a strict stance on the deductibility of outbound related-party royalty and service payments, with royalty deductions particularly under pressure where such payments are made to deemed ‘low-substance entities’. The harsh enforcement trend that has emerged in this area since 2014 continues.
Transfer pricing documentation was radically overhauled under SAT Announcement 42, issued in July 2016, which replicates the BEPS Action 13 local file, master file and CbyC documentation and reporting structure.
In light of the above, international companies are reevaluating the sustainability of their traditional Chinese transfer pricing positions. This is particularly urgent for companies with operations that have been rewarded on a limited-risk, cost-plus basis but that could arguably earn a higher return based on the concepts of location-specific advantages and China intangibles contributions (e.g. research and development (R&D) facilities, marketing and distribution functions). Extensive functional and value chain analyses, together with detailed review of the quality of transfer pricing documentation, are vital steps for preemptively managing tax risk going forward.