Paul Riley and Janelle Ingram examine China's unified enterprise income tax law as it relates to transfer pricing rules.
A new environment for transfer pricing
International tax directors consistently rate transfer pricing as their number one tax risk management issue. With high-level trends such as increases in foreign direct investment and international trade in goods and services, governments around the globe have emphasised transfer pricing as a mechanism for protecting national tax bases.
The increased emphasis on transfer pricing is evidenced by the growth in the number of jurisdictions that have specific transfer pricing regulatory regimes. In 1998 there were five countries (including Australia) with dedicated transfer pricing rules and documentation requirements. By 2007, this number had risen to around 40. Developing economies in particular have focused on transfer pricing and the implementation of specific transfer pricing rules. China is one example, having had transfer pricing rules in place for some time. In January of this year, changes to China's tax regime took effect. These incorporated modifications and additions to the transfer pricing regulatory regime, and included (for the first time) formal contemporaneous transfer pricing documentation rules.
The focus of this article is on these recent changes as they relate to transfer pricing, together with the implications of these changes for China's inbound and outbound investment. Among other things, these changes mean that enterprises in China will be subject to more stringent transfer pricing documentation and disclosure rules.
Evolution of China's transfer pricing rules Transfer pricing rules have existed in China for some time. Before the 2008 changes, China's State Administration of Taxation (SAT) issued transfer pricing rules in the 1998 guidelines Tax Administration Rules and Procedures for Transactions between Associated Enterprises. These rules were based on the arm's length principle and followed the OECD guidelines, although these were never specifically mentioned.
The 1998 rules were strengthened in 2004 with the issuance of circular Guoshuifa (2004) No.143, which centralised audit procedures and formalised audit case selection processes.
The SAT also issued a circular on advance pricing arrangements (APAs) in 2004, establishing application procedures and filing requirements for unilateral, bilateral and multilateral APAs.
The most recent development in China's transfer pricing regime has been the enactment of the new Enterprise Income Tax Law (EIT Law).
Operation of the Enterprise Income Tax Law The 10th National People's Congress enacted the EIT Law on 16 March 2007, unifying the income tax treatment of domestic and foreign enterprises. The EIT Law, which took effect from 1 January 2008, is broad in its scope.
Since the early 1990s, China has maintained a dual income tax regime, one for domestic enterprises and another for foreign (invested) enterprises (FIEs or FEs respectively).
While FIEs and FEs have historically enjoyed preferential tax treatment, the EIT Law creates a level playing field, promoting competition and transparency for all enterprises in China.
For example, only FIEs and FEs dealing with overseas related parties have historically had to comply with transfer-pricing regulations and disclosure requirements. As a result of the unifying EIT Law, transfer pricing is now also an issue for domestic enterprises.
Chapter 6 of the EIT Law, entitled 'Special tax adjustments', contains transfer pricing and anti-avoidance provisions, clarifies reporting requirements for related party transactions, introduces a cost share arrangement regime and includes additional guidance on APAs.
The rules enhance existing regulations and strengthen enforcement mechanisms for China's tax authorities.
The following sections set out the content and effect of the transfer pricing specific articles in the EIT Law.
Cost sharing agreements (CSAs) One anticipated change in the EIT Law is the adoption of cost sharing rules. Article 41 provides for cost sharing in relation to the joint development of intangible assets and the provision / receipt of labour services. While the detail regarding the new cost share rules is yet to be provided by the SAT, the inclusion of these rules signals a significant step forward on the part of the SAT in terms of their approach to transfer pricing.
Historically, taxpayers have had to bear overseas expenses that were not chargeable to entities in China given the non-deductibility status of management fees and an effective ceiling on royalty payments made abroad.
Multinationals operating in China will now have the opportunity to plan their arrangements and allocate costs with respect to the development of intangibles and provision of services more effectively, provided allocations of expenses are based on participants' anticipated benefits, and the underlying economics of the CSA reflect arm's length terms.
With minimal historical experience in implementing cost-sharing arrangements, it remains to be seen how China will deal with this provision in practice. The SAT is expected to provide further guidance with respect to buy-in and buy-out payments and other forms of CSAs in the near future.
Advance pricing arrangements (APAs) Article 42 of the EIT Law specifically addresses APAs, describing the circumstances in which relevant tax authorities may enter into an APA. While earlier guidance on APAs existed, this provision indicates strong support from China's central government, and should give taxpayers greater confidence to pursue APA applications with local tax bureaus.
Implementation of the new law (together with significant increases in cross-border activity) should mean APAs become more commonplace in China. By 2005 China had concluded over 200 unilateral APAs.
To date, the Chinese revenue authority has executed three bilateral APAs involving the US, South Korea and Japan.
Documentation requirements Article 43 requires the preparation of contemporaneous transfer pricing documentation, insofar as it requires an enterprise to include a report on its transactions with associated enterprises as part of its annual income tax return.
Article 43 also requires that, in the event that the tax authority conducts an investigation of related-party transactions, any other enterprise relevant to the investigation must also provide 'relevant materials'.
Article 44 of the EIT Law empowers tax authorities to assess an enterprise's taxable income when it refuses to provide (or provides incomplete) documentation.
While there remains uncertainty as to the form and content of documentation required, at a minimum it appears taxpayers may have to provide documentation containing information and data such as an organisational structure, overview of the taxpayer's business operations, information on related-party transactions, comparables analysis and the selection and application of transfer pricing methods.
Transfer pricing adjustments Article 41 reinforces the tax authorities' ability to make adjustments, based on 'any reasonable methods', where business transactions between related parties are not based on the arm's length principle.
Another important practical impact of the EIT Law on transfer pricing is the imposition of a special interest levy on anti-avoidance tax adjustments made by the tax authorities. This provision has evolved into a specific penalty regime on special tax adjustments, such as transfer pricing adjustments, as the calculation of the interest includes the sum of the going lending rate of the People's Bank of China corresponding to the period of the adjustment plus 5 per cent.
This levy can be waived if the taxpayer has prepared contemporaneous transfer pricing documentation.
Impact of associated provisions In addition to transfer pricing, though much of the EIT Law simply builds upon China's existing tax system, a number of key international tax concepts are also introduced, including rules around:
the concept of 'residence' (and foreign tax credits)
controlled foreign corporations (CFCs)
thin capitalisation
general anti-avoidance
For example, Article 46 (introducing thin capitalisation) stipulates that the ratio of an enterprise's debt investments to equity investments from related parties must follow prescribed criteria. If not, interest from excess debt may be non-deductible. The introduction of the thin capitalisation regime is expected to significantly alter the way multinationals allocate debt to their Chinese operations.
Article 47, a general anti-avoidance provision, empowers tax authorities to make appropriate adjustments if it deems enterprises to have entered into transactions or business arrangements with no 'reasonable' commercial substance. Enterprises in China will therefore need to re-examine their operational structures to ensure any arrangements that confer a tax advantage have a reasonable commercial basis.
Impact for investors From a transfer pricing perspective, the EIT Law provides greater potential for APAs, and formally recognises CSAs, thereby providing enterprises with the potential to plan more effectively with respect to contribution to the development of intangibles and allocation of costs for intra-group services. The recognition of the legitimacy of CSAs now provides a solid basis for considering the co-development of intangible assets between related parties.
Continuing the global and regional trend of recent years, contemporaneous transfer pricing documentation will also now be required under the EIT Law. As mentioned above, further guidance is expected to be released as to the requisite content of the documentation and filing requirements.
Transfer pricing audits and APA negotiations in China are expected to become more sophisticated in light of the increasing transfer pricing resources and technical expertise of the SAT and local Chinese tax bureaus. Although compliance with the documentation rules could become costly for taxpayers operating in China, given the increase in transfer pricing audits in China, documentation will become an effective tool for managing the risk of potential transfer pricing challenges.
Overall, the transfer pricing developments could have significant implications for Australian entities operating in China. Australia-China investment trade flows are still increasing as growth in the Chinese economy continues unabated.
Other considerations In addition to the transfer pricing impacts outlined above, the EIT Law applies a 25 per cent statutory tax rate to all enterprises, reducing the effective tax rate of domestic enterprises, and potentially increasing the effective tax rate for FIEs.
With the reduction in the nominal tax rate for domestic enterprises, and the removal of limitations on the deductibility of certain costs / expenses, domestic enterprises will enjoy reduced tax burdens. Though foreign tax credit and CFC rules will affect outbound investment, China expects to see a decline in the number of domestic enterprises diverting investment through FIEs by transferring domestic capital overseas before making inbound investments.
Arguably the most dramatic impact will be on foreign companies investing into China. Previously enjoyed tax concessions have been abolished, and accordingly, FIEs' tax burdens should rise. The EIT Law will affect decisions regarding business models, investment structures, site selection and financing strategies. As noted by Joseph Tse of Deloitte Touche Tohmatsu in Shanghai, FIEs should therefore 'be developing strategies that optimise global tax benefits and rely more on traditional international tax-planning tools such as intellectual property planning, tax-aligned supply chain planning and transfer price planning'.
FIEs investing into China should examine their investment structures from a tax planning perspective, and consider the use of tax treaty jurisdictions when restructuring investments into China. For example, both Hong Kong and Singapore have favourable treaties with China.
While the EIT Law imposes a 20 per cent withholding tax rate for non-resident enterprises on China-sourced income, Hong Kong and Singapore's double tax agreements with China limit dividend withholding tax rates to 5 and 10 per cent respectively.
In particular, Hong Kong has become a favourable jurisdiction for the establishment of holding companies for Chinese operations. Under the Hong Kong / China treaty, Hong Kong companies are subject to relatively low interest and royalty withholding taxes, namely 7 per cent, and from a Hong Kong perspective, dividends and capital gains will not be taxed.
Furthermore, the tax rates available to group entities located in Hong Kong and Singapore will be lower than the applicable tax rates in China. In Singapore, for example, tax rates of between zero and 10 per cent are available for qualified headquarter companies.
Many large multinationals use China as the hub of their manufacturing operations, or have established wholly foreign-owned enterprises in China to perform procurement, sourcing and distribution activities. As the EIT Law has removed certain incentives previously available for manufacturing FIEs, and given the increased tax rates for FIEs, minimising the costs of their operations in China will become more important.
Effective tax management techniques may be implemented by reassessing the current supply chain and possibly relocating functions and risks that were previously performed in China. Any business restructuring will obviously need to be considered on a case-by-case basis, and also having regard to of the EIT Law's anti-avoidance provisions.
A final word The EIT Law has heralded changes to the way multinationals will structure their businesses in China. The numerous incentives previously offered by China to attract foreign investment have been abolished. The EIT Law attempts to balance a number of competing goals (encouraging domestic investment, attracting foreign investment, and increasing economic development and innovation), while enhancing tax administration procedures.
This suite of legislative changes brings China's transfer pricing environment more in line with its international counterparts.
The EIT Law sends a strong message to enterprises operating in China that tax authorities will be more vigilant in their observance and application of the arm's length principle in a related-party context. Enterprises should therefore review their current operations in China and implement effective tax risk-management strategies to manage transfer pricing exposures, and identify any tax planning areas of opportunity.
Paul Riley is national transfer pricing leader of Deloitte Australia, and is CPA Australia's representative on the transfer pricing sub-committee of the Australian Taxation Office's national tax liaison group. Janelle Ingram is a senior analyst in Deloitte Australia's transfer pricing group.
For further informatin about China's Unified Enterprise Income Tax Law visit the Deloitte website.
