By David Oak, Spencer Chong, Rhett Liu, Kevin Tsoi, Qisheng Yu, Winnie Di and Jeff Yuan**
The State Administration of Taxation's ("SAT") release of several circulars setting comprehensive transfer pricing policy for China [note 1] has stimulated significant activity and debate within China, including both formal and informal discussions with the State Administration of Taxation concerning advance pricing arrangements ("APAs").
As part of these developments, further guidance on the role and application of APAs in China has been issued by the SAT. In addition, further discussions have been held with the SAT on this matter. This article looks in detail at the recent developments and trends in China's APA program drawing on the recent Circulars issued by the SAT, the authors' practical client experience, and formal/informal discussions with the SAT.
Recent APA program developments
Over the last two years, China's APA program has been growing and developing. Following on from China's first bilateral APA with Japan in April 2005, further bilateral APAs have been agreed to with the United States and Korea. In total, seven bilateral APAs have been agreed by the SAT to date with a further 35 APA and mutual agreement procedure cases currently under consideration including bilateral APA negotiations with Denmark, Japan, Korea, Singapore, and the United States.
As part of Circular 2, the SAT took the opportunity to issue further guidance on the mechanics of China's APA program. This guidance takes on board the SAT's learnings from recent APA cases. The key guidance coming out of Circular 2 is as follows:
- Specific eligibility criteria as to when an APA will be applicable. Per the SAT, APAs will generally apply to enterprises meeting all of the following criteria:
- annual related-party transactions over RMB40 million;
- compliance with the related-party disclosure requirements; and
- preparation, maintenance, and provision of contemporaneous documentation.
- APAs will cover transactions for three to five consecutive years (previously the period was two to four years).
- Introduction of a rollback provision. Once approved by the Chinese tax authorities, the pricing policy and calculation method adopted in an APA can be rolled back and applied to related-party transactions in the year of application or any prior years if related party transactions are the same or similar.
- Introduction of anonymous pre-filing meetings, which are invaluable in obtaining the Chinese tax authorities' view on potential APA applications on a no-names basis.
- Ability to submit for bilateral and unilateral APAs a dual application/letter of intent to both the SAT and the in-charge municipal or equivalent level tax authority. This is a very positive sign as it both increases certainty and credibility of the APA program.
- Confirmation of APA timelines following agreement to proceed at the initial pre-filing meeting.
- Documentation requirements specific to the implementation of an APA following formal agreement with Chinese tax authorities.
This additional guidance, particularly the rollback provision, anonymous pre-filing meetings, and dual application at both the SAT and in-charge municipal or equivalent tax authority level (for bilateral and multilateral APAs) will attract more taxpayers to China's APA program as it removes some of the uncertainty that has historically surrounded it. This additional guidance also demonstrates the importance and commitment that the SAT is placing on APAs and its desire to create a successful APA program within China going forward.
Indeed during the March 31 SAT seminar tax officials reiterated their view that they see APAs as an excellent tool for taxpayers to manage their transfer pricing risk and eliminate double taxation. APAs also benefit the Chinese tax authorities as they provide upfront clarity and certainty on an enterprise's transfer pricing arrangements helping to secure future tax revenues via a collaborative approach rather than an adversarial tax audit approach.
It is also worth noting that the SAT issued further guidance in the form of Guo Shui Han [2009] No. 188 (Circular 188) [note 2] concerning how federal, regional, and municipal governments should review taxpayers that have received adjustments, including keeping an eye on APA requests to ensure APAs do not counter transfer pricing adjustments. Circular 118 states that taxpayers are required to submit annual contemporaneous transfer pricing documentation as part of the SAT's five-year follow up regime. For taxpayers that have applied for an APA during the follow up administration period, the circular clarifies that tax authorities are still required to carry out a follow up review of the enterprise's related-party transactions and prevent a taxpayer's profits from declining. This means that until an APA has been agreed, the tax authorities are required to review the returns of a taxpayer in line with the settlement of tax adjustment, even if under a proposed APA a taxpayer's return may be different.
Observations
Detailed below are some of the key observations based on PricewaterhouseCoopers APA experiences and discussions with the SAT.
Attribution of profits
The Chinese tax authorities are concerned that the income allocated to China enterprises in related-party situations is not commensurate with the functions and risks it is undertaking and hence the level of profit generated in China is being understated. This concern originates from the Chinese tax authorities' belief that non-routine activities such as local marketing are being undertaken in China and that such value added activities should be remunerated accordingly.
The Chinese tax authorities' thinking is that because these non-routine activities potentially add value to the intangibles of the foreign group, the Chinese affiliates undertaking these functions and bearing the corresponding risks should be remunerated accordingly. Alternatively, the Chinese tax authorities could take the view that an intangible asset exists and has been created in China and as such should be appropriately remunerated.
As a result of this thinking, during APA negotiations, Chinese tax authorities often focus on the depth and extent of local functional analysis work resulting in more intensive fieldwork/examination. Therefore, taxpayers need to ensure that adequate work has been carried to review the functions, assets, and risks carried out by Chinese affiliates with particular focus on the review and appropriate remuneration of all non-routine functions. Furthermore, following the GlaxoSmithKline case, [note 3] the Chinese tax authorities have indicated that where non-routine contributions have been made in China a simple cost plus or transactional net margin method (TNMM) may not be appropriate and that consideration should be given to using alternative transfer pricing methods such as the profit split method.
Location savings
Chinese tax authorities are questioning whether the financial benefits resulting from lower operating costs in China as a result of cheaper land and lower labour costs when compared to other countries globally belong to the China affiliate in a related party situation rather than an offshore parent or affiliate. For example, the Chinese tax authorities are questioning whether a contract manufacturer should only receive a cost plus remuneration or whether it should receive a greater return in recognition for the location savings of operating in China.
This is an interesting debate which taxpayers need to be prepared to answer when discussing and negotiating an APA. Whilst in a contract manufacturing scenario there may be third-party examples of China entities receiving a cost plus remuneration supporting the view that location savings can and are be passed to an overseas entity, there may be other scenarios where the issue is more complex and requires careful consideration.
Negotiating intercompany agreements
The Chinese tax authorities also are taking a greater interest in the process undertaken by related parties in intercompany arrangements. The Chinese tax authorities are looking for evidence of bargaining/negotiation between related entities and asking whether an independent third-party would have agreed to enter into such an arrangement. This is consistent with international and OECD thinking in this area that related-party entities and hence the transactions they enter into should be looked at on a stand-alone basis.
With this in mind, during the negotiation of an APA, taxpayers should be prepared to provide evidence of negotiation between related entities and/or evidence that a third party would agree to enter into a similar arrangement.
Resources
Within the SAT there are only five or six transfer pricing specialists skilled and experienced enough to deal with APA cases, particularly bilateral cases. As such the SAT continues to be industry-focused and relies on regional or local tax authority resources to undertake detailed field work and negotiate unilateral APA cases.
Historically, this has resulted in reluctance from taxpayers to enter into the APA process due to a perceived lack of skilled resources within the SAT to deal with these matters. Whilst resourcing remains an issue, following the publication of Circular 2, the ability to simultaneously make an APA application to both the SAT and the regional or local Chinese tax authority for bilateral and multilateral APAs will assist in ensuring that going forward, there will be greater centralised coordination of APA applications which will help to ensure greater consistency and will also assist in enabling multi-China entity APA negotiations rather than separate negotiations with each individual tax bureau.
Furthermore, based on discussions with the SAT, a core team of around 200 transfer pricing specialists across China is being formed to enhance consistency and technical competency. This will also assist in helping to improve the efficiency of China's APA process.
Conclusion
Following the publication of Circular 2, and subsequent circulars, it is clear that the SAT is now placing greater importance on China's APA program. The SAT sees APAs as having a dual benefit; a way for taxpayers to effectively manage their transfer pricing risk and ensure certainty around an entity's transfer pricing arrangements going forward as well as an opportunity for Chinese tax authorities to lock in future tax revenues.
Furthermore, APAs also provide the Chinese tax authorities with greater insights on current transfer pricing business practices helping to increase the Chinese tax authority's level of transfer pricing experience. This will assist the SAT in identifying potential transfer pricing risk areas and areas for future audit focus.
Given the SAT's increased focus and willingness to enter into APAs, more bilateral APAs are likely in the near future as multinational companies look for greater certainty around transfer pricing arrangements. However, it should be noted that whilst the SAT is placing greater focus on APAs, the process in China is still by no means straightforward and taxpayers should ensure that they are adequately prepared before entering into APA negotiations.
**The authors are transfer pricing partners and senior managers with PricewaterhouseCoopers specialising in dispute resolution in China and Hong Kong. The PwC China and Hong Kong firm has concluded four of the seven bilateral APAs in China as well as numerous unilateral APAs.
Note:
- These include Guo Shui Fa [2008] No. 114 - Annual Reporting Forms for Related Party Dealings of Enterprises of the People's Republic of China (Circular 114) and Guo Shui Fa [2009] No. 2 - Implementation Measures of Special Tax Adjustments (Trial) (Circular 2).
Most recently the SAT held a full day seminar on 31 March 2009 to provide further explanations on China's latest rules on administering special tax adjustments.
Circular 188 - Intensifying Transfer Pricing Follow-up Administration - dated April 16, directed the nation's regional and local tax authorities to develop comprehensive systems to monitor taxpayers with transfer pricing adjustments for five years and to review their APA requests to ensure APAs do not undermine adjustments.
British parent GlaxoSmithKline settled its transfer pricing case with the U.S. government for $3.4 billion after the IRS claimed that Glaxo's U.S. affiliate was the economic owner of the U.S. marketing intangibles for a group of Glaxo drugs including Zantac and several other popular pharmaceuticals researched and developed in the United Kingdom.
This article is reproduced from its original publication entitled "SAT Promoting APAs in China" in the 28 May 2009 (Vol. 18, No. 2) issue of BNA Tax management transfer pricing report. Copyright 2009 by The Bureau of National Affairs, Inc. Reprinted with permission.
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