Anew notice, PRC Notice 146, requires tax authorities at all levels to participate in a nationwide search for, and investigation of, all large payments of service fees or royalties from Chinese resident enterprises to their offshore related parties. Notice 146 was issued by the State Administration of Taxation on 29 July 2014, but was only released to the public recently. The investigation called for in Notice 146 was scheduled for completion by 15 September 2014.
Who is affected by the notice?
Foreign invested enterprises (FIEs) that have been paying large service fees or royalties to their offshore affiliates located in tax havens and low-tax jurisdictions are the focus of the investigation under Notice 146. The investigation will examine the years from 2004 to 2013, which is as far back as the 10-year statute of limitations allows tax authorities to recover tax funds in transfer pricing and anti-avoidance cases.
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Most FIEs were expected at some point before 15 September 2014 to be required by PRC tax authorities to submit information about their service fees and royalties paid to offshore affiliates. If an FIE has made payments that raise red flags as described below, the tax authorities may initiate a transfer pricing audit. The transfer pricing audit could result in a transfer pricing adjustment to the FIE’s profits, or a denial of tax deductions claimed for service fee or royalty payments. Even after 15 September 2014, FIEs should expect a “new normal” of close scrutiny of service fee and royalty payments to offshore affiliates located in tax havens or low-tax jurisdictions.
What payments are at risk?
According to Notice 146, the following service fee payments by an FIE will be well scrutinised by PRC tax authorities:
- Service fees paid to a shareholder for services it provides (including planning, management and supervision services provided in support of the FIE’s business operations, accounting or human resources);
- Management service fees paid for “centralised” management of a business group;
- Service fees paid for duplicate or duplicable services that have been or could be provided by a third party or the FIE itself;
- Service fees paid for services that are unrelated to the functions and risks borne by the FIE, or paid for services that are mismatched with the operations or operational phase of the FIE; and
- Duplicate payment for services that have already been compensated as part of other related transactions.
Likewise, the following royalty payments by an FIE will be well scrutinised by PRC tax authorities:
- Royalties paid to an affiliate located in a tax haven;
- Royalties paid to an offshore affiliate that does not perform any functions, or only performs simple functions; and
- Large royalties paid to an offshore affiliate when (i) the FIE has made a significant contribution to the value of the licensed IP, or (ii) the IP has been depreciated.
What action should FIEs consider?
As part of the Organisation for Economic Co-operation and development’s Base Erosion and Profit Shifting Project, Chinese tax authorities have been strengthening transfer pricing audits of cross-border royalty and service fee payments in recent years. For further discussion of the recent cases on transfer pricing adjustments for service fees and royalties, please refer to the January & February 2014 issue and May & June 2014 issue of Baker & McKenzie’s China Tax Monthly.
In response to Notice 146, an FIE that has made or will make any service fee or royalty payments to its offshore affiliate should consider taking the following actions to safeguard its tax interests in China:
- Prepare and review the cross-border service or licence agreements to ensure that the service fees or royalties are charged at arm’s length in accordance with Chinese transfer pricing rules;
- Prepare detailed documentation to defend the reasonableness of the service fee or royalty payments;
- Ensure the foreign affiliate receiving service fee or royalty payments has sufficient substance; and
- Avoid making any service fee or royalty payments to an offshore affiliate located in a traditional tax haven.
In conclusion, Notice 146 is only one indication in a clear trend of the Chinese tax authorities increasing their focus on transfer pricing enforcement. With the number of transfer pricing audits against multinationals increasing, a multinational can expect to face more frequent transfer pricing scrutiny and more frequent audits.
And with more audits, the rare event of a transfer pricing adjustment will potentially become a recurring event that can no longer be passively accepted as a price of doing business in China.
In order to safeguard their tax interests in China, multinationals must carefully prepare defence strategies, stand firm during negotiations with tax bureaus, and be prepared to enter formal proceedings such as administrative review and litigation.
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