EY China TP Alert China s Jiangsu provincial state tax authority updates its compliance plan for international tax administration Following the first release of Compliance Plan for International Tax Administration three years ago, Jiangsu Provincial State Administration of Taxation (JSSAT) released the second edition, i.e. 2016-2018 Compliance Plan for International Tax Administration 1 (hereinafter referred to as the Compliance Administration Plan ). As international tax reform enters the post-beps period, the changes on international taxation rules and the increasing demands for tax transparency bring tremendous challenges to business operations as well as tax administration. The Compliance Administration Plan is issued in response to this global trend. View on international tax focus Of late, cross-border related party transactions have become one of the primary tax risk areas for multinational corporations (MNCs). Reducing tax risks relating to cross-border transactions not only serves to reduce operating risks and costs, but also addresses risks to the MNCs social standing and corporate reputation in an environment of increasing public scrutiny. The Compliance Administration Plan emphasizes that tax should be aligned with economic activities and value creation. The JSSAT brings attention to the perceived problems: some MNCs exalt legal form over economic substance; despite the significant contribution of Chinese market in the creation of global value, MNCs functional characterizations of their Chinese subsidiaries have remained unchanged for years. For example, even though its Chinese subsidiary has taken on increasing functions and risks, an MNC may continue to characterize it as a mere contract manufacturer, entitled to a low profit margin. 1 http://www.jsgs.gov.cn/art/2016/8/9/art_55_256279.html 1
The BEPS report on intangible asset transfer pricing identifies development, enhancement, maintenance, protection and exploitation (DEMPE) as the five sectors of intangible value creation. JSSAT emphasizes that, in practice, intangible value creation includes the activities of Chinese subsidiaries localizing, upgrading, expanding or undertaking entrusted R&D with respect to the group s original technology. The JSSAT emphasizes that location specific factors are important comparability factors. MNCs should fully consider the contribution of location specific factors when allocating the global profits. Globally, business restructuring is becoming more and more popular. The Compliance Administration Plan indicates that any business restructuring should have a reasonable commercial purpose and economic substance. Otherwise tax authorities could re-determine the nature of the restructuring and make tax adjustments accordingly. Pursuant to the BEPS report on Action 13, MNCs are required to disclose more detailed and higher quality information than in the past. JSSAT has noticed prominent problems with the quality of taxpayers documentation in the past, such as disclosures in transfer pricing documentation not being consistent with the tax returns, functional characterizations not being aligned with the actual situation, comparables analysis being too subjective, and special factors adjustments lacking rationality. In addition, JSSAT has found that local management often does not get involved in transfer pricing decision-making and does not communicate with the headquarters either, which may lead to contradictions and conflicts between the local file and the master file. Additionally, JSSAT pays special attention to certain mismatches between the factual situation and the profit profile, including the following significant ones: the whole group makes healthy profits while the Chinese subsidiaries make very low profits or even losses; the Chinese subsidiaries are major manufacturing bases of the group and the Chinese market is the key market of the group, but the Chinese subsidiaries are attributed a very small share of the profit; the Chinese subsidiaries enjoy preferential tax treatment due to having high-tech status and yet still earn low profits and pay great amounts of royalties to overseas. Guidance for MNCs on international tax administration In the Compliance Administration Plan, JSSAT makes the following observations and recommendations to Chinese subsidiaries of MNC groups: Incorporate cross-border transactions tax risk control into corporate governance and internal control procedures. For instance, the board of directors should map out the group s tax risk management strategy and make overall departmental arrangements for risk prevention. Significant tax matters should be discussed and approved by the board of directors. Fully consider the contribution of China s location specific factors, including excellent public infrastructure, large market scale and value-added labor, when determining the pricing policy. Review the actual functions performed and risks assumed by the Chinese subsidiaries, examine the functional characterization dynamically taking into account of the changes of business activities in China (for example, R&D activities and marketing actives), and consider appropriate compensation for any movement of functions to maintain the alignment between functions performed and profit attributed. The Compliance Administration Plan emphasizes that, although localization and entrusted R&D may be guided directly by the head office, they still have such features as local decision making, risk assumption, use of assets, significant staff input, and therefore play a unique role in value creation. Entrusted R&D is not a low-value intra-group service and should not be remunerated with a low cost-plus rate. As noted, the JSSAT takes the view that business restructuring should be based on reasonable commercial purposes rather than solely or primarily to obtain tax benefits. They emphasize that business restructurings should be recorded with a robust paper trail and that the profit attributable to the parties should be aligned with the assets and functions of the new configuration. MNCs should prepare various documentation (including local file, master file and country-by-country report) in a systematic way to avoid mistakes and omissions. Tax authorities will review the transfer pricing documentation to classify the tax risk level of the taxpayers. Those taxpayers that are classified as high tax risks are likely be selected as tax audit targets. The headquarters of MNCs are encouraged to help their Chinese subsidiaries disclose the actual situation with respect to the group s global structure, pricing principles and other information. 2 http://www.ey.com/publication/vwluassets/ey-china-tp-alert-sat-issues-highly-significant-new-rules/$file/ EY-china-tp-alert-sat-issues-highly-significant-new-rules.pdf 2
Guidance for outbound enterprises on international tax administration Outbound investment is becoming more and more common in China. Accordingly, JSSAT begins to focus on the transfer pricing issues affecting outbound enterprises. The guidance warns outbound companies to be mindful of foreign requirements but also seeks to protect China from profit shifting. Outbound enterprises should not artificially move the parent company s functions to foreign subsidiaries through arrangements with legal form but without economic substance in order to avoid domestic tax obligation. Outbound enterprises should undertake proper planning, taking into consideration regulations in both the home country and the host country. When the parent company transfers partial or full ownership of intangible assets abroad, the value of the intangibles should be assessed and the home country should be properly remunerated. When outbound enterprises encounter double taxation or tax disputes, the JSSAT reminds them that they can initiate the mutual agreement procedure (MAP) provisions of the relevant tax treaty to safeguard their rights and interests. Our observations and suggestions The Compliance Administration Plan demonstrates the Jiangsu tax authority s determination to enforce international tax rules in China. In some areas, the positions advanced in the Compliance Administration Plan seem to be very assertive and detailed as compared to the national rules. Taxpayers in the Jiangsu Province need to take this guidance very seriously and be prepared for strong enforcement efforts by the tax authority. At the same time, taxpayers should ensure robust documentation is in place to defend themselves against the tax authority s assertive claims, and be able to demonstrate that their transfer pricing policies are reasonable and consistently applied historically and across the globe. The following positions in the Compliance Administration Plan are worth special note: Guidance at the national level tends to emphasize location specific factors that differentiate China from developed countries, such as location savings due to lower wage and rent expenses. By comparison, the Compliance Administration Plan references factors those make China comparable to many developed countries, such as good infrastructure, large markets and skilled labor. The literal reading suggests that it might be possible to establish that comparable companies from developed countries that are used in a transfer pricing analysis are appropriate. Nevertheless, such technical possibility should be further validated with local tax authorities. On the other hand, it is crucially important that taxpayer groups ensure their Chinese affiliates are in fact compensated on a level commensurate with valid comparables and with the levels earned by other group companies in comparable circumstances. New documentation requirements, such as CBCR and master file, will make it easier for tax authorities to verify such matters. The Compliance Administration Plan emphasizes the importance of DEMPE analysis in determining the profits to be earned from intangibles developed through the efforts of a Chinese affiliate performing R&D. It warns that a low cost-plus rate should not be used and seems to suggest that a sharing of residual profits (that is, profits in excess of profits attributable to routine functions) may be more desirable. On the other hand, the Compliance Administration Plan does explicitly recognize that due regard needs to be given to decision-making functions of the foreign head office. In order to forestall a claim by the tax authorities to residual profits in the case where a Chinese affiliate merely performs R&D under the direction and control of another group company, several things are important: a thorough DEMPE analysis should be undertaken and documented, clearly showing that all important decisions are taken outside of China; the cost-plus markup rate used to compensate the Chinese affiliate should not be unreasonably low (especially if the group is very profitable) and should be based on comparable companies that employ similarly skilled technicians and researchers; and, if the Chinese affiliate does in fact enjoy location savings, proper account should be taken either through use of similarly advantaged comparables or through upward adjustments to the markup. Furthermore, if the DEMPE analysis indicates that the Chinese affiliate s personnel do perform important decisionmaking functions (especially if the affiliate enjoys high technology tax incentives), consideration should be given to provide the affiliate with a share of residual profits. 3
The Compliance Administration Plan suggests that multinationals should seriously consider putting in place a transfer pricing method that would allocate profit among affiliates based on value contribution. After collecting information on the value chain in the first step, the second step of such a method would be to analyze the core elements in value creation such as intangibles, fixed assets, personnel and market. The third step would involve allocating group profit based on core indicators, such as assets, sales, or expenses, consistent with the specific facts of the case. The Compliance Administration Plan recognizes that allocation should not be made on a formulary basis. Interestingly, this is a method that was previously proposed by the Consultation Draft issued by the SAT but subsequently withdrawn in final guidance. The continued interest in such a method shown by the Compliance Administration Plan highlights how important it is for taxpayers to ensure their documentation (both the master file and the local file) are of the highest quality. The stronger the case that a taxpayer can make for the transfer pricing method selected, the less the risk that an alternative method will be substituted for it. Documentation of the value chain is particularly important. For example, if the value chain analysis demonstrates the great importance of intangibles owned by headquarters and the DEMPE analysis demonstrates that the Chinese affiliate s role in creating and sustaining those intangibles is limited, the taxpayer may be able to argue that it would not be reasonable to allocate group profits based on an indicator that does not take intangibles into account (such as sales or tangible assets). Based on above and our continued attention to JSSAT s administrative measures on international tax, we have following suggestions for MNCs operating in China: By adopting the Gold Tax Phase III in China, JSSAT is carrying out tax administration based on big data, integrating information from tax returns, business databases and external resources, and using data warehousing technology to screen risks and monitor taxpayers profit fluctuations. In this regard, we recommend that MNCs improve their tax internal controls, and pay attention to information disclosure and quality of transfer pricing documentation, to prevent potential risks and enhance their ability to respond to risks. JSSAT identifies various mismatches though special analysis of function orientation and outbound payments. To this end, we recommend MNCs in China pay special attention to potential tax risks, especially for those who are paying large amount of royalty and service fees to overseas, as well as those who are enjoying hi-tech preferential tax treatment or R&D expenditures super deduction and still paying royalty fees or R&D service fees to overseas. JSSAT continually strengthens anti-tax avoidance by establishing a specialized organization at the provincial tax bureau level. Therefore, we suggest that MNCs actively review their existing transfer pricing policies, and ensure they are aligned with business functions and processes, through preparation of the transfer pricing local file and master file. We note that JSSAT is very open and willing to see professional tax advisors play a role in tax administration. In this regard, we recommend MNCs considering seeking professional services to help improve the quality of their tax filings and documentation. 4
Transfer Pricing Contacts of EY in China Beijing Shanghai Guangzhou / Shenzhen Hong Kong Joanne Su +86 10 5815 3380 joanne.su@cn.ey.com Leonard Zhang +86 10 5815 2815 leonard.zhang@cn.ey.com Carter Li +86 10 5815 2774 carter.li@cn.ey.com Lillian Du +86 10 5815 2606 lillian.du@cn.ey.com Bing Kun Zhao +86 10 5815 3000 bingkun.zhao@cn.ey.com Travis Qiu EY Greater China Transfer Pricing Leader +86 21 2228 2941 travis.qiu@cn.ey.com Julian Hong +86 21 2228 2726 julian.hong@cn.ey.com Kana Sakaide +86 21 2228 2289 kana.sakaide@cn.ey.com Mark Ma +86 21 2228 4763 mark.ma@cn.ey.com Janice Ng +86 21 2228 2938 janice.ng@cn.ey.com David Chamberlain +86 21 2228 3766 david-g.chamberlain@cn.ey.com Jean N Li +86 755 2238 5600 jean-n.li@cn.ey.com Shenzhen Lawrence F Cheung +86 755 2502 8383 lawrence-f.cheung@cn.ey.com Taipei George Chou +886 2 2720 4000 Ext. 2735 george.chou@tw.ey.com Suzhou Ananda Jiang +86 512 6763 3283 ananda.jiang@cn.ey.com Curt B Kinsky EY Asia-Pacific Transfer Pricing Leader +852 2629 3098 curt.kinsky@hk.ey.com Martin Richter +852 2629 3938 martin.richter@hk.ey.com Kenny Wei +852 2629 3941 kenny.wei@hk.ey.com Justin Kyte +852 2629 3880 justin.kyte@hk.ey.com Il Kook Chung +86 21 2228 2697 il-kook.chung@cn.ey.com Zhi Bin Yao +86 21 2228 3429 zhibin.yao@cn.ey.com 5
EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. 2017 Ernst & Young (China) Advisory Limited All Rights Reserved. APAC no. 03004680 ED None. This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com/china Follow us on WeChat Scan the QR code and stay up to date with the latest EY news.