By Bill Ye(partner), Duan Tao(partner) and Jessie Yu (managing associate)
In the wake of a high-tech giant's $14.5 billion EU tax ruling and the intensifying scrutiny of the accounts of other high-tech giants, international taxation rules have become a major topic for discussion. Not surprisingly, businesses and their advisers have become very interested in potential measures that regulators may implement to balance the economic relations between states, and between states and enterprises.
The 2016-2018 Compliance Plan on International Tax Administration (hereafter referred to as the “Plan”) issued by the State Tax Bureau’s (“SAT”) Jiangsu Provincial Office gives an indication of China’s position on international tax rules.
Even though the Plan is not legally binding, it is considered that this move by the Jiangsu Provincial Office, is a forerunner of China’s international taxation and anti-tax avoidance management policies, and will help enterprises predict future measures of the State Tax Bureau .
Based on the 2014 Compliance Plan on International Tax Administration, the new 2016 Plan covers fourteen areas. Highlights of the Plan are set out below:
I. Information collection and documentation
a) Tax filing requirements
The Plan points out that enterprises must comply with the overall tax filing and recording requirements of international taxation standards. In addition to the recording of related party transactions in enterprise income tax (EIT) annual returns, comprehensive tax filing also requires the recording of non-resident withholdings, non-resident contracts, offshore payments, treaty benefits, indirect transfers, offshore investments, special tax treatment and so on. The Plan emphasizes that enterprises are responsible for making certain filings and making them correctly. For example, after transactional contracts, are signed, enterprises must make the required filings. The self-reported filings of share transfers by purchasers will directly affect the tax risk they will assume. Contractual terms and pricing policies will become key points for auditing in international tax administration in the future. Research and development (“R&D”) service contracts and the arrangement for ownership of R&D results will affect the nature of service charges. Tax authorities will consider whether the contractual arrangement conforms to the substance of the economic business and will adjust the distribution of profit when necessary.
b) Improving the quality of contemporaneous transfer pricing documentation
The Plan proposes that “the quality of contemporaneous transfer pricing documentation is important for risk rating”. Following the shift of international tax administration to a risk management model, the amount and quality of information required for cross-border transactions is expected to increase. Since contemporaneous transfer pricing documentation has become the main source of information for international tax management, tax authorities will concentrate more on information about related party transactions. They will review global business arrangements and profit allocation from the perspective of the group’s integrated value chain. The group shareholding structure, cross-border transaction arrangements, global profit allocation and the like will all become the focus of tax authorities.
In relation to the quality of contemporaneous transfer pricing documentation, the Plan highlights some issues with present practice. For example, a “lack of reasonable basis when adjusting for special factors”. Some enterprises still use their design capacity as the basis for capacity adjustment, and the reasonableness of this is questionable. These practices may be the focus of tax authorities in the future when reviewing contemporaneous documentation.
c) The influence of “The Multilateral Convention on Mutual Administrative Assistance in Tax Matters”, CRS and FATCA
The Plan emphasizes that the entry into force of a number of international conventions such as “The Multilateral Convention on Mutual Administrative Assistance in Tax Matters”, CRS, and FATCA will greatly improve information transparency, facilitate international cooperation between tax authorities and further strengthen the supervision of anti-tax avoidance in the new economic environment.
From September 2017, individuals and their controlled companies will need to provide to Chinese tax authorities information about their bank accounts (up to the end of 2016) in at least fifty-six countries and regions (including Bermuda, BVI, Cayman Islands, Seychelles, Luxembourg, England, France, Germany etc.). From September 2018 they must provide bank information from another forty-one countries and regions such as Australia, Canada, Hong Kong, Japan, Macao, New Zealand, Singapore, and Switzerland.
With the automatic exchange of business and financial information, tax related information will be more transparent worldwide, and there is no doubt that the taxpayers will face a more stringent inspection from tax authorities. It will be prudent for multinational taxpayers to reconsider and assess historic tax planning arrangements which were based on previously opaque information.
d) Big data, information sharing between tax authorities and enterprises and transparency
In addition to filings and records, the Plan proposes to evaluate tax risks with the aid of big data analysis including of third party information. The Plan requires self-reporting by enterprises, proactively submitting relevant materials in the process of transactions and during tax inspections.
Although the Plan contains some issues that need further discussion, the Plan aims to enhance the integrity of tax administration. In response to these systemic requirements and regulations, business managers must consider the overall compliance effect and attend to submitting consistent and coherent documents which meet the rationale of tax authorities. Enterprises should also be aware of the potential risks arising from information disclosure: enterprises must fulfill their legal obligations of filing and disclosure in a timely manner to improve tax filing creditability and to reduce management risk; and to be careful to avoid potential audit risks derived from excessive disclosure. Management must also be aware when exchanging information with the tax authorities of information they are also supplying to other governmental authorities and to information management in general
II. A clear position in proactive management
a) Risk control of cross-border taxation
The Plan points out that usually, cross-border taxation risks are the main tax risks faced by multi-national corporations. To effectively control internal risks and prevent cross-border tax risks, the Plan suggests incorporating cross-border tax risk management in corporate governance and internal control. Those significant issues involving related party transaction pricing, cross-border business restructuring and cross-border structure design should be approved by the board of directors.
Cross-border tax risk management includes the consideration of tax, finance, law, capital, business and human resources. To ensure the consistency of external information to be submitted to authorities, departments of multi-national corporations need to cooperate with each other. Tax is not the only risk area. For example, related party transactions may result in disputes in the operation of a joint venture.Therefore when addressing taxation corporate governance should also consider the impact of risk on other areas of the business.
The Plan specifically mentions several overlapping risk mismatches such as: 1) inconsistency of the profit trend of the group and the Chinese enterprise; 2) inconsistency of the group’s social image and its tax contribution; 3) inconsistency of the value contribution of enterprises in China and profit allocation; 4) inconsistency of the status of high-tech and new technology businesses and their tax performance; 5) mismatch between the expansion of business scale and poor profit performance; 6) mismatch between huge external payments and long-term small profit or even loss.
b) Contributions of China as a favorable location to show profit
The Plan reiterates that China, as a favorable location equipped with well-established public facilities, an enormous market, high value-added services and relatively low costs helps enterprises to create more value. The BEPS Action Plan requires enterprises to disclose the influence of locations on their pricing and to analyze the contribution of locations on their created value. These requirements are also incorporated in Bulletin No.42. In addition, the Plan especially warns that multi-national corporations with income, assets, high value-added services and profits from China and a lower rate of profits and taxes paid in China may face relatively higher risks in tax management. Although the Plan has not put forward an explicit distribution proportion or a formula, in light of the situations of global information disclosure, profit redistribution is a risk faced by multinational corporations.
As for intangible assets, the Plan points out enterprises generally pay more attention to the legal form of the business arrangement rather than the economic substance and this can be problematic. For example, based on the head office formal organization of R&D and marketing, the group does not distribute the economic interest attributable to the effect of local R&D and marketing to the local firm. The Plan records that enterprises should measure the contribution of local R&D projects and their return by evaluating their decision making process, risk assumptions, asset utilization and labor inputs. Contract R&D is not an internal group function, but need not be valued using a low cost plus mark-up. However the legal owners of intangible assets should not be entitled to excess profits simply because of their identity as owner
Over the past five years, tax authorities in China have focused on the local value of Chinese enterprises’ intangible assets in transfer pricing reviews. Contribution and attribution redistribution of local intangible assets has been seen in some cases. The contribution of China’s favorable location to profit distribution is expected to be an important legal, tax and internal management item for transnational corporations.
Although the Plan has not systematically explained the application of transfer pricing methods, it points in the general direction of choosing proper transfer pricing methods on the basis of value contribution when related party businesses are involved. In the context of globalization, the inherent defects of traditional transfer pricing methods have become apparent when applied to highly integrated businesses, while the advantages of other methods such as the profit split method become more obvious. One reason is that many enterprises are no longer simple contract manufacturers but now contribute more to the surplus value in the supply chain. Another reason is that Chinese tax authorities have improved their capability and can obtain more information from more sources. Against this background, the profits Chinese enterprises should be making and what transfer pricing method should be used will be big challenges for transnational corporations in the future.
In order to evaluate the reasonableness of their trading models and pricing policy, businesses must consider their overall equity structure, operational arrangements and profit allocation. Based on these evaluations, enterprises may adjust related party transactions and related party pricing mechanisms to effectively reduce international tax administration risks.
III. Extensive expansion of trading concerns
In addition to the foregoing, the Plan emphasizes thin capitalization, CFC, profit shifting by using intangible or financial instruments, treaty abuse, and artificial avoidance of permanent establishment. The SAT Jiangsu Provincial Office also specifically points out the international tax administration matters that need thought when restructuring a business. Business restructuring will involve a range of matters which may be unrelated to tax avoidance. As tax efficiency structuring has been seen in recent cases and because the tax authorities are accumulating experience in tax avoidance behavior transnational corporations will face greater scrutiny in the future. With the BEPS Action Plan coming into effect in various countries, Bulletin 42 issued by SAT in June, 2016 shows SAT taking a lead in carrying out reform of contemporaneous documentation and related party transaction filing. The Plan reflects the attitude of provincial-level tax authorities on international anti-tax avoidance regulation against the international background. As the SAT Jiangsu Provincial Office has always been the model for anti-tax avoidance regulators, we believe the Plan may reflect the attitude of SAT to some extent. Therefore, the Plan may be regarded as a risk indication letter. It is advisable that enterprises reconsider their existing systems for information management, trading arrangements and tax risk evaluation in a holistic way. By fully understanding the position of Chinese tax authorities, enterprises may establish their own international tax administration system and so improve tax compliance and reduce potential risks.
Editor’s note: this article was simultaneously published on Chinalawinsight.com