China: Tax authorities examine service fees and royalties to overseas parties

published on September 25, 2019 | reading time approx. 4 minutes

On July 23, 2019, the Tianjin Port Free Trade Zone tax bureau of the State Administration of Taxation (SAT) issued a notice on the examination of payments to overseas parties, requiring enterprises listed in the notice to submit relevant documents before July 31, 2019 to examine their large payments to overseas parties in 2017 and 2018.

SAT required the enterprises to submit the following documents:

Description of payment to overseas parties in 2017 and 2018;
Contract and agreement pertinent to large payment to overseas parties;
Statistical table of large payment to overseas parties (containing filing example);
Digital version of the contemporaneous Transfer Pricing (TP) documentation (applies for enterprises that have exceeded the appropriate thresholds);
Other supporting documents.

It can be seen from the statistical table required by the SAT that this inspection focuses on the service fees and royalties paid to overseas parties. The statistical table requires the enterprise to provide the type, the specific name and the pricing policy of service/royalty, the country/region of the payee and the term of the contract.

In recent years, the payment of non-trade fees to related parties has been a main target for audits of the Chinese tax authorities. In 2017, the SAT issued Public Notice No. 6, proposing a whole set of special tax investigation adjustment procedures, from investigation filing procedure to mutual agreement procedure, aimed at strengthening the monitoring of related transaction profits. Notably, Public Notice No. 6 clearly specifies the TP management of intangible assets and related party service transactions. The Tianjin Port Free Trade Zone tax bureau starting to examine the service fee and royalty payment to overseas parties, can be seen as a practical implementation of the Public Notice No. 6. Therefore, taxpayers shall begin to pay full attention to the TP management of intangible assets and related party services stipulated in Public Notice No. 6.

TP management of intangible assets

According to notice No. 6, when determining the value contribution of enterprise and its related parties to intangible assets and the corresponding profit distribution, the global operation process of the group should be comprehensively analyzed, and the value contribution of all parties in the development, value enhancement, maintenance, protection, exploitation (DEMPE) and promotion of intangible assets should be fully considered. Notably, in addition to DEMPE functions proposed by OECD, Chinese tax authorities have added the "promotion" function, requiring taxpayers to fully consider the value contribution of the promotion activities performed by Chinese companies to intangible assets.

Legal and economic ownership

In addition, the legal and economic ownership of intangible assets should be distinguished. An enterprise that only has legal ownership, but does not effectively contribute to the value of intangible assets, should not be entitled to the participate in the profit distribution of intangible assets. If the enterprise pays royalties to a related party that only has the legal ownership of intangible assets, the full royalty shall not be tax deductible. In addition, Public Notice No. 6 also proposed that those who only provide funds but fail to perform relevant functions and assume corresponding risks should only get a reasonable return on capital costs. Thus, it can be seen that Public Notice No. 6 is consistent with the core idea of BEPS action plan, that is, the profit distribution should match the value contribution.

Special tax adjustment

In addition, Public Notice No. 6 also lists several cases where tax authorities can implement special tax adjustment on royalties. If, in the process of paying royalties, the fundamental value of intangible assets or the functions, risks and assets of the parties have changed, or Chinese companies contribute to the subsequent improvement of intangible assets value, the enterprise shall adjust the royalty in due course. Besides, we would like to draw particular attention from loss-making or thin-profit enterprises to the fact that the tax authorities is entitled to implement special tax adjustment if the royalty paid by enterprises does not match the economic benefits they bring.

In practice, high and new technology enterprises that pay huge royalties are often questioned by tax authorities. We recommend that such enterprises prepare additional documentation in advance to demonstrate that the local R&D functions are different from that of the related parties, and that the license provided by related parties brings unique and significant value to the enterprise. If it fails to explain, the tax authorities may conduct special tax adjustment, or even revoke the high-tech qualification of the enterprise, and require the enterprise to return the tax benefits enjoyed in previous years and pay penalties.

TP management of related party service transactions

According to the Public Notice No. 6, related party service transactions should be beneficial ones that comply with the arm’s length principle and can bring direct or indirect economic benefits to service recipients. Public Notice No. 6 explicitly listed six non-beneficial services as follows

Duplicate services that have already been purchased or implemented on their own;
Shareholder activities;
Services that only aim to obtain additional income due to affiliation to the group;
Services that have been compensated in other related party transactions;
Services that have nothing to do with the functions performed and risks undertaken by the service recipient, or that do not meet its business needs;
Other services that do not bring economic benefits or that a third party is un-willing to purchase or perform.

We suggest that enterprises review whether the service fee paid to overseas parties belongs to the category of non-beneficial services mentioned in the Public Notice No. 6, and make timely adjustment to avoid the risk of special tax adjustment.

Classification of shareholder activities

It is crucial to note that, compared with OECD, the SAT holds a stricter definition of shareholder activities – in Public Notice No. 6, shareholder activities also includes "financial, tax, human resource and legal activities serving the need for group decision-making, supervision, control, and compliance”. However, in practice, the parent company of an international group often charge such fees from its subsidiaries. Enterprises are required by the Tianjin Port Free Trade Zone tax bureau to select from service type options in the statistical table. The options include group management (i.e. human resource, finance, software services, etc.). We estimate that the tax authority will closely examine whether such management services belong to the non-beneficial services stipulated in Public Notice No. 6.

Conclusion

In recent years, China's tax authorities have significantly increased their monitoring of profits from cross-border transactions and introduced a series of anti-tax avoidance regulations. We suggest that enterprises should pay close attention to the regulation updates and review the appropriateness of related party transactions accordingly. In addition, the enterprise shall prepare and submit compliance documents as required by regulations and ensure the consistency of data. For example, in the current inspection of the Tianjin Port Free Trade Zone tax bureau, enterprises need to provide the contemporaneous TP documentation, and the tax bureau may cross-compare the information in various compliance documents.