21 October 2016 Global Tax Alert News from Transfer Pricing China s SAT issues new guidance on administration of advance pricing agreements EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: www.ey.com/taxalerts Executive summary On 18 October 2016, China s State Administration of Taxation (SAT) issued SAT Bulletin Gonggao [2016] No. 64 (Bulletin on Issues Related to Improving the Administration of Advance Pricing Arrangements) (Bulletin 64). Effective from 1 December 2016, Bulletin 64 governs the administration of advance pricing agreements (APAs) in China. Bulletin 64 supersedes and replaces Chapter 6 of Circular Guoshuifa [2009] No. 2 (Implementation Measures for Special Tax Adjustments (Trial Implementation)) (Circular 2). An APA is an agreement between a taxpayer and one or more tax authorities regarding how transfer prices will be calculated in the future. Bulletin 64 evidences a strong commitment by the SAT to further develop its APA program. It also demonstrates China s commitment to the global project lead by the Organisation of Economic Co-operation and Development (OECD) to combat base erosion and profit shifting (BEPS) and improve international tax cooperation. At the same time, it continues to emphasize transfer pricing issues of particular concern to China, including value chain analysis and location specific advantages.
2 Global Tax Alert Transfer Pricing Detailed discussion China s APA program history By way of history, Chinese local tax authorities entered into the first unilateral APA in 1998, while the APA program was formalized in 2005. The most recent APA Annual Report issued by the SAT covered APA experience from 2005 through 2014. Between 2005 and 2014, a cumulative total of 113 APAs were concluded (70 unilateral and 43 bilateral). Bilateral APAs were concluded with 16 partner countries or regions. As of 31 December 2014, there were 90 APA requests that were in the pre-acceptance stage and another 39 that were in process. There are a significant number of new requests each year. By contrast, between 2005 and 2014, the most APAs concluded in a single year were 19 in 2013; in 2014, only nine were concluded. There is a clear trend toward bilateral APAs and the certainty with regard to double taxation that comes with them; of the 90 APA requests in the pre-acceptance stage, 83 were bilateral APA requests and only seven were unilateral. BEPS implementation The BEPS project was initiated in 2013 by the Group of Twenty (G20), an international group consisting of 20 of the world s largest economies; China is a member of the G20. Led by the OECD, the BEPS project sought to address 15 action items that represented the most pressing issues in international taxation. The OECD issued final reports on all 15 action items in October 2015. Some of these reports imposed minimum standards that all tax jurisdictions participating in the BEPS project have committed to implement. In addition to the countries in the G20 and the OECD, tax jurisdictions that have signed on to the so-called Inclusive Framework have also committed to the BEPS project and the minimum standards. As of 5 September, a total of 85 tax jurisdictions had joined the Inclusive Framework and another 19 committed to join by December. Action 14 of the BEPS project involves a commitment by participating tax jurisdictions to make international tax dispute resolution mechanisms more effective. A key dispute resolution mechanism is the mutual agreement procedure (MAP), which is contained in most bilateral tax treaties between tax jurisdictions. Under the MAP process, the competent authorities of each treaty partner agree to meet and try to resolve double taxation cases brought to them by taxpayers. Bilateral APAs are concluded by competent authorities under the authority of the MAP process. A minimum standard under Action 14 is the participation by tax jurisdictions in a peer review process whereby the effectiveness of the tax jurisdiction s MAP process is assessed by other tax jurisdictions. By committing to the peer review process, China has agreed to put attentional focus on its MAP and APA processes. In this regard, the SAT recently added a new anti-avoidance division under the international tax department. It is anticipated that this division may recruit a significant number of new transfer pricing specialists, which could even double the combined headcount of the existing two divisions. Moreover, significant further increases are expected by the end of 2017. One major task of this new division is to support the MAP and APA programs. Another minimum standard in the BEPS project is associated with Action 5, which is focused on combatting harmful tax practices by tax jurisdictions. Under this minimum standard, tax jurisdictions agree to a spontaneous exchange of information on certain tax rulings, including all unilateral APAs. Specifically, participants on the BEPS project commit to providing periodic reports to other tax jurisdictions where local taxpayers who have been granted unilateral APAs have related party transactions. Article 20 of Bulletin 64 puts taxpayers on notice that their unilateral APAs will be subject to information exchange under Action 5. APA process In order to apply for an APA, article 4 of Bulletin 64 provides that a taxpayer generally should have had related party transactions in excess of RMB40 million for each of the past three years. This is somewhat more restrictive than under Circular 2, which also set a RMB40 million threshold but did not specify that the transactions should be continuous for three years. There are six steps in the APA process: pre-filing meeting, intention discussion, analysis and evaluation, formal application, negotiation and conclusion of the arrangement, and execution monitoring. In contrast to Circular 2, Bulletin 64 does not allow the pre-filing meeting to be anonymous and does not specify the time periods between each of the steps.
Global Tax Alert Transfer Pricing 3 It is noteworthy that there are extensive interactions between the taxpayer and the tax authorities well before the APA application is formally accepted. Taxpayers need to be prepared to perform significant analysis and provide extensive documentation during the process. In brief, the six steps noted above involve the following: Pre-filing meeting. All taxpayers considering an APA must have a pre-filing meeting first. The pre-filing meeting cannot be anonymous. Intention discussion. If the tax authority and the taxpayer reach a conclusion in the pre-filing meeting, the taxpayer would then file a letter of intention and a draft APA application. The tax authority may reject the letter of intention or may proceed to analyze and evaluate the draft application. Analysis and evaluation. If the tax authority proceeds with the case, it may discuss the draft application with the taxpayer, may conduct on-site interviews, and may negotiate with the taxpayer to amend the application. Formal application. If the tax authority is satisfied with the draft application, it will notify the taxpayer that it can submit a formal APA application. Again, the tax authority may reject the application or may proceed to negotiate the APA. Negotiation and conclusion. In a unilateral APA case, the tax authority will negotiate with the taxpayer on the final terms of the APA. In a bilateral APA case, the SAT will negotiate with the other jurisdiction s competent authority. If agreements are reached, all parties will sign the APA. Execution monitoring. The taxpayer must file an annual report with the tax authorities while the APA is in force. The tax authority will monitor compliance with the APA s terms. If there are substantial changes in the operation of the taxpayer, the APA may be terminated or renegotiated. Value chain analysis and location specific advantages (LSAs) Bulletin 64 makes numerous references to analysis of the value chain and of LSAs, such as location savings and market premium. This is in keeping with the contemporaneous documentation requirements the SAT put in place on 29 June 2016 for taxpayers with significant related party transactions. See Bulletin [2016] No. 42 (Bulletin on Improving Administration of Related Party Transaction Reporting and Contemporaneous Documentation). Bulletin 64 provides that the role of LSAs is one of the topics for discussion at pre-filing meetings. Both value chain analysis and analysis of LSAs are required elements of the draft application materials submitted prior to intention discussions. Article 16 makes clear that the quality of the value chain and LSA analyses is a key factor in the SAT s decision whether to prioritize the taxpayer s APA application. The SAT has not defined what a value chain is or how it may differ from a supply chain. Nor has the SAT provided any specific guidance on how to undertake a value chain analysis. However, it is clear that the SAT wants information on how profits are allocated among the related parties who participate in the value chain, including disclosure of how much profit each participant has earned. Analysis of LSAs can also be challenging. The measurement of location savings requires a comparison of wages prevailing in China versus the countries where the comparable companies operate, among other things. The SAT has provided some guidance on how adjustments might be made for location savings in its contribution to the United Nations Practical Manual on Transfer Pricing for Developing Countries (UN Manual), published in 2013. China s contribution to the UN Manual outlined a six step process for adjusting comparable benchmarks to account for Chinese location savings. Prioritization of APAs by the SAT Given the large backlog of APA applications, the SAT s criteria for prioritizing the applications are a matter of some significance. The SAT lays out the criteria in article 16 of the Bulletin 42. As noted, the quality of the taxpayer s value chain and LSA analyses is an important factor. In fact, in our experience, the SAT is far more likely to prioritize an application where interesting issues are raised in this area than an application that relies on a more routine transfer pricing analysis. Another important criterion is whether the taxpayer has an A rating under the SAT s taxpayer credit rating system. This is a system the SAT has developed based on a database with information about the taxpayer s compliance with tax filing requirements, cooperation in tax investigations, and other indicators. This system has also been used by the SAT in recent years in determining whether to launch a tax investigation against particular taxpayers.
4 Global Tax Alert Transfer Pricing The criteria also include: Whether the taxpayer s related party transaction reporting (with its tax returns) and its contemporaneous documentation are complete and reasonable with sufficient disclosure Whether a transfer pricing investigation has been made by tax authorities and whether the case has been closed Whether the application is a renewal and whether the relevant facts and circumstances have changed since the prior APA Whether the taxpayer pro-actively cooperates with tax authorities with respect to the APA Whether the other tax authority involved in a bilateral or multilateral APA has a strong will for negotiation and attaches high importance to the application Unilateral APAs: multi-jurisdictional In the case where a unilateral APA involves the allocation of profits among multiple jurisdictions within China, such as provinces, autonomous regions and major municipalities, in contrast to unilateral APAs involving a single jurisdiction where local tax authorities take the lead, article 17 of Bulletin 64 makes clear that the SAT itself will coordinate the APA process in these cases. Use of interquartile range and adjustment to the median Although article 12 provides that the interquartile range will be respected in APA cases, there is a strong preference for results at or above the median. If the taxpayer s results fall outside the interquartile range, the adjustment will be made to the median of the range. This contrasts with the practices of some treaty partners to make adjustments to the nearest edge of the interquartile range. Moreover, if the taxpayer s weighted average results over the entire APA period fall below the median (after any adjustment), article 12 provides that the tax authority will not accept any renewal application. This provision may lead treaty partners to seek adjustment to the median in all cases to avoid being disadvantaged. Impact In conclusion, Bulletin 64 provides updated guidance on the APA process in China and demonstrates China s commitment to continue to improve dispute resolution processes with its treaty parties. Taxpayers should take particular note of the continued importance placed by the SAT on value chain analysis and consideration of Chinese location specific advantages.
Global Tax Alert Transfer Pricing 5 For additional information with respect to this Alert, please contact the following: Ernst & Young (China) Advisory Limited, Beijing Joanne Su +86 10 5815 3380 joanne.su@cn.ey.com Leonard Zhang +86 10 5815 2815 leonard.zhang@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 Ernst & Young (China) Advisory Limited, Shanghai Travis Qiu +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 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 Ernst & Young (China) Advisory Limited, Guangzhou Carter Li +86 20 2881 2701 carter.li@cn.ey.com Ernst & Young (China) Advisory Limited, Shenzhen Lawrence F Cheung +86 755 2502 8383 lawrence-f.cheung@cn.ey.com Jean N Li +86 755 2238 5600 jean-n.li@cn.ey.com Ernst & Young (China) Advisory Limited, Hong Kong Curt B Kinsky +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 Ernst & Young (China) Advisory Limited, Taipei George Chou +886 2 2720 4000 Ext. 2735 george.chou@tw.ey.com Ernst & Young LLP, China Desk, New York Min Fei +1 212 773 5622 min.fei@ey.com Vickie Lin +1 212 773 6001 vickie.lin@ey.com Claire Geng +1 212 773 0229 claire.geng1@ey.com Ernst & Young LLP, China Desk, San Jose Diana Wu +1 408 947 6873 diana.wu@ey.com Ernst & Young LLP, China Desk, Chicago Ally Liu +1 212 773 3306 ally.liu@ey.com Ernst & Young LLP, Asia Pacific Business Group, New York Chris Finnerty +1 212 773 7479 chris.finnerty@ey.com Kaz Parsch +1 212 773 7201 kazuyo.parsch@ey.com Bee-Khun Yap +1 212 773 1816 bee-khun.yap@ey.com Ernst & Young LLP, Asia Pacific Business Group, Houston Trang Martin +1 713 751 5775 trang.martin@ey.com
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