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China & Hong Kong Latest Transfer Pricing Developments
www.pwc.com/tp
Navigating through the complexity
June 2015
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Agenda
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1Introduction and recent developments of Base Erosion and Profit Shifting (BEPS)
2 Recent developments in transfer pricing regulations and enforcement in China
3 Advance Pricing Arrangement regime in China and Hong Kong
4 In a nutshell
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Introduction and recent developments of Base Erosion and Profit Shifting (“BEPS”)
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The Impact
SAT’s response
Recent BEPS
update
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In the headlines…
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BEPS: Base erosion and profit shifting
Commissioned by G20 and devised by the OECD
Domestic and international tax rules fail to keep pace with changing business models. Lack of coherence of tax rules between countries. TP rules permit separation of profits from economic substance.
• Shifting profits in ways that erode the taxable base to locations with favourable tax treatment
• No or unduly low tax
• Consensus driven approach involving alignment of domestic rules, changes to Model DTAs and Commentary and Transfer Pricing Guidelines
What is BEPS?
How to address BEPS?
Wh
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Wh
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The Impact
SAT’s response
Recent BEPS
update
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Addressing Base erosion and profit shifting
Current update……
• G20 summit
• <Addressing Base Erosion and Profit Shifting> (12 February 2013)
• <Action Plan on Base Erosion and Profit Shifting> (19 July 2013)
• Any new update?
9
Addressing Base Erosion and Profit Shiftinghttp://www.oecd-ilibrary.org/taxation/addressing-base-erosion-and-profit-shifting_9789264192744-en
Action Plan on base Erosion and Profit shiftinghttp://www.oecd.org/tax/beps.htm
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The Impact
SAT’s response
Recent BEPS
update
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OECD 15 Actions and 7 Deliverables for 2014
11
1 Addressing the tax challenges of the digital economy
2 Neutralising the effects of hybrid mismatch arrangements
3 Strengthening CFC rules
4 Limiting base erosion via interest deductions and other financial payments
5 Countering harmful tax practices more effectively, taking into account transparency and substance
6 Prevent treaty abuse
7 Artificial avoidance of PE status
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OECD 15 Actions and 7 Deliverables for 2014
12
8 Align TP outcomes with value creation: intangibles
9 Align TP outcomes with value creation: risks and capital
10 Align TP outcomes with value creation: other high risk transactions
11 Establish methodologies to collect and analyse data on BEPS and the actions to address it
12 Require taxpayers to disclose their aggressive tax planning arrangements
13 Re-examine TP documentation
14 Make dispute resolution mechanisms more effective
15 Develop a multilateral instrument
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The Impact
SAT’s response
Recent BEPS
update
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Impact of BEPS…
14
Nexus
• Review of the taxation principles applicable to the digital business
• Widening the definition of PE
Transfer pricing
• Substance.
• Attribution of profit to the PE
• Intangibles: Legal ownership vs economic ownership
• Further documentation obligations
Financing
• Hybrids
• Further attention to financial transactions with related parties.
• Limitations to deduct interest expenses
Anti-abuse
• Additional anti-abuse legislation is expected.
• Tax inspection could focus more in the review of anti-abuse legislation.
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The impact
SAT’s response
Recent BEPS
update
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China SAT’s Responses and Opinions
16
SAT Announcement on 17 September 2014
SAT Propaganda Conference on BEPS
Project on 25 September 2014
• Showing strong supportive gesture to the OECD’s BEPS project
• Establishing a BEPS task force within the SAT
• Taking this opportunity to improve China's domestic tax rules and international tax administration capabilities
• Identifying 15 unacceptable tax practices
• Emphasizing SAT’s view of the OECD recommendations
• Providing the SAT’s observations on specific BEPS Action Plans
• Sharing the SAT’s action plans on an international level and domestic level to address BEPS timetable
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15 Unacceptable Tax Practices (1/2)
17
SAT’s official identified 15 unacceptable tax practices, which reflect the SAT’s determination to tackle BEPS issues in China:
Base Erosion and Profit Shifting
Double / Multiple Non-taxation
Aggressive Tax Planning
Tax Regimes that are not Transparent
Holding Structures or Transactional Arrangements
without Economic Substance
Deduction of Inappropriate Costs
Loss incurred by Chinese
Subsidiaries with Single / Simple
Functions
Treaty Abuse
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15 Unacceptable Tax Practices (2/2)
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SAT’s official identified 15 unacceptable tax practices, which reflect the SAT’s determination to tackle BEPS issues in China:
Unreasonable Over-pricing of
Intangibles
Remuneration Inconsistent with
Function and Contribution to Value Creation
High-Tech Company with Low
Profit Margins
China's Location Specific Advantages
not Observed
Losses Transferred from Foreign Entities to the
Chinese Subsidiaries
Refusal to Provide Data / Information /
Documentation to Chinese Tax Bureaux
upon Request
Hybrid Mismatch Arrangements for the Purpose of Tax
Avoidance
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SAT’s increased focus on Anti-avoidance
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In a recent public seminar, an SAT official has reiterated the SAT’s increased focus on anti-avoidance. The following trend shown during the seminar shows the increase in tax revenue from SAT’s continuous and relentless effort in combating and cracking down the cross border tax avoidance and evasion:
Published by SAT during a public seminar in April 2015
2014年中国反避税贡献税款523亿元
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Jiangsu State Tax Bureau’s Recent Development on International Taxation Administration
Jiangsu STB is the first and only provincial tax bureau, which had established a specific branch to centralise the transfer pricing investigation and APA administration.
• Jiangsu State Tax Bureau (“Jiangsu STB”) is well known for its sophistication and aggressiveness in transfer pricing investigation.
• In June 2014, Jiangsu STB issued a paper entitled <Administrative Plan on international tax compliance for 2014-2015>, summarizing their current stance towards the BEPS Action Plan and highlighting the most important tax risks in an international context for MNEs.
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Jiangsu STB’s Administrative Plan on international tax compliance for 2014 — 2015
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• Establish off-shore structure to avoid tax jurisdiction• Base erosion by cross-border investment or financing• Erosion of the profit of domestic enterprise by overseas output of intangible
assets• No report or under-report of overseas income by overseas investing
enterprises• Functional restructure and mismatch of economic substance and profit level• Profit transfer by means of associated outbound payment• Lowering the tax burden of the whole group by off-setting intercompany
transactions• Profit transfer by means of purchasing overseas associated enterprise with
unreasonable price• Provide associated R&D service without responding gains or returns• Benefit the whole group by assuming implicit cost without corresponding
compensation• Tax avoiding transactions by means of shell company in tax heaven or
offshore account • Not report capital gains obtained by taking advantage of start-up period• Avoid non-resident tax obligation thorough three-party contract
Tax risks of cross-border taxation
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BEPS
Overview
Current updates
OECD’s Actions and Deliverables
in 2014
The impact
SAT’s response
Recent BEPS
update
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Recent Updates
OECD 15 Actions and 7 Deliverables for 2014
23
1 Addressing the tax challenges of the digital economy
2 Neutralising the effects of hybrid mismatch arrangements
3 Strengthening CFC rules
4 Limiting base erosion via interest deductions and other financial payments
5 Countering harmful tax practices more effectively, taking into account transparency and substance
6 Prevent treaty abuse
7 Artificial avoidance of PE status
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Recent Updates
OECD 15 Actions and 7 Deliverables for 2014
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8 Align TP outcomes with value creation: intangibles
9 Align TP outcomes with value creation: risks and capital
10 Align TP outcomes with value creation: other high risk transactions
11 Establish methodologies to collect and analyse data on BEPS and the actions to address it
12 Require taxpayers to disclose their aggressive tax planning arrangements
13 Re-examine TP documentation
14 Make dispute resolution mechanisms more effective
15 Develop a multilateral instrument
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Issue date Action Plans Key message
31 March’15 Action 12 Require taxpayers to disclose their aggressive tax planning arrangements
Sets out a standard framework for a mandatory disclosure regimethat ensures consistency while providing sufficient flexibility to deal with country specific risks and to allow tax administrations to control the quantity and type of disclosure
3 April’15 Action 3Strengthen CFC Rules
Focuses on developing recommendations for the design of CFC rules to combat BEPS
16 April’15 Action 11Establish methodologies to collect and analyse data on BEPS and the actions to address it
Improve availability and analysis of data on BEPS, including to:
• monitor the implementation of the Action Plan and;
• evaluate effectiveness and economic impact of actions to address BEPS on an ongoing basis
29 April’15 Action 8Assuring that TP outcomes are in line with value creation Intangibles
To ensure contributions are tantamount to the benefits received under a CCA
15 May’15 Action 7Prevent the artificial avoidance of PE status
Expansion of scope of existing PE rules
22 May’15 Action 6Prevent Treaty Abuse
Includes a simplified Limitation on Benefits (LOB) Article for inclusion in the OECD Model Income Tax Convention and provides ‘conclusions and proposals’ on 20 targeted issues
Recent BEPS updates - At a glance
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Discussion Draft on Revisions to Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (“CCAs”)
• On 29 April 2015, the OECD released a discussion draft proposals under Action 8 of the BEPS Action Plan
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BEPS Update
• Proposed fundamental modifications to Chapter VIII of the OECD Transfer Pricing Guidelines with respect to measuring the value of contributions to CCAs and the tax characterisation of contributions, balancing payments and buy-in/ buy-out payments; and to make it consistent with other BEPS amendments including those addressing the fundamental issues on risk, capital, recharacterisation and intangibles
• Consistent with the underlying concept of BEPS initiative, the primary goal of the proposed revision – to ensure contributions are tantamount to the benefits received under a CCA
• The OECD invited targeted comments on these proposals by 29 May 2015 The input will be discussed during a public consultation on 6/7 July 2015
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OECD releases revised BEPS proposals on Permanent Establishments
• On 15 May 2015, the OECD released revised proposals on the Permanent Establishments (PE) rules in Article 5 of the OECD Model Tax Treaty
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BEPS Update
• On 15 May 2015, the OECD released revised proposals on the Permanent Establishments (PE) rules in Article 5 of the OECD Model Tax Treaty
• Scope of dependent agent rule is expanded (including narrowing the scope of independent agent rule)
• Scope of specific activity PE exemptions is narrowed
• Proposed anti-fragmentation rule to prevent abuse of the PE rules by segregating activities across associated entities
• Expansion of the scope of existing PE rules
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Recent developments in transfer pricing regulations and enforcement in China
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TP in China
China TP regulations
Intangibles
Intra-group
services
Investments in/ out of
China
Location Specific
Advantages
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Briefly, SAT’s recent focus area of international tax development in China:
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• To take part in international tax rules formulation along the principle of “profits should be taxed in the location where economic activities take place and values are created”
• To improve domestic tax laws and systems• Revision of Tax Collection and Administration Law and Individual
Income Tax Law (in 2 or 3 years)• Tax regulations recently issued: SAT Order No.31, SAT Public Notice
[2015] No.7, SAT Public Notice [2015] No.16• To formulate detailed tax rules regarding controlled foreign
corporation and hybrid mismatch
• To strengthen anti-avoidance measures and Exchange of Information
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Briefly, SAT’s recent focus area of international tax development in China:
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• To help taxpayers by:• Making tax regulations more transparent and clarify about taxpayers
rights and obligations;• Soliciting feedback from different stakeholders in respect of tax reform in
China
• To help developing countries to upgrade their tax administration and collection capabilities, consistent with China’s One Belt One Road strategy
• Following issuance of OECD discussion draft on CCAs, SAT issued State Council Circular [2015] No. 27 effecting the below:• Remove approval requirement on a series of tax matters, including Cost
Sharing Agreement; • Cancelling the non-administrative approval of 49 items and adjusting the
approval authority of 84 items that requires government internal approval
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TP in China
China TP regulations
Intangibles
Intra-group
services
Investments in/out of
China
Location Specific
Advantages
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Definition of IntangiblesOECD Perspective
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Commercial intangibles
• Either used for the production of a good or the provision of a service.
• Or business assets transferred to customers or used in the operation of business (e.g. software)
Trade intangibles
• Often created through risky and costly R&D activities.
• E.g. patents, know-how, designs, and models
Marketing intangibles
• Product of market research or sales activities and aids in commercial exploitation or have an important promotional value.
• E.g. trade names, trademarks, customer lists, distribution channels and unique packaging
(OECD Transfer Pricing Guidelines, paragraph 6.2)
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HNTE• Are the “contract manufacturing” companies
allowed to be entitled to HNTE status or to enjoy super deduction of R&D expense?
• Higher return is expected if R&D related activities are performed?
Royalty• Can the rate of royalty sustain after China’s
contribution to the value of IP becomes more notable?
34
China’s perspective: Jiangsu State Tax Bureau’s official opinions on High/New Tech Enterprise (HNTE) and royalty
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TP in China
China TP regulations
Intangibles
Intra-group
services
Investments in/out of
China
Location Specific
Advantages
Services fee for shareholder activities not deductibleSAT submitted official Response to the United Nations regarding intra-group services and management fees, reaffirming the importance of arm’s length principle on intra-group services payment
Profit shifting via outbound payments The State Tax Bureau of the Jiangsu Province issued the Administrative Plan on international tax compliance for 2014-2015, highlighted the most important tax risks in an international context for MNEs were related to BEPS
Six-point testsOutlined a ‘six-point test’ to determine whether transfer pricing adjustment is required
Scrutiny on outbound service fee and royalty feeWith the released of Circular 146, The SAT requested local-level bureaus to launch a comprehensive tax examination on the significant service fee and royalty fee payments made by Chinese enterprises to their overseas related parties
Four types of “non-deductible” payments The SAT issued Public Notice 16: Certain Corporate Income Tax Matters on Outbound Payments to Overseas Related Parties provided guidance on outbound payments to foreign related parties
Background of Public Notice 16 (“PN16”)
Mar 2014
Apr 2014
Jun 2014
Aug 2014
Mar 2015
36
Arm’s Length Principle and Authenticity test
4 types of “non-deductible” payments
Key focus of Public Notice 16
37
• No approval is required in advance of any overseas related party payments
• The tax authority is empowered to request for contracts or agreements concluded with its overseas related party, and relevant documentation within a specified period, to test the arm’s length nature of the related party payment
• The tax authority is empowered to make special tax adjustments in cases of non-compliance with the arm’s length principle
Arm’s Length Principle and Authenticity test
Enterprises must comply with the arm’s length principle when making outbound payments to avoid special tax adjustments by the tax authority; the tax authority is empowered to request for relevant related party documentations to proof the authenticity and arm’s length nature of the transaction
PublicNotice
16
Adjustment period:
10 Years(commencing from year of
transaction)
Official interpretation
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Unqualified service fee
Unqualified overseas related parties
Royalties paid to related
parties without contribution to value creation of underlying
intangible assets
Royalties paid for incidental benefits from financing or
listing activities
4 Types of “non-deductible” payments
Non-deductible
39
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TP in China
China TP regulations
Intangibles
Intra-group
services
Investments in/out of
China
Location Specific
Advantages
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Implications on MNC operations in China
Global value chain vs. Profit split method
• Historical trend: setting up of certain simple functions entities in China by MNCs
• Examples: Contract manufacturers involved in R&D process; High and New Technologies Enterprises (HTNEs) enjoying preferential tax rates but pay outbound royalty to parent company
• Key question: Which party to secure profits deriving from an integrated value chain?
• China perspective: assess the importance of the entities, to justify a higher return of the single function performed
• Indicative changes towards Profit Split concept in China’s tax landscape
• Potential usage of the profit split method will increase in China bringing additional income to the country
• Flip side: whether Chinese tax authority is willing to accept the losses from the implementation of the profit split method?
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Implications on outbound investments from China
Principal structure model vs. Profit split method
• Historical trend:
• setting up of headquarters in lower tax jurisdictions by Chinese entities, economic activities remain in China
• Chinese operating company pays management fee/ royalty to offshore “headquarters”, which have no economic substance
• China perspective: challenge the substance of offshore “headquarters” and assess the importance of the economic activities of China operating company
• Key question: whether profit split method is appropriate to capture the contribution of Chinese operating companies?
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In a recent public seminar, the Deputy Director of SAT International Taxation Department (Ms. Wang Xiaoyue) has shared her the SAT’s agenda to enhance administration for outbound investments: formulating CFC implementation rules, Foreign Tax Credit management, Information Sharing System, expansion of knowledge database of more countries’ tax systems.
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TP in China
China TP regulations
Intangibles
Intra-group
services
Investments in/out of
China
Location Specific
Advantages
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The attribution of location savings and market premium
• OECD: location savings do not belong automatically to one party but must be allocated in line with the bargaining situation
- Need to determine the appropriate allocation of location savings: the arm’s length principle (based on bargaining positions)
- Due to lack of sufficient comparable data, need to conduct a vertical analysis of entities along the value chain
• Location savings and market premium are new transfer pricing (“TP”) challenges often seen in BRICS* economies with low cost, but booming economy and huge market, such as China and India
*BRICS: Brazil, Russia, India and China
44
Market premium: pull of sales volume and price
Location savings: reducing prices of factors of production
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Quantification and allocation of location specific advantages
45
Unique features in China limiting relevance of non-Chinese companies as comparables
• Fast economic growth, rising income and a huge consumer base with great purchasing power creating imbalance of supply and demand
• Impact of government regulations and policies on production and consumption
• Consumer general preference to foreign brands
Location savings and market premium
China authorities apply LSAs in transfer pricing investigations and APA negotiations
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Advance Pricing Arrangement (“APA”) regime in China and Hong Kong
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SAT Reports China completed Eight Bilateral APAs, 11 Unilateral APAs, in 2013
47
Key development:
China’s SAT releases its annual APA
report for 2013
Key takeaway:China signs 8 BAPA and 11
Unilateral Agreements in
2013
What’s next:Demand for
BAPAs continues to outstrip the SAT’s limited staff resources
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China APAs
48
1
2
3
4
In 2013, total of 11 unilateral APAs and 8 bilateral APAs, representing an all year high, among which 5 were signed with Asian countries, 2 were with European countries, 1 was with North American country.
5
From 2005 to 2013, 147 intentions of formal applications for bilateral APAs (of which 37 were concluded) were received. The number of APA applications will continue to increase.
By 31 December 2013, cumulative total of APAs signed is 104, 67 unilateral and 37 bilateral.
Due to lack of resources in SAT, significant requests for APA are waiting for acceptance.
For new APA application, different type of related party transactions (e.g. services, intangibles), an innovative application of TP method (e.g. profit split method), or a high-quality analysis for intangibles and market premium will get SAT’s attention and priority consideration.
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2003 2005 2006 2007 2008 2010 2011 2012 2013 2014In
Progress
Hong Kong DTA Network
Belgium
Thailand
MainlandChina
Luxembourg
Vietnam
Brunei
Netherlands
Indonesia
Hungary
Kuwait
Austria
UnitedKingdom
Ireland
Liechtenstein
France
Japan
New Zealand
Portugal
Spain
Czech Republic
Switzerland
Malta
Jersey
Malaysia
Mexico
Canada
Italy
Guernsey
Qatar
Korea
SouthAfrica
United Arab
Emirates
Bahrain
Bangladesh
Finland
Germany
India
Israel
Latvia
Macao SAR
Mauritius
Pakistan
Romania
Russia
Saudi Arabia49
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Hong Kong APA program’s development
50
HK APA is still progressing
• APA program was introduced in 2012 with cautious optimism in Hong Kong• Associated practical challenges were fully apprehended• APA is accepted as an effective dispute resolution mechanism
HK APA experience
• IRD is open to fair negotiations with enterprises• Shift in bilateral relationship between IRD and enterprise• Reduce TP audits and consequential adjustments and penalties
Snapshot of APA filings
• Trade: distribution, wholesaling, service, manufacturing, research and development
• BAPA partners: Mainland, Netherlands, Japan, Korea• TP methodology: TNMM-FCMU, TNMM-operating margin, cost plus, profit
split• Processing time of BAPA concluded: 15 to 24 months• Period of BAPA concluded: 5 years
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Hong Kong APAs
HK IRD very encouraging of APA
applications
Five APA applications accepted by the HK IRD
to date
Two concluded negotiations with
Netherlands and Japan
Open and transparent approach is one of the
key success factors
Source: Information as at 31 October 2014 per IRD comments at a public seminar
51
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A Recent Bilateral APA Case (Scope)
52
Parent company in Country A
Manufacturing company in Country A
Third party assemblers in Country A
Hong Kong company
Third party suppliers in Country B
Third party manufacturers in
Country B
Finished products
Semi-finished products
Manufactured parts W
Manufacturedparts X
Manufactured parts W & XKey components & materials
Key components
Materials
• Finished products with unique characteristics
• Country A:• Major assembly
• Hong Kong:• Procurement• Monitoring third party
manufacturers• Exchange and inventory
risks• No R&D and marketing
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A Recent Bilateral APA Case (Technical Issues)
53
• Business nature: wholesaler or contract manufacturer
• Review of possible internal comparables
• TNMM – Full Cost Mark-Up
• Exclusion of “extraordinary loss” from FCMU for a particular year
• Determining the arm’s length range
• Weighted average approach
• Pooled approach
• Compensating adjustment
• Term adjustment
• Year-by-year adjustment
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In a nutshell
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Managing TP risks
55
(a) Review the current risk profile, identify “high risk” areas and take immediate actions
(b) Review the economic substance along the value chain and whether the tax arrangement is consistent with the economic substance
Proper TP documentation in place to get ready for a potential transfer pricing investigation
Effective & efficient communication maintained with local level tax bureaus
(a) Sound ongoing internal tax risk control and improve charges mechanism
(b) Sustainable intra-group charges structure
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Tax function in China – Being aware of the reality
56
Be pro-active!What are the high risk areas?
Be flexible!SAT views are also development, be open-minded and adapt to the changes
Be prepared!Be aware and get ready to address unique challenges in China
Be sustainable!Tax arrangement follows economic substance, build sound tax internal control system
01 02 03 04
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Thank you!
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The information contained in this presentation is of a general nature only. It is not meant to be
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please ensure that you obtain advice specific to your circumstances from your usual PwC
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The materials contained in this presentation were assembled in April 2015 and were based on
information available at that time.
