China - response to BEPS

China - response to BEPS

China has been a strong proponent of the implementation of the BEPS outputs, building on the important contributions China made to the formulation of the BEPS 2015 deliverables. As China hosts the G20 and the Forum on Tax Administration in 2016, this year is set to be a crucial one for BEPS implementation in China. A range of new regulations will likely be issued, with major impacts for multinational companies.

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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 announced a series of prospective BEPS-related tax regulation changes encompassing transfer pricing, permanent establishment rules, controlled foreign company rules, and treaty shopping rules. These regulatory changes are augmented by stricter enforcement actions taken by the Chinese tax administration in recent years against perceived aggressive tax planning and close scrutiny of crossborder related-party royalty and service payments.

Comparatively, some of the BEPS Action Plan recommendations will likely have less impact in China due to its regulatory framework, which has limited the incidence of BEPS in somecases. 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, such as in the area of offshore indirect disposal rules.2 These rules are now a central part of 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 steadily in coming years. Emblematic of this development is the G20’s February 2015 announcement that China would establish an international tax policy research center for international tax policy design and research as well as technical assistanceto developing economies.

Integrating BEPS actions in China’s tax law and practice

A number of the 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.

Permanent establishments:

The SAT has stated firm support for Chinese implementation of the BEPS permanent establishment proposals (Action 7):

  • Chinese tax treaties have started to be updated for the BEPS permanent establishment rules (e.g. China-Chile tax treaty signed on May 2015), and the SAT has said it would introduce updated permanent establishment recognition and profit attribution guidance in 2016.
  • An information exchange platform is being set up to help local tax authorities across China to track and target potential permanent establishment enforcement cases. The SAT has indicated that the existing Chinese treaty guidance on permanent establishments³ can be used to support immediate application (i.e. before treaties are updated) of some of the expanded BEPS permanent establishment concepts.

Treaty abuse:

China has started introducing the minimum standards under BEPS Action 6 in its treaties, including the limitation on benefits (LOB) rule and principal purposes test (PPT), starting with the China-Chile tax treaty. To facilitate the use of the PPT to counter treaty shopping, in addition to China’s general anti-avoidance rule (GAAR), China has introduced new procedural rules for accessing treaty relief.⁴ These rules abolish tax authority pre-approvals and provide that withholding agents will apply treaty relief using a concept of beneficial ownership, which is more in line with international practice than the former commercial substance-focused concept.⁵ The tax authorities will then apply follow up procedures and use the LOB, PPT or GAAR as appropriate.

Given the additional potential exposures for withholding agents, and the need for treaty relief claimants to prove reasonable business purposes and absence of tax avoidance purposes, businesses in China are already planning on improving procedures and documentation.

Controlled foreign company rules:

In a forthcoming circular on ‘special tax adjustments’, the SAT will provide extensive clarifications on China’s CFC rules.⁶ The types of income targeted by the rules are described in great detail. The latest draft draws extensively on the BEPS Action 3 recommendations on the design of controlled foreign ‘excess profits’ test. These clarified rules aim to support recently increased enforcement efforts and are underpinned by enhanced controlled foreign company reporting rules.

Other actions:

The SAT has signaled an intent to roll out anti-hybrid mismatch rules (Action2) later in 2016 and continues to examine possible taxation approaches to digital economy businesses (Action 1).

Transfer pricing and creation of value

The SAT’s draft circular on special tax adjustments seeks to leverage 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 reference to the transfer pricing concepts used by China integrated into the updated OECD transfer pricing guidelines.In particular, the Chinese tax authoritiesmake reference in transfer pricing administration to concepts of location specific advantages (LSA) and the contributions of Chinese entities to group intangibles. They leverage theseconcepts to argue for allocating more profits to Chinese group entities.

LSAs 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’sburgeoning consumer classes.

The draft special tax adjustments circular leverages the enhanced BEPS transfer pricing guidance on ‘local market advantages’ (an OECD conceptequivalent to Chinese LSAs) to formalize the LSA concept in Chinese guidance.However, the Chinese tax authorities may push this concept further in practice than anticipated by the OECDand will probably call for transfer pricing comparability adjustments or use of the profit split method based on the circular’s new value contribution allocation method.

The SAT’s draft circular also leverages the new BEPS framework regarding the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles for compensatinggroup members for contributions to intangible asset value creation.

Note, however, that China has adapted the BEPS DEMPE framework to its own circumstances. The draft Chineseguidance adds (local) promotion to the framework. It emphasizes the contribution of manufacturers and marketers to the enhancement of intangible asset value and downplays the importance of high-level strategicplanning and control of intangible asset development.

The draft guidance could thus lead China and other countries to arrive at different conclusions about the relative contributions of international group members to intangibles valuecreation, leading to different profit attributions and potential double taxation. China’s position on intangible assets broadens the circumstancesin which China may push for transfer pricing comparability adjustments and profit splits and seek to deny deductions for outbound payments for licensed intellectual property.

Regarding intragroup payments, the special tax adjustments circular takes a strict stance on the deductibility of outbound related-party service payments, particularly where suchpayments are made to deemed ‘low function entities’. The harsh enforcement trend that emerged in this area in 2014 and 2015 continues.

Transfer pricing documentation is set to be radically overhauled under the new circular to support these efforts, replicating the BEPS Action 13 local file, master file, country-by-countrydocumentation and reporting structure.The existing Chinese thresholds for contemporaneous transfer pricing documentation are also set to be adjusted. Pending the finalization ofthe special tax adjustments circular, the final content of the local file and documentation thresholds are still to be confirmed.

In view of the above, international companies have been re-evaluating the sustainability of their traditional Chinese transfer pricing positions.This is particularly true for companieswith operations that have been rewarded on a limited-risk, cost-plus basis but which could arguably earn a higher return on the basis of the LSA and China intangibles contributionsconcepts (e.g. R&D facilities, marketing and distribution functions).Extensive functional and value chain analysis, together with detailed review of the quality of transfer pricingdocumentation, are vital steps for preemptively managing tax risk going forward.

 

Footnotes

³See SAT Circular [2010] No.75.

⁴See SAT Announcement [2015] No.60.

⁵See SAT Circular [2009] No.601.

⁶See SAT Public Consultation Draft of a Circular on
Implementation Measures for Special Tax Adjustments, issued on 17 September
2015.

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