CIT Annual Declaration: Deducting Expenses for Overseas Related-parties

First of all, the related-party expenses shall be proved to have sufficient business substance and the pricing policy for such expenses shall be in line with the arm’s length principle.

In practice, many taxpayers usually receive invoices for services provided by overseas related parties at the end of the year or the beginning of the next year and are requested to recognize these expenses and arrange the payment, though without conclusion of actual service contract or having only a simple-format contract without disclosure of the business substance of the transaction. In some cases, taxpayers are even not able to describe the details or provide evidence about how the services are rendered by the overseas related parties to the Chinese companies.

All these factors may lead to significant risks when the taxpayer deducts such expenses from the taxable income in annual CIT calculation. According to our practical experiences, there are also some taxpayers who misunderstand that as long as there is a contract signed by the related party, a pro forma invoice and a withholding tax payment certificate, the expense can be regarded as eligible for deduction from CIT-taxable income without compliance risks. In fact, in recent years, the Chinese tax authority has widely adopted the method of post-administration for reviewing transfer pricing issues, and it is commonly seen that the taxpayer will be asked by its in-charge tax authority to provide further supporting documents on certain related-party transactions, in particular on related-party expenses, after the annual CIT reconciliation has been closed.

As such, an important prerequisite for deducting the related-party expenses in annual CIT calculation is that the taxpayer has prepared a full set of formal documentation, including a service contact describing the transaction nature and content of the relevant services, a pro forma invoice and other relevant documents supporting the business substance of the transaction, which proves that the transaction can be deemed as a reasonable related-party transaction contributing value and bringing benefits to the domestic enterprises.

Whether an expense charged by the overseas related party is subject to withholding tax obligation in China shall be assessed on a case-by-case basis taking into account of the business substance of the transaction. In terms of  withholding CIT, if there lacks sufficient evidence to prove that the transaction actually occurred overseas, even if the contract indicates that the service is provided outside of China, the service fee may not be determined as an expense incurred overseas for CIT exemption purposes.

In practice, it is common for a Chinese corporate taxpayer to accrue service fees at year-end according to the pro forma invoices issued by its overseas related party, but the taxpayer does not accrue the corresponding withholding taxes because the payment of the relevant service fees has not yet been settled. In this case, the expenses may not be allowed to be subtracted from the taxable income, unless the withholding tax has been paid before annual CIT reconciliation and the expenses meet the requirement of business substance mentioned above.

Related-party service transactions are very common in practice and the tax consequence concerned are complex and need to be analyzed case by case, so as to enable the taxpayer to make an appropriate self-assessment in accordance with Chinese tax regulations. Packaging various service costs in a large frame contract without sufficient disclosure and description of business substance of the services may lead to further investigation by tax authorities, nor is it useful in terms of tax optimization. During the annual CIT reconciliation, we suggest that the corporate taxpayers should keep an eye on the nature of their transactions and the payment of withholding tax in the tax year for a comprehensive assessment. In addition, we advise that the taxpayers should pay attention to the historical situation and future projection of related-party services in previous and coming years to ensure the reasonableness and consistency of the disclosure of the same type of service fees in each tax year. For related-party service fees involving multiple types of transactions, it is recommended that the taxpayers may seek assistance from external professionals to support with the self-assessment of tax liabilities to pursue tax compliance to the best possible extent.