Some common trends that need to be considered and addressed by multinationals in China, including:

•Functional and risk profile and economic outcomes not aligned

The Chinese tax authorities often emphasize that the enterprise’s functional profile should match the economic outcomes it realizes. In some cases, a company performs R&D, manufacturing and local marketing and sales activities but is defined as a toll manufacturer, so only compensated with a low return on a cost plus basis. In addition, as with other similar cases in practice, the company is characterized as a high-tech enterprise enjoying preferential tax policies, which is clearly inconsistent with its toll manufacturer label.

The Chinese tax authority considers that the economic substance is not reflected in commercially realistic outcomes and thus would consider that the profit split may be a more appropriate method than the Transactional Net Margin Method (“TNMM”) for measuring the performance of a high-tech enterprise and a special tax adjustment would be made accordingly.

•Shifting profits outside China by inappropriately paying service fees to the related party

Recently, the SAT released the Notice of Anti-Avoidance Examination on Significant Outbound Payments (Circular [2014] No. 146). In this Circular, the SAT requests the local-level tax bureaus to launch a comprehensive tax examination on significant outbound service fee and royalty fee payments to overseas related parties of a multinational company, with an aim to strengthen the tax administration on intra-group charges and prevent profit shifting.

• Providing R&D services to offshore related parties but failing to indicate corresponding incomes or returns

After signing the contract R&D agreement, the R&D activities performed by the Chinese subsidiary were compensated with a low return on a cost plus basis. The concept is that the investors should receive more of the profits generated based on the presumption that capital is always closely linked with risks. Since the functions performed by the Chinese subsidiary are financed by the overseas related party, the risks are naturally on the side of the latter and therefore most of the returns should be attributed to them. Also, as the Chinese Company utilizes the IP (results of the R&D process) it should pay royalties to the IP owner (i.e., the BVI entity).

To this kind of arrangement, the Chinese tax authorities would argue that the intercompany agreement is aimed at intentionally shifting the legal and economic rights of the IP to the overseas related party.

•Bearing hidden costs benefiting the overall business but failing to obtain corresponding compensation

The SAT accepts the focus of the BEPS report regarding an increase in information disclosed by transfer pricing documents and encourages enterprises to provide relevant information on their global group organization structure, economic activity, profit distribution and tax payments in different jurisdictions (i.e., the master file and country by country reporting requirements), besides preparation of relevant materials of their own enterprises in the contemporaneous transfer pricing documentation (i.e., the local file). In practice, during transfer pricing audits, some Chinese tax authorities have requested taxpayers to provide the global supply chain profitability information.

Conclusions

Multinational companies operating in China should recognize, monitor and mitigate the transfer pricing risks in the increasingly tough and challenging transfer pricing audit environment in China from now on. Multinational companies should pro-actively address any potential transfer pricing issues and risks and identify transactions and arrangements that might be challenged by the Chinese tax authorities.

This article was created on: 2017.09.20