Transfer Pricing Updates and Challenges in Southern China

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1 Presented by : Rhett Liu, PricewaterhouseCoopers, Transfer pricing partner Philip Hung, PricewaterhouseCoopers, Tax Director Date: 9 October 2013 Transfer Pricing Updates and Challenges in Southern China Webinar on 9 October 2013

2 Disclaimer The materials of this seminar / workshop / conference are intended to provide general information and guidance on the subject concerned. Examples and other materials in this seminar / workshop / conference are only for illustrative purposes and should not be relied upon for technical answers. The Hong Kong Institute of Certified Public Accountants (The Institute), the speaker(s) and the firm(s) that the speaker(s) is representing take no responsibility for any errors or omissions in, or for the loss incurred by individuals or companies due to the use of, the materials of this seminar / workshop / conference. No claims, action or legal proceedings in connection with this seminar/workshop/conference brought by any individuals or companies having reference to the materials on this seminar / workshop / conference will be entertained by the Institute, the speaker(s) and the firm(s) that the speaker(s) is representing.

3 Today s presenters Rhett Liu Partner Transfer Pricing PwC Hong Kong rhett.k.liu@hk.pwc.com Philip Hung Director Tax Investigation PwC Hong Kong philip.t.hung@hk.pwc.com

4 Section 1 Latest Transfer Pricing Environment in China

5 TP development trends and focus in China - The SAT s balanced approach on transfer pricing Administration Contemporaneous Transfer Pricing Documentation Related-party transactions disclosure requirements Valuation methods Indirect tax implications International collaboration Additional tax liability of RMB 7.2 billion (equivalent to USD 1.1 billion) in 2010, and RMB 20.8 billion (equivalent to USD 3.3 billion) in 2011 Service APA /BAPA MAP / competent authority negotiation Additional TP adjustment of RMB 796 million (equivalent to USD 126 million) in 2010, and RMB 700 million (equivalent to USD 111 million) in 2011 Investigation Further improve the anti-tax avoidance monitoring system Joint audit Panel Total tax adjustment of RMB 2.3 billion (equivalent to USD 365 million) in 2010, and RMB 2.4 billion (equivalent to USD 380 million) in 2011

6 Transfer Pricing Documentation Frequently demanded by tax authorities nowadays Historical Situation Random selection of taxpayers and a longer time frame. TPD containing general factual details may be accepted in the past. Wait and See approach to preparing TPD may have worked for some taxpayers. Moderate to high risk of queries from tax authorities. Generalisations on technical aspects of TP analysis may be accepted in the past. TPD review process less systematic. Current Situation Tax authorities explicitly request TPD earlier across a larger sample of taxpayers. In some provinces, all taxpayers are selected. More disclosure and specific factual details are required in the TPD. Reactive strategy no longer viable. Taxpayers need to be proactive with TPD. High risk of queries from tax authorities. Higher quality of TPD required regarding technical TP analysis. Tax authorities note differences between local CPAs and Big 4. Systematic TPD review using balanced scorecard approach.

Trend Formal Audit: Substantial resource and time cost burden to the tax authority Self adjustment: SAT and municipal level tax authority encourage lower level tax authority to be more proactive in

7 Self adjustment Legal basis Guoshuifa [2009]No. 2 Guoshuifa [2012]No.13 Make adjustment to the median value of the benchmarked interquartile range Tax authority encourages taxpayer to make self adjustment to rectify TP problem in accordance with China regulation. Trend Formal Audit: Substantial resource and time cost burden to the tax authority Self adjustment: SAT and municipal level tax authority encourage lower level tax authority to be more proactive in driving self adjustment scheme Potentially unfavourable factor Rigid standard: May only consider median value, without taking into account of the specific fact and circumstances of each case Local resources: Lower level tax authority may lack experience in dealing with TP dispute Double taxation: A result of voluntary tax Formal audit risk: cannot rule out the possibility that an audit will happen in future even taxpayer had turn itself in making a self adjustment

8 TP development trends and focus in China APA China has concluded BAPAs with Japan, Korea, USA, Demark and Singapore and has BAPAs in the pipeline with Switzerland and other key regional jurisdictions. Now that the APA process is better established, taxpayers and SAT will probably continue to pursue more and more APA applications. However, due to the complexities and costs involved in the process change, it will not be too rapid but step-by-step. Continued increase in BAPAs while unilateral APAs will slow or even decline. PwC has assisted in most of the BAPAs that China has concluded as of 2010 and as of June Comparable uncontrolled Price Method As of 2010 As of June 2012 Total # of BAPAs concluded by China # of BAPAs assisted by Number of APAs Signed by Year Year Unilateral APAs Bilateral APAs Multilateral APAs Total Resale Price method TP methods applied in APAs signed between Cost Plus method TNMM Full Cost Mark-up TNMM Return on Capital Employed TNMM Return on Sales TNMM Berry Ratio Profit Split method PwC DTT KPMG EY 0 0 Other 0 1 Other Note: the total #of BAPAs as of 2010 is officially published; the # as of June 30, 2012 as well as the advisors are PwC estimates and not published. The number assisted by PwC is listed as a range to maintain propriety of the information.

9 APA in China Signed bilateral APAs by regions of counterparty * North 14% Concluded bilateral APAs with Japan, Korea, USA, Demark and Singapore and has bilateral APAs in the pipeline with Switzerland and other key regional jurisdictions. Euro 17% Asia 69% SAT may pursue APAs with additional trading partners or for diverse new types of transactions shifting from manufacturing and buy-sell to intangible asset transfers and services. Latest issued APA Report on Aug 2013 Case Number of APA signed* Unilateral APA Bilateral APA * As of December 31, 2012 Source: China Advanced Pricing Arrangement Annual Report 2012

10 TP investigation trends in China TP Investigation in China ( ) The SAT plans to further improve the anti-tax avoidance monitoring system through: Case closed Total Adjustments (RMB million) Emphasis on the equal importance of administration, service and investigation, creating anti-avoidance prevention and control system Expanding focus into: Enterprises extending to domestic enterprises, especially going-out enterprises Industries extending to financial services, trading, and other services industries Transactions extending to transfers of equities or intangibles and financial arrangements between related parties Locations extending to Central and Western China; and Measures extending to cost sharing agreements, controlled foreign companies, thin capitalization, and general antiavoidance Improving human resources and accumulating expertise Promote the use of analytical methods and establish a panel of economic experts Develop regional industry expertise Increasing international activities

11 Section 2 Latest Transfer Pricing Environment in Hong Kong

12 Transfer pricing trends in Hong Kong DIPN 48 (APA) issued on 29 March 2012 Treaty network continues to expand IRD increasing resources staff and training Increase in queries on intercompany transactions

13 Developments of Hong Kong s CDTA network Belgium Thailand Luxembourg Vietnam Mainland Dec 2008 July 2013 Brunei UK Portugal Malaysia Netherlands Ireland Spain Mexico Indonesia Liechtenstein Czech Rep. Canada Hungary France Switzerland Italy Kuwait Japan Malta Guernsey Austria New Zealand Jersey Qatar

14 Statistics results of the field audit & investigations in Hong Kong Results 2005/ / / / / / / /13 No. of cases completed Understated earnings and profits (HK$ million) 1,873 1,875 1,864 1,862 1,803 1,805 1,804 1,802 10, , , , , , , ,348.0 Average understatement per case (HK$ million) Back tax and penalties assessed (HK$ million) 2, , , , , , , ,

15 Statistics results of the field audit on tax avoidance cases in Hong Kong Results 2005/ / / / / / / /13 No. of cases completed Understated earnings and profits (HK$ million) Average understatement per case (HK$ million) , , , , , , , , Back tax and penalties assessed (HK$ million) , , , ,523.8

16 Examples of situations that may be queried by IRD or overseas tax authorities Pays royalties overseas but has A&P activity in HK or HK brand No intercompany agreements / No TP documentation Significant services fees or royalty fees Procurement Hub in HK Retail and technology company (intangibles, BEPS, LSAs in China) Group structures resulting in double non-taxation (i.e. HK offshore) Low tax jurisdictions / HK has profits but no clear reason for HK entity or lack of substance for HK entity Potential reference to China practice Loss Profit fluctuation Transaction with tax haven company

17 Tax Investigations and Field Audit in Hong Kong - Key TP Investigation focus TP related issues are likely to be challenged by the IRD under the anti-avoidance provisions Economic substance Sound transfer pricing policy Documentation evidence TP could be regarded as a tool for tax avoidance or evasion instead of a bona fide business issue in the commercial world Methodology as settlement basis Contract processing case Continuous loss for HK subsidiary of MNC

18 Hong Kong launched APA in April 2012 DIPN 45 DIPN 46 DIPN 47 DIPN 48 Increased resources April 2009 Decembe r 2009 June IRD

19 Latest APA development in Hong Kong Programme Highlights On 29 March 2012,the Inland Revenue Department ( IRD ) took an important step forward by formalizing the Advance Pricing Arrangement ( APA ) programme in Hong Kong and issued Departmental Interpretation and Practice Notes Number 48 Advance Pricing Arrangement (DIPN48). APA is appropriate for: Noteworthy aspects of guidance on the APA framework: Relatively large, complex or controversial related party transactions The APA programme is open to all resident and non-resident enterprises with a permanent establishment in Hong Kong that are subject to profits tax and have related party transactions pertinent to Hong Kong. Related party transactions in countries that frequently challenge transfer pricing The APA will not agree precisely the actual profit but stipulate the methodology to determine the transfer pricing Requiring particularly high levels of certainty, for example business restructuring, IPO or M&A related situations. Process: Pre-filing Formal application Analysis and evaluation Negotiation and agreement Drafting, execution and monitoring Once concluded, the APA would be in effect for a period of generally 3 to 5 years

20 Latest APA development in Hong Kong - Programme Highlights (Continued) Eligibility thresholds HK$80m p.a. sale and purchase of goods transactions; HK$40m p.a. services transactions; or HK$20m p.a. intangible property transactions. Collateral issues material issues in addition to the intercompany transactions Processing time tentative timeframe for concluding APA is 18 months from acceptance of formal application Voluntary disclosure penalty reduction available if APA application submitted before audit or queries Renewal seek renewal at least six months before expiration of APA Rollback application of APA transfer pricing methodology to prior years at taxpayer s request or initiated by IRD

21 Section 3 Hot Topic in China / Hong Kong Transfer pricing

22 Location specific advantages Why does it matter? Tax authorities cite location specific advantages ( LSAs ) as a reason for China to retain the extraordinary high profits earned by entities with operations in China. Manufacturing Retail and Consumer Products Location savings Location factors allowing products to be produced faster, cheaper, better Applies to all industries Market premium Location factors allowing products to be sold for a higher price Particularly relevant to retail business and high value/luxury consumer goods

23 China vs OECD views - Tug of war between emerging and developed economies China Published in Oct 2012 in the United Nations Practical Manual on Transfer Pricing for Developing Countries ( UN TP Manual ) Presents SAT s views and practices on TP issues in China as a developing country Issues not addressed in the OECD TP Guidelines: - lack of reliable comparables, - local specific advantages, - alternative methods to traditional transactional or profits-based approaches to fit China s unique economic and geographic factors. OECD Location saving is a comparability factor No need to be paid for since it cannot be owned, controlled or transferred, but it may affect the arm s length price for other transactions Use of local market comparables If no comparable, adopt the 4-step approach: Whether location savings exist The amount of any location savings Whether they are passed on to independent customers or suppliers How any net location savings not passed on to customers and suppliers should be allocated

24 A China case regarding market premium Automotive OEM in Southern China Foreign partner s nonroutine profit Foreign partner s non-routine profit JV pays royalty to foreign investor JV s profit before royalty payment JV s non-routine profit 1. Non-routine profit for intangibles owned by JV 2. LSA (e.g. location savings, market premium Consumer preference to foreign brands in general, barriers to entry, and others The value of intangibles reflect JV s non-routine profits Routine profit Routine profit

Sourcing operation Continuous loss Suppliers / Manufacturers Sale of goods Should a

25 A Hong Kong case regarding sourcing operation - Sourcing centre HK group company HK Agency agreement Commission $$$ (Sourcing of goods) Ex-HK Overseas group company Tax position Sourcing operation Continuous loss Suppliers / Manufacturers Sale of goods Should a sourcing centre for the group substantiate loss? IRD considered transfer pricing as a settlement basis

26 Q&A Session Please drop questions into the question box.

27 Thank you! Please fill in the evaluation form. The information contained in this presentation is of a general nature only. It is not meant to be comprehensive and does not constitute legal or tax advice. PricewaterhouseCoopers Ltd ("PwC") has no obligation to update the information as law and practice change. The application and impact of laws can vary widely based on the specific facts involved. No reader should act or refrain from acting on the basis of any material contained in this presentation without obtaining advice specific to their circumstances from their usual PwC client service team or their other advisers. The materials contained in this presentation were assembled in March 2012 and were based on the law enforceable and information available at that time PricewaterhouseCoopers Ltd. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Ltd which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

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