China Tax Center. China Tax & Investment Express. Tax circulars

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1 Issue No July 2015 China Tax Center China Tax & Investment Express (CTIE) * brings you the latest tax and business announcements on a weekly basis. CTIE provides a synopsis of each announcement including a weblink that leads you to the full content of the announcement (in Chinese). Please feel free to contact your Ernst & Young client service professionals for further assistance if you find the announcements have an impact on your business operations. This CTIE does not replace our China Tax & Investment News* which will continue to be prepared and distributed to provide more in-depth analyses of tax and business developments in China. * If you wish to access these previous issues of CTIE and China Tax & Investment News, please contact us. Tax circulars Zhejiang State Tax Bureau released the Guideline for Tax Risk Management of Fees paid to Overseas Related Parties (Please note that we generally do not cover local authorities circulars but we are covering this due to its potential relevance to entities throughout China) Synopsis Further to Guoshuifa [2009] No. 2 ( Circular 2, i.e., Implementation Measures for Special Tax Adjustments) and SAT Announcement [2015] No. 16 ( Announcement 16, i.e., Notice regarding Corporate Income Tax (CIT) issues related to fees paid to overseas related parties) as well as the relevant achievements of the Organization for Economic Co-operation and Development (OECD)/G20 Base Erosion and Profit Shifting (BEPS) project, Zhejiang State Tax Bureau (STB) released the Guideline for Tax Risk Management of Fees paid to Overseas Related Parties (hereinafter referred to as the Guideline ) on 30 June (Please refer to Transfer Pricing Update Issues , , , International Tax and the Transaction Tax Bulletin released in June 2009, CTIE and the Transfer Pricing Update released in March 2015 for details of Circular 2 and Announcement 16.) Although the Guideline was released to guide the implementation of rules for tax authorities in Zhejiang, it has laid out a detailed interpretation of Announcement 16 in a rather comprehensive way which may indicate the general view of tax authorities and may bring value to all taxpayers involved with cross-border payments to related parties. We recommend taxpayers take into consideration the messages in this circular to avoid potential challenges from tax authorities.

2 Key contents of the Guideline are as follows: Examples of non-deductible cross-border service fees and royalty fees to overseas related parties (hereinafter referred to as the cross-border payments ) The Guideline summaries and sets out the following examples of non-deductible cross-border payments as prescribed in Announcement 16 (including but not limited to service fees and royalties) to overseas related parties: Non-deductible cross-border payments as prescribed in Announcement 16 Examples made in the Guideline Cross-border payments with no business substance Cross-border payments that could not produce direct or indirect economic benefits to the domestic enterprise A domestic enterprise and its overseas related party enter into a service contract or royalty contract, but the overseas related party has not performed any functions, undertaken any risks, nor engaged in any substantial operation. Under which, the overseas related party was established in a tax haven (especially if it has no assets, substantial operation, business premises or local employees and is paying low taxes or enjoying tax exemption), or has no capacity to either perform the relevant functions or undertake any relevant risks. The domestic enterprise pays fees to its overseas related parties for intangible assets that have no value or the value should have already been fully amortized. The domestic enterprise pays fees for services not related to its functions, risks and operations: A group company provides services unrelated or less related to the functions of the domestic enterprise in exchange of high service income through a service fee sharing arrangement among its global subsidiaries. The head office listed overseas shares its costs of road show, maintenance of investor relationships and the building up of the company s image to the domestic enterprise. Service fees for activities that the domestic enterprise has already performed by itself or purchased from third parties: The domestic enterprise has purchased the service from third parties. The domestic enterprise has the capacity to perform the service itself but still pays the relevant service fees to its overseas related parties. Services have been compensated as part of other related party transactions: The domestic enterprise has paid the relevant fees to its overseas related party when purchasing certain equipment but has still paid additional fees for installation and training (especially installation/training charges for low tech equipment). 2

3 Non-deductible cross-border payments as prescribed in Announcement 16 Examples made in the Guideline Cross-border payments that could not produce direct or indirect economic benefits to the domestic enterprise (Cont d) Royalty fees paid for technology or brand already owned by the domestic enterprise: The domestic enterprise with a capacity for research & development (R&D, especially High-and-New Technology Enterprise) has spent significant financial and human capital in the development of certain technology, patent and brand with relevant intangible assets created (especially localized intangible assets), but still pays royalties to its overseas related parties. The domestic company pays royalty fees to its overseas related parties for an expired patent where the technology can be obtained in an opened channel. Other service fees or royalty fees that could not produce direct or indirect economic benefits to the domestic enterprise: The domestic enterprise is established with sound operation but its profitability has been decreased due to a significant amount of overseas service/royalty charges not related to its business operation or not relevant to its income generation. The domestic enterprise is undertaking a single function (e.g., contract manufacturer) and the value of technology attached to its products has been excluded in the pricing of the buy-sell transactions with its overseas related party but still pays significant royalty fees. Unnecessary cross-border payments related to incidental benefits to the domestic enterprises All products of the domestic enterprise are sold to its overseas related parties. The domestic enterprise does not undertake market functions but pays its overseas related parties royalty fees for the trademark. No specific services were provided by the overseas related parties even though the domestic enterprise may have obtained additional benefits due to the affiliations with the multinational group: The domestic enterprise may have obtained additional benefits through the centralized procurement, internal information system, centralized administration and enhanced borrowing power, etc. and pay service fees for little or no services provided by the head office or its overseas related parties. A related party within the group has received specific services that have incidental or contingent effects on the other related companies (including the domestic enterprise). Payments are made to secure the investment interests of the investors: For the purposes of control, administration and monitoring, the group company shares services that are supposed to be conducted at the investors/group level (e.g., internal audit) to the subsidiaries. The group company charges administration fees or service fees to its subsidiaries for internal administration. 3

4 Non-deductible cross-border payments as prescribed in Announcement 16 Examples made in the Guideline Unnecessary cross-border payments related to incidental benefits to the domestic enterprises (Cont d) Cross-border payments exceeding services fees that could be incurred if the services were provided by independent third parties Royalty fees are paid for affiliated interests due to overseas listing of the related parties: The overseas listed company charges royalty fees (especially for brand licensing fees) to the domestic company for its brand effects or social influences. Unreasonable amounts of service fees are paid to overseas related parties: The service fee charged to the domestic enterprise has a higher mark-up ratio compared with independent third parties. The service fee charged to the domestic enterprise is based on a fixed ratio to its sales amount; however, the actual cost of the domestic enterprise is fixed. Unreasonable amount of royalty fees are paid to overseas related parties: The domestic enterprise has spent a substantial amount of R&D expenses during the development of the patent or the technology but still pays a significant amount of licensing fee to its overseas related party. The domestic enterprise has spent a substantial amount of marketing fees on development of the localized brand but still pays a significant amount of brand licensing fees to its overseas related party. The domestic enterprise and its overseas related parties jointly work in the development of intangible assets and the domestic enterprise contributes by undertaking major functions and risks while major costs are allocated to the domestic enterprise, but the domestic enterprise still pays a significant amount of brand licensing fees to its overseas related parties. The domestic enterprise pays royalty fees, which are higher than those of independent third parties, for the right to use certain technology to its overseas related party. Interest payments are made to overseas related parties with unreasonable interest rates or debt structures: The domestic enterprise pays interest for loans borrowed from its overseas related parties with interest rates higher than the market rates. The debt investment of the domestic enterprise exceeds the thin capitalization rule and the reasonableness of the capital structure and interest charge cannot be substantiated. 4

5 High risk planning The Guideline also illustrates the following high risk planning to avoid tax obligations of non-residents: Misleading information about the location of services performed While the actual services were performed in China, the taxpayer claims that the services were performed outside of China as they were provided through the internet (and the servers are located outside of China); or the contracts state that the services are to be performed outside of China. Royalties disguised as services performed outside of China The taxpayer may state various types of service items (e.g., consultation, training, commission) instead of royalties in the contracts or claim royalties as technology services. Avoiding being seen as having constituted a permanent establishment (PE) The taxpayer may cut a single service contract into pieces in order to avoid being seen as constituting a PE. Offset service fees and royalty fees in other transactions The domestic enterprise accepts services or licenses provided by its overseas related parties and offset the relevant charges through purchase and sales transactions with its overseas related parties in order to avoid the record filing obligation for overseas payments and tax obligation of non-residents. Testing methods The Guideline specifies the following testing methods that tax authorities in Zhejiang could adopt to assess the tax considerations of payments to overseas related parties: Authenticity test The tax authorities shall examine whether the documentation submitted by the domestic enterprises is in line with their actual business operations. On-site investigations may be performed to confirm whether genuine services are being performed and whether the values of the intangible assets exist. The tax authorities should ensure that the overseas related parties have undertaken the relevant functions/risks and have actual business operations. Overseas related parties in tax havens shall be closely monitored. Payments to overseas related parties without substances shall be disallowed. Necessity test The tax authorities shall examine and test whether the services/technologies/brands that the domestic enterprises are paying for are in line with the needs of their business operations. Irrelevant expenses shall be disallowed. Benefit test The tax authorities shall examine and test whether the payments match with the economic benefits brought to the domestic enterprise. Payments exceeding the fees that may be incurred if the services were performed by independent third parties will be disallowed. Where the domestic enterprise only obtains incidental benefits due to its affiliation with the multinational group, such payments are considered unnecessary. Where overseas related parties provide certain services other than the incidental benefits, only the payments related to genuine services are acceptable. 5

6 Value creation test Value creation test for the developer The tax authorities shall examine the contribution to the development of intangible assets that the royalty fees the domestic enterprise pays for. Where the intangible assets were developed within China and the overseas related parties merely own the legal rights of the relevant intangible assets without contribution to value creation, the payments of royalty fees shall be considered unnecessary. Where the intangible assets were jointly developed with related parties, tax authorities shall test the contributions made by each related party during the creation of intangible assets to define the proper royalty fees to be paid. Where the intangible assets existed and were owned by overseas related parties, the tax authorities should consider the contributions made by the domestic enterprises, such as improvement of the intangible assets, to determine the proper royalty fees to be paid. Value creation test based on the place of creation Where overseas related parties charge service fees to the domestic enterprises, the tax authorities should define the actual places where the services were performed, in order to determine whether China has the taxing right. Duplication test The tax authorities shall examine the relevant contracts and the actual performance of the services to determine whether the domestic enterprises make duplicate payments to the same services/technology. Remuneration test Remuneration test on costs The tax authorities shall examine the relevant contracts and documents to test the service costs incurred in order to determine whether the service fees paid to the overseas related parties match their costs of services. Remuneration test on offsetting transactions The tax authorities shall examine whether there are related party transactions other than services/royalty transactions and determine whether certain payments were offset and whether the overseas related parties have already received the payments through transfer pricing or other channels. Zhejiang tax authorities approaches To strengthen the tax administration of payments to overseas related parties, Zhejiang tax authorities shall adopt the following approaches to mitigate the relevant tax risks: Encourage domestic enterprises to report on a voluntary basis Domestic enterprises that made payments to overseas related parties are required to complete the report form for related party transactions during the annual CIT filing and provide the relevant contracts and record filing forms as prescribed in SAT/SAFE Announcement [2013] No. 40 ( Announcement 40, i.e., Notice regarding certain issues related to the documentation filing with tax authorities for foreign exchange payment under service trade items). (Please refer to CITE for details of Announcement 40.) Zhejiang tax authorities shall enhance the level of examination work for record filings and may require taxpayers to submit additional documents if in doubt. Taxpayers may perform self-assessments and provide additional supporting documents during the record filing for significant amount of payment. Enhance tax risk screening processes Zhejiang tax authorities shall enhance tax risk screening processes based on their database and analyze relevant payments and the profitability of enterprises. Taxpayers with negative association between payment and profitability shall be closely monitored. 6

7 Strengthen anti-tax-avoidance Zhejiang tax authorities shall actively fight tax avoidance from payments to overseas related parties and at the same time, take an active role in consideration of application for advance pricing arrangements. Improve the cooperation scheme between the tax authorities and other government authorities to enhance supervision for payments to overseas related parties Zhejiang state/local tax authorities, administration bureaus for foreign exchange, administration bureaus for industry and commerce, customs, etc. shall strengthen the information sharing and the cooperation schemes to enhance the overall supervision for payments to overseas related parties. Furthermore, Zhejiang tax authorities will work with overseas tax authorities and tax agents to obtain information and encourage tax compliance. In addition, the Guideline attaches the relevant sample documents for the payments to overseas related parties. Those are also good references for taxpayers. Our observations Upon the issuance of Announcement 16, there has been controversy and doubt as to how to interpret the nondeductible cross-border payments as prescribed in Announcement 16, which put a lot of pressures on taxpayers when performing self-assessments and analyzing their tax risks. The Guideline released by Zhejiang State Tax Bureau is the first local implementation rule released in this regard. The following is worth noting: The Guideline provides comprehensive examples to illustrate the non-deductible cross-border payments. This presents a clearer picture for the taxpayers. In addition, the Guideline also summarizes certain ways of planning that would be challenged by the tax authorities. In this respect, taxpayers could pay special attention to and take proper precautions. On top of the benefit test as introduced in the Announcement 16, the Guideline further introduces the authenticity test, necessity test, value creation test, duplication test and remuneration test which shall be adopted by Zhejiang tax authorities in the examination and testing of tax risks for cross-border payments. These are all very concrete tests that a taxpayer can also adopt on self-assessment. (Note: The aforementioned six test methods were formerly introduced by State Administration of Taxation (SAT) in 2014 in a commentary letter submitted to the United Nations.) The Zhejiang government urges the tax authorities to enhance tax administration through cooperation with other government authorities, overseas tax authorities and tax agencies. In other words, the tax authorities would seek help from outside sources and taxpayers would have a higher detection risk. The sample document attached to the Guideline covers the main content of the transfer pricing documentation as prescribed in Circular 2. This states that taxpayers should pay close attention to the the transactions for cross-border payments, i.e., item 3 of the sample document, which is marked as the most important information. According to the streamline administration called by the State Council, the SAT has removed certain approval requirements, such as the approval requirement for cost allocation agreements and the requirement of obtaining tax clearance certificate for overseas remittance. Although the aim of removing the approval requirements is to simplify the tax administration procedures, it also leaves taxpayers with uncertainties as they would not receive formal approvals or confirmations from tax authorities. For instance, the determination of deductibility of cross-border payments based on the high level stipulations in Announcement 16 may be very judgmental. The examples provided in the Guideline would be a very helpful reference for taxpayers to perform self-examination. Even though the Guideline was released on a local basis and may not be adopted by tax authorities in other provinces, it would still serve as a good reference for general taxpayers so that they can be more prepared to face challenges from their supervising tax authorities. Taxpayers in Zhejiang and other locations are advised to study the Guideline and actively communicate with tax professionals if in doubt. We shall keep you posted for any further developments. You can click this link to access the full content of the Guideline: You can click this link to access the full content of Announcement 16: 7

8 You can click this link to access the full content of Circular 2: You can click this link to access the full content of Announcement 40: Notice regarding Value-Added Tax (VAT) policies related to space launch (Caishui [2015] No. 66) Synopsis To cope with the prevailing VAT policies for space transportation services, the Ministry of Finance (MOF) and the SAT jointly released Caishui [2015] No. 66 ( Circular 66 ) on 15 June 2015 to specify the following VAT policies for space launch: Space transportation services provided by domestic entities shall be subject to VAT at zero rate and VAT Exemption, Refund ( ER ) policy. This states that space transportation services provided by domestic entities shall be exempt from VAT while the input VAT incurred for the purchase of space vehicle and relevant goods as well as supporting services listed in Circular 66 for the space launch shall be refundable. Delivery of spacecraft and relevant goods as listed in Circular 66 on the expected track after the space launch by domestic entities shall be applicable for the ER policy. Circular 66 also prescribes the relevant formulae and application procedures for the VAT refund. Circular 66 took retroactive effective from 1 January However, the tax refund for delivery to the expected track in 2013 as indicated in the relevant contracts may also refer to Circular 66. You can click this link to access the full content of Circular 66: Notice regarding certain issues related to the pilot run of electronic VAT invoices via the upgraded VAT invoice system (Shuizonghan [2015] No. 373) Synopsis To cope with the current development needs, the SAT released Shuizonghan [2015] No. 373 ( Circular 373 ) on 9 July 2015 to launch the pilot run of electronic VAT invoices via the upgraded VAT invoice system in Beijing, Shanghai, Zhejiang and Shenzhen (hereinafter referred to as the pilot areas ) from 1 August According to Circular 373, with the upgraded VAT invoice system, the taxpayers shall be able to issue electronic general VAT invoices (a sample of the electronic VAT invoice is attached in Circular 373). VAT taxpayers in the pilot areas shall have their VAT invoice system upgraded before 1 August The use of the electronic general VAT invoices and VAT invoice system shall be expanded nationwide upon the completion of the pilot run. You can click this link to access the full content of Circular 373: Business circular Notice regarding the commencement of joint annual reporting for foreign investment enterprises (FIEs) in 2015 (Shangzihan [2015] No. 366) Synopsis On 13 July 2015, the MOF, SAT, Ministry of Commerce and National Bureau of Statistics jointly released Shangzihan [2015] No. 366 ( Circular 366 ) for the commencement of joint annual reporting for FIEs in

9 According to Circular 366, from 16 July 2015 to 15 October 2015, FIEs with legal entity status established in China (except for FIEs established in 2015) are required to login the National System for Online Annual Reporting and Information Sharing for Investment and Business Operation of FIEs ( 全国外商投资企业年度投资经营信息网上联合报告及共享系统 ) via to complete the annual reporting for investment and business operation for year Relevant information reported by FIEs shall be opened to the public according to the Interim Regulations on Enterprise Information Publicity (hereinafter referred to as Regulations ) released through State Council Order [2014] No You may click this link to access full content of Circular 366: You may click this link to access full content of the Regulations: Customs circular Notice regarding the implementation of zero tariff treatment for certain goods under the Closer Economic Partnership Arrangement (CEPA) in the second half of year 2015 (Shuiweihui [2015] No. 8) Synopsis According to the Mainland and Hong Kong/Macau CEPA as well as the relevant Supplements, the Customs Tariff Commission of the State Council released Shuiweihui [2015] No. 8 ( Circular 8 ) on 28 June 2015 to announce the implementation of zero tariff treatment for three types of Hong Kong origin products and four types of Macau origin products from 1 July Detailed lists of the products and the corresponding HS codes are prescribed in the attachments of Circular 8. You can click this link to access the full content of Circular 8: Other business and tax related circulars recently announced by central government authorities: Notice regarding Business Tax preferential policies for agriculture-related loans for the rural finance division of Agricultural Bank of China (Caishui [2015] No. 67) Notice regarding the modification of the Administrative Measures for Licensing of Courier Service Operations (MOT Order [2015] No. 15) Notice regarding the public opinion consultation on the Decision on the Cessation of Certain Regulations related to the Guiding Catalogs of Industrial Structure Adjustment (Discussion Draft) 9

10 Contact us For more information, please contact your usual EY contact or one of the following of EY s China tax leaders. Office Tax Leaders Martin Ngai (Beijing) martin.ngai@cn.ey.com Fisher Tian (Tianjin) fisher.tian@cn.ey.com Samuel Yan (Dalian/Shenyang) samuel.yan@cn.ey.com Lucy Wang (Qingdao) lucy-c.wang@cn.ey.com Joanne Su (Xi an) joanne.su@cn.ey.com Vickie Tan (Shanghai) vickie.tan@cn.ey.com Raymond Zhu (Wuhan) raymond.zhu@cn.ey.com Audrie Xia (Suzhou) audrie.xia@cn.ey.com Andrew Chen (Nanjing) andrew-jp.chen@cn.ey.com Patricia Xia (Hangzhou) patricia.xia@cn.ey.com Chuan Shi (Chengdu) chuan.shi@cn.ey.com Clement Yuen (Shenzhen) clement.yuen@cn.ey.com Rio Chan (Guangzhou/Changsha) rio.chan@cn.ey.com Jean Li (Xiamen) jean-n.li@cn.ey.com Tracy Ho (Hong Kong) tracy.ho@hk.ey.com Heidi Liu (Taipei) heidi.liu@tw.ey.com Service Line Tax Leaders Andrew Choy (International Tax & Transfer Pricing) andrew.choy@cn.ey.com Paul Wen (Human Capital) paul.wen@hk.ey.com Kenneth Leung (Indirect Tax) kenneth.leung@cn.ey.com Becky Lai (Tax Policy) becky.lai@hk.ey.com David Chan (Transaction Tax) david.chan@hk.ey.com Samuel Yan (Global Compliance & Reporting) samuel.yan@cn.ey.com Sector Leaders Henry Chan (Financial Services) henry.chan@cn.ey.com Alan Lan (Energy & Resources) alan.lan@cn.ey.com Martin Ngai (Technology, Media, Telecommunications) martin.ngai@cn.ey.com Vickie Tan (Life Science) vickie.tan@cn.ey.com Gary Chan (Real Estate) gary.chan@cn.ey.com Audrie Xia (Consumer Products) audrie.xia@cn.ey.com Walter Tong (Automotive & Transportation) walter.tong@cn.ey.com Raymond Zhu (Government& Public Sector) raymond.zhu@cn.ey.com Greater China Tax Leader Walter Tong walter.tong@cn.ey.com Author China Tax Center Jane Hui jane.hui@hk.ey.com 10

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