By: Bill Ye (Partner), Ma Xiaoyu (Associate)
The State Administration of Taxation (“SAT”) issued Bulletin 42 on 29 June 2016 to improve administration of related-party transaction reporting and contemporaneous documentation (“Bulletin 42”). With the first wave of comment behind us, many questions have emerged. Among the controversial provisions, Article 18 stands out It exempts enterprises transacting only with their domestic related parties from preparing master files, local files and special issue files. The new provisions will have a significant impact on taxpayers. So what is the trend of regulation of domestic related-party transactions under Bulletin 42?
Special provisions for domestic related-party transactions were first set out in the Measures for the Implementation of Special Tax Adjustments (for Trial Implementation), Guoshuifa  No. 2 (“Circular 2”). According to Circular 2, as a general rule, no transfer pricing adjustments need to be made to transactions between domestic related parties and eligible domestic enterprises, for example, those less than 50% foreign-owned whose related-party transactions are conducted with domestic affiliates only, may be exempt from preparing contemporaneous documentation.
For enterprises transacting only with domestic related parties, exemption from preparing contemporaneous documentation has become a general principle in Bulletin 42 rather than an exception as in Circular 2. This reflects SAT’s regulatory policy and experience in the past nine years, that is domestic related-party transactions are not a focus of regulating. We understand the main reason is that , adjustments to domestic related-party transactions do not increase total tax revenue except for special cases where differences in tax rates or profit-and-loss conditions exist. In addition, transfer pricing itself is not a tax regulation in the strict sense, but is a subjective judgment, which is prone to abuse and disputes. In light of this, SAT has decided in principle not to make transfer pricing adjustments to transactions between domestic related parties. The decision is also meant to avoid a waste of tax administration resources as a consequence of local government competition for tax revenue.
Under the exemption in Bulletin 42, it is clear that even if an enterprise is subject to transfer pricing investigation and the tax authorities require it to submit contemporaneous documentation which is not prepared by the enterprise, then still, interest under Article 122 of the Regulation on the Implementation of the Enterprise Income Tax Law, or penalties under Article 62 of the Tax Collection and Administration Law will not apply as long as the enterprise transacts only with its domestic related parties.
However, does that mean there is no problem with the administration of transfer pricing involving domestic related-party transactions? Will companies no longer have to worry about domestic related-party transactions under Bulletin 42? How should tax authorities and enterprises deal with related-party transactions?
1. Contemporaneous documentation for related-party transactions under Bulletin 42
Take a hypothetical example. Three domestic factories export goods directly to foreign countries and all enjoy big profits. Now, what if the factories sell products at relatively low prices to a domestic related trading company which in turn exports the products?
Under Circular 2, it will not be burdensome for the intermediate trader to prepare contemporaneous documentation if it is able to set reasonable prices for its domestic purchases and foreign sales and remain profitable. The domestic factories with little profit or slight losses may not draw the attention of the tax authority since they are not required to prepare contemporaneous documentation. This may ultimately lead to asymmetric information and trades. In this case, if the tax authority believes that the three factories have indirectly transferred their profits abroad through the intermediate trader, is it able to make transfer pricing adjustments to these factories, and how? Theoretically, the tax authority may conduct a joint investigation coordinated by SAT, but that will be difficult in reality.
There is another question: does the exemption from preparing contemporaneous documentation mean that businesses will be totally free from being investigated in relation to transfer pricing? Obviously, the answer is no. This is because profits may be transferred indirectly whenever a domestic related-party is involved in overseas transactions, regardless of whether or not adjustments are made to domestic related-party transactions due to different tax rates. Therefore, enterprises that are exempt from preparing contemporaneous documentation for domestic related-party transactions may still be subject to transfer pricing investigation and adjustments. In other words, even though documentation is not required, enterprises still need to consider the risk based on their overall related-party transactions, and prepare for the possibility of investigation by having good corporate governance and internal information collection system; otherwise if they lower their standards of compliance management because of the exemption on contemporaneous documentation they will be exposed to risk.
Relaxing regulation of domestic related-party transactions is based on the whole course of a transaction without a party involving in a cross-border related transaction where a cross-border profit transfer occurs. In order to reduce business and regulatory costs under Bulletin 42, more work needs to be done, for example, an exchange of contemporaneous documentation reports and full-chain analysis of group companies.
2. Transfer pricing investigations into domestic related-party transactions: Present and Future
Both Bulletin 42 and Circular 2 confirm that no adjustments will be made to domestic related-party transactions in principle. Since 2012 the focus of anti-tax avoidance has been on domestic enterprises. According to public reports, the first transfer pricing investigation of a domestic related-party transaction in China was conducted in 2013, in Jiaxing, Zhejiang province. However we have learnt that investigation and adjustment of domestic related-party transactions began much earlier and have since been reported following the Jiaxing case. The available cases, show that adjustments were aimed at enterprises that benefited from differences in tax rates and had a history of losses.
An enterprise may take advantage of different tax rates to transfer profits to a domestic related-party that enjoys a preferential tax rate so as to minimize tax. A preferential tax rate is granted by the government to stimulate development of some industries (such as high-tech enterprises and enterprises with both a Software Product Registration Certificate and a Software Enterprise Certificate) or regions (such as Xinjiang and Tibet). From a functional risk point of view, investigations into the related-party transactions of high-tech enterprises may at the same time call their status as high-tech enterprises into question, a problem that may require extra attention. In another scenario, an enterprise with a history of losses that participates in a related-party transaction may carry forward the tax losses to reduce its tax liabilities. Given the five-year carry forward period, such an arrangement may even give rise to permanent differences in taxation. Therefore, it has long been a regulatory focus of tax authorities.
Some suggest that an enterprise that transfers profits to another one enjoying fiscal subsidies (for example, tax refunds) should also be subject to transfer pricing investigation because its tax liabilities are actually reduced. However, this is a false proposition. Unlike the cases of enterprises with different tax rates or a history of losses, benefiting from fiscal subsidies does not constitute a tax avoidance arrangement in the legal sense. Fiscal subsidies are granted to enterprises with the aim of attracting investment; the government will refund to the firm, tax paid and retained by local government. As such preferential treatment does not reduce the tax actually paid by the enterprise, any transfer pricing adjustments will not increase the tax revenue payable by that enterprise. If such treatment is viewed as reducing the country’s overall tax revenue, then it is up to local government to control fiscal subsidies, and not up to tax authorities to impose adjustment.
The biggest risk relating to domestic related-party transactions is that, local tax authorities, in an effort to expand taxation income, tend to stretch the interpretation of the Tax Collection and Administration Law and accordingly initiate investigations even where there are no differences in tax rates in spite of the special procedures provided in the Measures for the Implementation of Special Tax Adjustments. Such investigations may be of both turnover tax and income tax without any corresponding adjustment.
First, it remains to be clarified whether it is mandatory for transfer pricing investigations into related-party transactions to follow the case-filing mechanism under the Measures for the Administration of General Anti-Tax Avoidance (for Trial Implementation). Since SAT is reluctant to make adjustments to domestic related-party transactions and these provisions were drafted primarily in relation to enterprise income tax, their coordination with the Tax Collection and Administration Law needs to be further managed. In practice, the Tax Collection and Administration Law has been used for transfer pricing adjustments to related-party transactions with respect to turnover tax (e.g. adjustments made to business tax several years ago when it was not replaced by VAT), while some tax authorities have investigated and adjusted income tax based on the Tax Collection and Administration Law instead of the case-filing mechanism. Therefore, further coordination of regulations and practice is needed.
In addition, the Enterprise Income Tax Law provides that costs and expenses shall be true and reasonable in related-party service transactions and accordingly some tax authorities require adjustments to these expenses. How this harmonises with the transfer pricing management of related-party service transactions is not only a matter to be resolved, but is also a factor affecting the tax administration of cross-border service transactions. Furthermore, the VIE structure and other special transaction structures also impose new challenges on the management of domestic related-party transactions.
More importantly, there lacks corresponding adjustment mechanism in relation to domestic related-party transactions. For cross-border related-party transactions, under Article 9 of the OECD Convention, where adjustments have been made by a Contracting State, the other State may request such corresponding adjustments as it deems necessary. Taxpayers may also request their respective authorities to consult with each other about adjustments. When domestic related party transaction adjustments have been made to one party to a transaction, there is not any domestic mechanism available to the other to request corresponding adjustments. Therefore, it will often lead to double taxation. In addition transfer pricing adjustments may be made to value-added tax, but the Interim Regulations on Value-added Tax do not say whether corresponding input credit are allowed. In fact, a corresponding adjustment may be a good way to avoid economic double taxation in domestic related-party transactions.
3. Another material risk in domestic related-party transactions
Another interesting issue is that, for enterprises carrying on both domestic and cross-border related-party transactions (e.g., exports through a trading company as mentioned above), domestic and cross-border transactions are not separately considered in determining the threshold for preparing contemporaneous documentation under Bulletin 42. Article 11 of Bulletin 42 provides that a master file is required if “the annual related-party transaction amount exceeds RMB 1 billion”. Article 13 provides that a local file is required if related-party transactions during the year meet any of the following conditions: 1) the amount of transferred ownership of tangible assets exceeds RMB 200 million; 2) the amount of transferred financial assets exceeds RMB 100 million; 3) the amount of transferred ownership of intangible assets exceeds RMB 100 million; 4) the total amount of other related-party transactions exceeds RMB 40 million. It is understood that such amounts are to be calculated by including both domestic and cross-border related-party transactions, and preparation of contemporaneous documentation is required if one of the above thresholds is met.
How is the issue to be dealt with for investigation and adjustments to related-party transactions? If an enterprise mainly carries out sales transactions with its domestic related parties, and only pays a royalty fee to its cross-border related parties, shall adjustments be made only to the cross-border related-party transactions or on a consolidated basis including domestic and cross-border related-party transactions? In known cases, tax authorities have adopted the transactional net profit method in adjusting the overall transactions of an enterprise. Based on this calculation, the tax arrears to be paid by the enterprise will be multiple times the royalty fee. Theoretically, this method seems flawless, but in practice it is unreasonable because adjustments are made to both domestic and cross-border related-party transactions without corresponding adjustments to domestic related-party transactions. Then it follows that if an enterprise carries out both domestic and cross-border related-party transactions, shall adjustments be made only to cross-border related-party transactions? And how? It is worth considering how to avoid distorting the legislative intent in applying the relevant method of adjustment.
Bulletin 42 extends the exemption of transfer pricing adjustments to domestic related-party transactions, reflecting SAT’s goodwill and efforts to introduce an easier policy for tax collection and administration. However, it may not be wise for enterprises to relax their risk management of domestic related-party transactions; instead, they need to strengthen their management systems with a variety of factors taken into consideration for the following reasons:
- Although currently, enterprises carrying out only domestic related-party transactions are exempt from preparing contemporaneous documentation, they may still be subject to transfer pricing investigation. Thus, risk management should not be loosened;
- There remain risks of transfer pricing investigation and adjustments to domestic related-party transactions, and in some circumstances, enterprises may face greater risks when they are associated with cross-border related-party transactions;
- It is important to manage domestic related-party transactions from the source. With respect to transfer pricing investigation and adjustments to domestic related-party transactions, enterprises need to pay attention to relevant policies and management systems, and manage relevant issues in combination with other taxation issues. When faced with investigation and adjustments, enterprises need to communicate fully, follow procedures, and seek corresponding adjustments.
Editor’s note: This article was simultaneously published on Chinalawinsight.com