Stricter monitoring system of cross-border transactions in China

published on April 9, 2019 | Reading time approx. 3 minutes

In focus - multinational enterprises

In recent years, China has strengthened its anti-tax avoidance efforts. After the release of Public Notice 6 in March 2017 which provides rules on risk management, investigations and transfer pricing ("TP") adjustments and emphasizes the establishment and enhancement of a monitoring system of related party transaction profit levels, the State Tax Bureau of Jiangsu began to collect data for establishing the pilot system from April 2018. In total 150 multinational enterprises (MNE) located in Jiangsu are required to provide information from 2008 to 2016 regarding their contemporaneous documentation, financial reports and other data to be incorporated into the monitoring system.

Analysis and assessment of tax risks

State Administration of Taxation (SAT) aims to create a "global" data source for each of the MNE under supervision. Based on these global data, tax authorities are able to evaluate the tax risks of MNEs in China by applying the appropriate qualitative and quantitative indicators on global, China overall and individual enterprise's level. The indicators are selected with reference to the BEPS action plans developed by G20 and OECD. Together with the value chain analysis, a potential tax revenue loss deviation amount will be calculated and MNEs will be marked with low, medium or high tax risks in the system. It is worth noting that Jiangsu State Tax Bureau has stressed the importance of the value chain analysis in the determination of profit level for cross-border related party transactions. In the background of a changing business environment, more and more Chinese subsidiaries perform more functions and assume more risks so that they cannot be simply characterized as routine companies whose remuneration is based on the standard TP method (e.g. cost plus method). In such cases, the remuneration should be reconsidered based on value chain analysis and a more appropriate method such as profit split. This is also in line with the revised guidance on profit split method (PSM) recently issued by OECD in July 2018 which has pointed out three scenarios where profit split method may be the most appropriate method: each party makes unique and valuable contributions, the business operations are highly integrated, the parties share the assumption of economically significant risks, or separately assume closely related risks.

Ranking of multinational enterprises in the monitoring system

Further, tax authorities will also evaluate the tax compliance willingness of a MNE from many aspects, e.g. global tax planning style, quality of the compliance work (related party transaction disclosures and contemporaneous documentation), internal control of related party transaction risks, cooperation of the management, etc. MNEs will be then ranked in the system according to both the potential tax revenue loss deviation calculated and the compliance willingness level rated. It is noteworthy that the willingness to comply is also considered as a key factor for evaluating the tax risks according to the new monitoring system.

If MNEs are marked with medium to high risk level in the system and receive a tax risk notification from the tax authorities, MNEs are encouraged to communicate actively with the competent tax authority and take proactive measures such as self-adjustment proposal to mitigate tax risks. Otherwise there will be high risks of being under TP investigation and adjusted with penalty interests.

Pilot run of the monitoring system

The new monitoring system is currently piloted in Jiangsu province and will very likely to be expanded nationwide. As the new system requires higher consistency of the information disclosure, taxpayers are recommended to review and ensure the information consistency among audit reports, tax returns, related party transactions forms,TP documentation, as well as other public source.

Homework for enterprises

In addition, the current approach adopted by Jiangsu Tax Bureau again has demonstrated SAT's emphasis on the value chain analysis for MNEs and its preference of using PSM in case where the Chinese entity or the Chinese operation integrated does not only undertake routine functions. Taxpayers should reconsider whether the current TP method is the most appropriate one, taking into account the functions performed, risks assumed and assets contributed by each party and the Chinese operation integrated and rectify the pricing policy where needed.

Profit Split Method – different views in China

It is also worth noting that China holds certain different views in the applying PSM compared to the OECD guidelines as follows, which may also need to be taken into consideration when setting the global TP policies:

Besides the DEMPE-functions (Development, Enhancement, Maintenance, Protection, Exploitation), China also takes the promotion function into consideration for the analysis of the value contribution of intangible assets;
The location specific factors (cost savings and market premium) should be taken into account for an appropriate adjustment of the remuneration of the routine functions while applying the profit split method;
Outbound non-trade payment is under strict foreign exchange control in China and therefore a price setting purely via PSM might encounter certain difficulties in practice where certain alternative approach embedding the profit split concept might need to be considered for both the tax risk mitigation an practical implementation purpose.