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24 Mar 2015

State Administration of Taxation Promulgated New Transfer Pricing Rules

On 18 March 2015, the State Administration of Taxation promulgated the “Announcement of the State Administration of Taxation on Enterprise Income Tax Issues concerning Payments by Enterprises to their Offshore Affiliates” (Announcement No. 16, 2015 of the State Administration of Taxation, “Announcement 16”). Announcement 16 provides for rules on transfer pricing in connection with payments by domestic enterprises to their offshore affiliates and is expected to cause a material impact on multinationals with substantive cross-border payments and VIE structured enterprises that have no actual overseas operations. The key contents of Announcement 16 are as follows:

1. Specific Requirements on Offshore Receivers

Announcement 16 specifically provides that, in order for domestic enterprises to make any payment to its offshore affiliate, the offshore receiver must satisfy such requirements as “performing functions, bearing risks and having substantial business operations”.

2. Increased Power of Tax Authorities

In accordance with Article 41 of the Law of the People’s Republic of China on Enterprise Income Tax (“Law on Enterprise Income Tax”), if a domestic enterprise does not follow the principle of arm’s-length transactions while making payments to its offshore affiliates (“Non-Arm’s Length Transactions”), relevant tax authorities have the power to use reasonable calculation methods to recalculate the “fair” payment amount and adjust the taxable amount accordingly.

In addition to the recalculation above, Announcement 16 also provides that relevant tax authorities have the power to directly prohibit the inclusion of payments for Non-Arm’s Length Transactions in enterprise costs, thus significantly increasing tax authorities’ power in the relevant matters. In particular, this practice will help the tax authorities deal with transactions where the “fair” payment amount is hard to calculate.

3. Labor Costs

For transactions concerning labor costs, Announcement 16 provides that if the labor concerned is irrelevant to the domestic enterprise’s functional risk or operation, or if the labor concerned is booked in the name of an affiliate but actually purchased from a third party or rendered by the domestic enterprise directly, the relevant transactions shall be recognized as Non-Arm’s Length Transactions.

4. Royalties for Intangible Assets

For transactions involving royalties for intangible assets, Announcement 16 provides that an affiliate’s contribution to the value generation of the intangible assets shall be taken into consideration in determining the economic benefits that such affiliate is entitled to. The payment of royalty fees to an affiliate who is the legal owner of relevant intangible assets but has made no contribution to its value generation can be recognized as a Non-Arm’s Length Transaction.

5. Years of Retrospection

According to Announcement 16, tax authorities may exercise the power of special tax adjustments with respect to a Non-Arm’s Length Transaction at any time within a 10-year period commencing from the year in which such transaction was first taxed, thus exposing such transactions to significantly greater risk of investigation.

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In conclusion, Announcement 16 has strengthened governmental administration over transfer pricing for offshore payments and now require the offshore receivers of such payments to be “performing functions, bearing risks and having substantial business operations”. It is anticipated that Announcement 16 will cause significant impact on multinationals that have operations in different jurisdictions and substantive cross-border payment arrangements. Relevant enterprises are recommended to pay close attention to the implementation of Announcement 16 so as to make corresponding adjustments in time.

On a related note, in the years leading up to Announcement 16, certain VIE-structured companies transferred their domestic profits to offshore holding companies by disbursing royalties for intangible assets that supposedly belong to the offshore holding companies. As such offshore holding companies typically have no actual operations and therefore cannot satisfy the requirements of “performing functions, bearing risks and having substantial business operations,” Announcement 16 may present substantive hurdles to the continuation of such practice. That said, as Announcement 16 does not apply to payments among domestic affiliates, a domestic company can still make a payment to its affiliated WFOE and have the WFOE subsequently transfer such payment to the offshore holding company in the form of a profit distribution.

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