Articles China (People's Rep.) Andreas Riedl and Thomas Steinbach* Transfer Pricing Documentation Requirements The authors compare the documentation standard arising from the BEPS Action 13 Final Report with the documentation standard that was introduced in China under Bulletin 42. The differences between the two standards are presented and the possible intentions of Bulletin 42 are discussed in detail. 1. Introduction During the past 10 years, China has gone through a rapid process of change, from having basically no formal transfer pricing documentation requirements until 2008, to one of the first countries to adopt the OECD s Base Erosion and Profit Shifting (BEPS) Action 13 results into its local legislation. On 29 June 2016, the State Administration of Taxation (SAT) released Bulletin 42 in which it sets out the new Chinese documentation requirements. However, the Chinese tax authorities did not implement the OECD requirements one for one into Chinese law. The requirements set out in Bulletin 42 go far beyond the disclosure requirements put forward by the OECD, based on the SAT s strong view that there is a need to adapt the implementation of BEPS to China s unique circumstances. The authors will provide an overview of the differences between Bulletin 42 and BEPS Action 13, and analyses the possible implications of the to a certain extent rigorous new Chinese documentation requirements. 2. The Different Documentation Standards At the end of 2015, the OECD published its final reports under the BEPS project with best intentions. In the aftermath, many countries went on to implement the results of this project. The implementations differ significantly and so, to understand the problems regarding differing documentation standards, the concepts of the OECD and the SAT will be explained and the differences will be laid out. The problems resulting from differing documentation standards do multiply for MNEs that are active in numerous countries, and a centralized documentation structure is therefore linked to a high amount of administrative work to keep up with the developments. 2.1. Documentation requirements under BEPS Action 13 * Andreas Riedl is Senior Manager Transfer Pricing at WTS, Frankfurt, and Thomas Steinbach is Consultant Transfer Pricing at WTS, Frankfurt. On 5 October 2015, the OECD released its final report on Action 13, Transfer Pricing Documentation and Country-by-Country Reporting, under its BEPS Action Plan, which contains revised standards for transfer pricing documentation. The revised standards entail a three-tiered approach to transfer pricing documentation and country-by-country reporting, including: a master file that provides tax administrations with high-level information on the global business operations and transfer pricing policies of the multinational enterprise (MNE); a specific local file that provides a local tax administration with information on material related-party transactions of the single entity at hand, the amounts involved and the company s analysis of the arm s length nature of those transactions; and a country-by-country reporting template that includes global information on revenue (with related and unrelated parties), profits, income tax paid and taxes accrued, employees, stated capital and retained earnings, and tangible assets for each tax jurisdiction in which the MNE does business. In addition, the template includes information identifying each entity within the MNE doing business in a particular tax jurisdiction and the business activities each entity conducts. The standards that were set by the OECD expand previous existing standards extensively and lead to a significant compliance burden expansion for MNEs. 1 2.2. Bulletin 42 On 29 June 2016, the SAT issued new regulations regarding the documentation of related-party transactions, known as Bulletin 42, 2 which will replace the current transfer pricing documentation regulations laid out in Guoshuifa [2008] Circular 114 and Guoshuifa [2009] Circular 2 (Circular 2) 3 for fiscal year 2016 and onwards. In the context of the BEPS initiative, Bulletin 42 can be considered as China s new law regarding the implementation of BEPS Action 13 in its local law. For the most part, Bulletin 42 adopts the three-tiered approach as laid out in the final report under BEPS Action 13, i.e. master file, local file and country-by-country reporting. Nevertheless, there are significant differences between Bulletin 42 and the standards set by the OECD. 3. Differences between BEPS Action 13 and Bulletin 42 In addition to the three-tiered documentation framework set out in the final report under BEPS Action 13, Bulletin 1. OECD, Transfer Pricing Documentation and Country-by-Country Reporting Action 13: 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project (OECD Publishing 5 Oct. 2015), International Organizations Documentation IBFD. 2. CN: State Administration of Taxation, Bulletin [2016] 42, Final Rules on Transfer Pricing. 3. CN: Guoshuifa [2008] Circular 114 and Guoshuifa [2009] Circular 2. 171
Andreas Riedl and Thomas Steinbach 42 will require Chinese taxpayers to provide additional information in their local files, namely: a value chain analysis; details on location-specific advantages; and information on intra-group service transactions. In addition, a special issue file and an increased number of related-party transaction forms will have to be submitted. The requirements for transfer pricing information disclosure therefore go beyond what is expected under BEPS Action 13. The additional requirements are explained in more detail below. 3.1. Value chain analysis Bulletin 42 stipulates the inclusion of a value chain analysis as part of the economic analysis for the local file documentation. In particular, the value chain analysis should focus on the value contributions of each participant in the overall value chain and provide details on the allocation of the profits along the value chain among the participants involved, regardless of the applied transfer pricing method. This information must be presented together with standalone and consolidated financial statements. In addition, the transactions and flows of funds and goods for each value chain within the MNE must be explained in detail, from the initial design of a product to production, marketing, sales and other relevant activities, depending on the type of product or service concerned. Bulletin 42 also contains a list with the information that is to be included in the value chain analysis, although no guidelines are provided as to how detailed the required information to be disclosed must be. Based on the information available, it seems that the quantitative contributions of each affiliate participating in a business will pose the biggest challenges for MNEs regarding the preparation of the local file. A general description of the value chains will also be a part of the master file. Given the level of detail required, the local file under Bulletin 42 is designed as an enhancement of the country-by-country reporting. As the required information does not always detail single transactions of the specific group company under review, it will be possible to judge specific transactions only in some cases. The information will therefore mainly be used for risk analysis purposes at the moment. Nevertheless, further developments can be expected in the near future. The discussion draft of Bulletin 42 already suggested that the value chain apportionment method could be used as an alternative to the generally accepted transfer pricing methods. The local tax office of the Jiangsu province recently issued its 2016-18 compliance plan in which it officially encourages taxpayers to use such value chain apportionment method in practice. However, it is not yet clear whether this new method will be included by the SAT in the list of formally accepted transfer pricing methods. Taking into account these discussions, it seems probable that the information required regarding the detailed value contributions will be used for more than just risk analysis purposes within tax audits later on. 3.2. Location-specific advantages The topic of location-specific advantages was introduced by the United Nations in its Practical Manual on Transfer Pricing for Developing Countries. Since implementation in the China Country Practices chapter, 4 location-specific advantages have become one of the main issues on which the SAT focuses in transfer pricing audits. However, the requirements set out in Bulletin 42 go further and will require Chinese companies to make an attempt to quantify location-specific factors (in the form of location savings and market premiums) and assess their contribution to the overall value chain. The UN Manual provides general guidance on how location savings could be measured for developing countries in practice, stating that the bargaining power between Chinese entities and the foreign parent must be taken into account, which in turn depends on the competitiveness of the market and the question as to whether the Chinese entity is the only entity in a given industry of the MNE that has, for example, the technical capabilities to manufacture a product and can therefore be said to have significant bargaining power. However, Bulletin 42 did not provide detailed guidance on how to quantify location-specific advantages as part of the value chain analysis, leading to additional uncertainty for Chinese taxpayers. The OECD officially addressed the issue of location savings for the first time in chapter IX of the Transfer Pricing Guidelines (OECD Guidelines) on business restructurings. It is clear from various discussions of location-specific advantages, as well as the definition of intangibles for transfer pricing purposes, that the OECD Guidelines do not consider location-specific advantages to be intangibles because they are market features that a group would be capable of neither owning nor controlling, but merely be able to use. Even though location-specific advantages are recognized by the OECD as an important factor in a transfer pricing analysis, the OECD also explicitly reiterates its reliance on the arm s length standard, stating that such factors are not separately compensable but should be dealt with as a part of the comparability analysis. 3.3. Intra-group service transactions In addition, Bulletin 42 prescribes a higher disclosure standard on intra-group services, an area which has long been a key focus of the SAT, which is likely to impact many taxpayers. Companies with group-allocated service charges will have to provide in their local files information regarding the calculation process of the underlying service fee and a detailed benefit test from the perspective of the service recipient. Service transactions have, in fact, always been a critical topic whenever they represent a cost for Chinese entities. In practice, in order to get actual cash for any kind of 4. UN, Dept. of Econ. & Soc. Affairs, United Nations Practical Manual on Transfer Pricing for Developing Countries, at 374, sec. 10.3 (2013). 172 International Transfer Pricing Journal May/June 2017 IBFD
Transfer Pricing Documentation Requirements service charges out of the country, Chinese taxpayers must go through a variety of administrative procedures, including the filing of forms and the provision of separate audit reports that must be approved first by the SAT before any transfer of funds can take place. Also with regard to the recent OECD BEPS developments in the area of service transactions, it is noteworthy that China seems to reflect a completely different standpoint. For example, while BEPS Actions 8-10 intend to simplify the transfer pricing documentation requirements for low value-adding intra-group services in future, China expressly decided not to adopt this measure. In an area where the OECD recognized the need to offer a simplified approach for taxpayers, the Chinese authorities rather enhanced their regulations even more. 3.4. Special issue file A special issue file will be required in addition to the master file and local file for taxpayers that enter into cost-sharing agreements or fall under the thin capitalization requirements in China. Even though certain requirements regarding the documentation of cost-sharing agreements and thin capitalization were already an integral part of the general transfer pricing documentation requirements under Circular 2, 5 Bulletin 42 extends these requirements and requires additional information from taxpayers if they entered into a cost-sharing agreement or if their debt-to-equity ratio exceeds a certain threshold. Regarding cost-sharing agreements, information will have to be disclosed as to whether any party that is not a participant of the cost-sharing agreement uses or used the results of that agreement and how the allocation of the payments among the participants took place. Furthermore, the anticipated benefits must be calculated, including the selection of parameters, calculation method and reasons for any change. As the OECD already enhanced the requirements regarding cost-sharing agreements with its reworked Transfer Pricing Guidelines and made them difficult to handle, it seems as if the Chinese regulations will render cost-sharing agreements completely impractical in a Chinese context. Regarding thin capitalization, an analysis must be performed as to whether an independent, non-related enterprise would be capable and willing to agree to the financing terms, the amount and the interest rate agreed between the related parties. As the OECD did not specify detailed requirements regarding financial transactions, yet, the Chinese regulations also exceed the OECD Guidelines on this issue. The OECD is expected to publish a draft regarding financial transactions in the near future. Taxpayers can only hope that the OECD draft will not lead to major differences compared to the Chinese regulations, as this would lead to a further risk of double taxation down the road. 5. Ch. 7 (administration of cost-sharing agreements) & ch. 9 (administration of thin capitalization) Circular 2. 3.5. Related-party transaction forms Bulletin 42 increases the number of related-party transaction forms that must be submitted, from 9 to 22. These forms also include the country-by-country reporting forms, as stipulated in BEPS Action 13. Where the country-by-country reporting forms under Bulletin 42 fully align with the OECD requirements regarding country-by-country reporting under BEPS Action 13, the inclusion of the remaining related-party transaction forms leads also in this area to overall more comprehensive disclosure requirements for Chinese taxpayers as compared to BEPS Action 13. Even the related-party transaction forms that already existed under Circular 2 have been revamped and will require more detailed information. The old Intangible Asset Transaction Form will be replaced with two new forms, one regarding the transfer of ownership of intangible assets and the other related to the transfer of rights to use intangible assets. Other major additions to the related-party transaction forms include: disclosure of internal organizational information, including names, headcount, responsibility and business processes for each department, as well as the upper level to which it reports; disclosure of overseas related parties, such as disclosure of general information and tax liabilities for overseas related parties, including their business scope, effective tax rate, registered capital, total investment, preferential tax treatments, etc.; and a Financial Analysis Form on Annual Affiliated Transactions between Enterprises which will enable the tax authorities to collect the enterprise s related-party transaction results and financial performance. Even if the country-by-country reporting requirements can be considered in line with the OECD standards, the additional forms lead to enhanced one-sided country-by-country reporting in China that will not be transparent for other jurisdictions, as this information will not be exchanged under the Multilateral Competent Authority Agreement on the Exchange of Country-by-Country Reports that was signed by China in 2016. 3.6. Further master and local file disclosure requirements Generally, a master file will be required if the annual related-party transactions exceed RMB 1 billion or if the group has already prepared a master file for previous years. The master file to be prepared under Bulletin 42 aligns, for the most part, with the requirements set out in BEPS Action 13, but goes into more detail with regard to areas like industrial structure adjustments and the functions, risks, assets and personnel of the MNE s most important R&D facilities. Such information will allow the SAT to analyse whether certain R&D entities were characterized correctly and, eventually, whether a residual profit should be attributed to those entities. 173
Andreas Riedl and Thomas Steinbach Where BEPS Action 13 merely requires the disclosure of unilateral advance pricing agreements (APAs), the master file under Bulletin 42 requires entities to disclose also bilateral APAs entered into by any entities within the group. Moreover, critical information such as financial statements of each related party in the value chain and tax rulings in other countries must be disclosed. A local file is required if (i) related-party transactions in tangible goods exceed RMB 200 million in one year, (ii) related-party transactions involving either the transfer of rights to intangibles or the transfer of financial assets exceed RMB 100 million in one year or (iii) other related-party transactions (e.g. services or royalties) in aggregate exceed RMB 40 million in one year or in a combination of the three conditions. It can be expected that, in particular, the low threshold of condition (ii) regarding transfers of intangibles or financial assets will lead to more entities having to prepare a local file in future. It is unfortunate that the OECD did not set a minimum threshold so that smaller MNEs would be excluded from the documentation requirements which could have been adopted by the Chinese tax authorities in a second step. 4. Possible Intentions behind Bulletin 42 The question arises as to why the Chinese tax authorities did not implement the BEPS Action 13 results as they were agreed upon by member countries. The intentions are not clear, but some reasons seem to be plausible and will be considered in further detail below. 4.1. Enhanced transparency requirements When comparing the requirements under BEPS Action 13 with the requirements stipulated by the SAT in Bulletin 42, it becomes apparent that China s new transfer pricing documentation requirements are, by far, more detailed than under Circular 2 and also go beyond what is expected by the BEPS initiative. Not only will the broadened scope of Bulletin 42 generally impose significant challenges on taxpayers with regard to information collection, data analysis and disclosure, the SAT has also yet to provide more precise instructions on how detailed information must be disclosed in relation to the value chain analysis, or as regards how to measure the impact of location-specific advantages in general. Given that the requirements set out in BEPS Action 13 already represent a significant increase in the administrative burden related to the collection of data within MNEs, the SAT decided to take further additional steps and introduced a legal framework that requires an even more in-depth analysis from taxpayers and will lead to even greater transparency regarding the global structure of MNEs. When, on 30 January 2014, the OECD released its first discussion draft on Action 13, the model template for country-by-country reporting still included (among several others) separate columns for the disclosure of royalty payments as well as service fees. However, when the countries involved started their negotiations as to the feasibility and appropriateness of the information to be disclosed, information regarding royalties and services was eventually removed from the model template. Nevertheless, China was one of the few countries that expressly argued in favour of inclusion of the royalty and service information in the final country-by-country reporting template. Within the OECD, a compromise was agreed concerning which information is to be required from taxpayers so that (i) a risk assessment can be conducted by the tax authorities and (ii) the arm s length nature of transactions can be analysed. Bulletin 42 reveals that the Chinese tax authorities have gone beyond this international compromise as regards all three parts of the documentation approach. This, in conjunction with the above discussed decision to not adopt the simplified measure for low value-adding services as suggested by the OECD, seems to emphasize the SAT s position under which it views all service transactions as potential threats to artificially shift profits out of China, and provides strong support for the SAT s ongoing campaign to challenge tax deductions of outbound related-party payments. 4.2. Shift of burden of proof The burden of proof that a related-party transaction was conducted at arm s length rests with the taxpayer. Under article 43(2) of the corporate income tax law in China, the taxpayer under investigation, its related parties and other relevant companies are obligated to provide relevant information upon request if the tax authorities conduct a transfer pricing investigation. If the taxpayer under investigation fails to provide information concerning its related-party transactions or provides false or incomplete information that does not truly reflect the situation of its related-party transactions, the tax authorities may determine the taxpayer s deemed taxable income. Information required by the tax authorities during a transfer pricing investigation may include: the taxpayer s contemporaneous transfer pricing documentation; relevant overseas information regarding resale prices (or transfer prices) and/or ultimate sales prices of tangible goods, intangible goods and services involved in the related-party transactions; and other relevant information relating to related-party transactions. Clearly, with Bulletin 42 taxpayers will face more pressure to demonstrate that their transfer pricing documentation is in line with the compliance requirements as laid out by the SAT, and it remains to be seen whether taxpayers will generally be able to provide the required level of information. The question that remains concerns the degree to which the new disclosure requirements under Bulletin 42 intend to ensure that they reserve a right to shift the burden of proof to the taxpayer in cases where the tax authorities find ground to challenge transfer prices. Given the detailed information required, it is to be expected that many MNEs will fail to provide necessary information in full compliance with Bulletin 42, especially if the SAT does not clarify the degree of detail required for informa- 174 International Transfer Pricing Journal May/June 2017 IBFD
Transfer Pricing Documentation Requirements tion such as that required in the course of a value chain analysis or for the related-party transaction forms. Also, the deadline for filing the related-party transaction forms is 31 May following the financial year concerned which can be considered an ambitious target for most MNEs, given the level of detail required. For this reason, many Chinese companies have been busy with trial-runs based on 2015 figures to prepare themselves for the actual deadline on 31 May 2017. In this context it could be an option for the Chinese tax authorities to calculate the deemed profit of the taxpayer by applying a formula-based methodology using the data collected within the described forms, which in turn would lead to a unilateral introduction of formulary apportionment in China. 6,7 5. Conclusion With the release of Bulletin 42, China was one of the first countries to have implemented the OECD s three-tiered documentation approach into practice. Nevertheless, the Chinese tax authorities went well beyond the OECD approach and enhanced the taxpayer compliance burden even further. What remains to be seen is whether China s adapted version of BEPS Action 13 will be expedient in light of the goals the OECD has set. Apart from the obvious aim to reduce harmful tax practices on a global scale and to create transparency in that regard, BEPS Action 13 was seen positively by MNEs, as it introduced a consistent standard of transfer pricing documentation. The Chinese implementation shows that as the OECD Guidelines serve as a minimum standard a centralized approach regarding transfer pricing documentation among MNEs will require adjustments in some jurisdictions. Automated processes will need to be designed in a flexible way so that such specific local requirements, as were introduced in China, can be taken into account, too. In addition, the SAT seems open to other transfer pricing methods in addition to the already accepted OECD methods. If, however, the proposed value chain apportionment method would lead to a global formulary apportionment, this would represent a step away from the arm s length principle itself. Furthermore, the application of such an alternative method would lead to a high risk of double taxation for MNEs if such a method were not introduced on a global scale and recognized by most countries. As a result, it is obvious that the Chinese implementation of BEPS Action 13 will lead to an even heavier compliance burden than anticipated by the OECD. Furthermore, discussions in tax audits will not become easier, taking into account a shift of the burden of proof in cases where the compliance requirements are deemed not to have been met. If the future implementation of BEPS Action 13 by other countries will be inspired by this Chinese approach, uncertainty for taxpayers will increase and the goal of a standardized documentation format will not be achieved. 6. R. Robillard, BEPS: Is the OECD Now at the Gates of Global Formulary Apportionment?, 43 Intertax 6 & 7, at 447 (2015) (regarding the effect of BEPS on a possible introduction of global formulary apportionment in general). 7. Y. Brauner, Formula Based Transfer Pricing, 42 Intertax 10, at 615 (2014) (discussing the possibility of a unilateral introduction of formula-based transfer pricing in the United States). 175