China Tax/Business News Flash 

Useful clarification on transfer pricing measures
      
Just a few weeks before the first filing deadline for China's new Corporate Income Tax ("CIT") Return Package, China's State Administration of Taxation ("SAT") organised a full-day seminar in Beijing on 31 March 2009 to provide further clarification on China's latest administration rules on the "Special Tax Adjustments".  These rules were released on 9 January 2009 in the form of Guo Shui Fa [2009] No. 2 entitled the Implementation Measures of Special Tax Adjustments (Trial) ("Circular 2"), relating to the rules of contemporaneous transfer pricing documentation, cost sharing, thin capitalisation, controlled foreign corporation, and general anti-avoidance (please refer to our News Flash 2009 Issue 1 for the general understanding of Circular 2).
  
Through this seminar, the SAT held an open dialogue with taxpayers, their representatives, and tax practitioners not only asking them to provide feedback on Circular 2, but also addressing their questions on any ambiguous terminology or interpretation.  This Issue of News Flash highlights the key messages we collected from this SAT seminar.
   
SAT presentations
  
Overall direction
    
In the opening speech of the seminar, the Director of International Taxation Department [note 1] addressed the participants with the focus on China's new anti-tax avoidance measures in the context of economic globalization.  His key messages revealed the overall direction of the Chinese tax authorities for anti-tax avoidance in the foreseeable future as follows:

[note 1]: The International Tax Department of the SAT is responsible for, among other things, formulating and implementing Circular 2 and the Director is Mr Wang Xiao Ping.

• The Chinese tax authorities will further explore new anti-tax avoidance measures by way of contemporaneous transfer pricing documentation, thin capitalization, and controlled foreign corporation rules ("CFC rules"), and general anti-avoidance rules ("GAAR").
    
• In 2009, the SAT has planned to conduct bilateral advance pricing arrangement ("APA") negotiations with the competent authorities of Japan, Korea, Singapore, US, and Denmark.
    
• The SAT will intensify efforts to collect information by leveraging their internal and external databases (e.g., databases containing information from CIT returns and export tax refunds) and by exchanging information with treaty partners.
      
• The SAT will beef up joint transfer pricing audit enforcement (in the form of national or regional joint audits on group companies as well as industry-wide transfer pricing audits) persistently in future years.
    
• The SAT plans to expand its specialized team of anti-tax avoidance personnel to 500 officials over the next three years.

Clarification on Circular 2
    
Following the opening address, the Deputy Chief of Anti-tax Avoidance Division of International Taxation Department [note 2:] walked through the key chapters of Circular 2, and provided proactively her views on some ambiguous terminologies or interpretation of Circular 2.

[note 2]: The anti-tax avoidance Division of International Tax Department is the key driver in formulating and implementing Circular 2,and the Deputy Division Chief is Ms. Wang Xiao Yue.
   
A few taxpayers and their representatives were invited to deliver speeches about their views on Circular 2.  Generally, they agreed that the issuance of Circular 2 earmarked a milestone in China's anti-tax avoidance framework.  To a large extent, Circular 2 is important and useful to serve as comprehensive guidelines for taxpayers in China as well as their overseas headquarters to comply with the arms' length principles in respect of related party transactions for China tax purposes.
    
Inevitably, they also raised various practical concerns during their speech and the Q&A session, on the ambiguities and uncertainties that they encountered under Circular 2, especially relating to contemporaneous transfer pricing documentation, annual reporting of related party transactions, cost sharing arrangements, and thin capitalization.  The officials from Anti-tax Avoidance Division provided their responses to all these questions openly and constructively.
    
Summarised below is the clarification by the SAT officials provided in the Seminar on some of the most widely concerned issues:

• Transfer pricing policies in economic downturn
  
  
  In response to concerns that the current economic downturn may have an adverse impact on the profitability of Chinese enterprises, the SAT officials reinforced the principle that the profitability of an enterprise should generally be commensurate with the functions performed, risks assumed, and assets owned or used in the related party transactions.  They made particular reference to Article 39 of Circular 2 which states that enterprises with simple manufacturing / processing functions should generally generate a certain level of profits and not sustain losses.  In particular, the SAT officials emphasized that the Chinese tax authorities would pay particular attention to review cross-border related party transactions of multinational companies and disallow any losses shifted to subsidiaries in China unreasonably during the economic downturn.
    
  

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• Preparation of contemporaneous transfer pricing documentation
  
  
  Circular 2 provides for several criteria whereby the taxpayers who meet one of them are required to prepare contemporaneous transfer pricing documentation.  The criteria are broadly by virtue of sales / purchase of tangible goods and provision of services.  The SAT officials clarified that, strictly speaking, once the taxpayer meets one of these criteria, either the one for tangible goods or service provision, the taxpayer has to prepare contemporaneous transfer pricing documentation covering all types of related party transactions (please refer to our News Flash 2009 Issue 1 for the general understanding of Circular 2).  However, the SAT officials also hinted that they will leave it to the taxpayers as their own management decision as to whether or not to document the arm's length nature of those related party transactions, if these transactions were just insignificant and hence low risk in a particular year.
         
  According to the SAT officials, the Chinese tax authorities have planned to select transfer pricing audit targets in 2010 based on the review and assessment of contemporaneous transfer pricing documentation prepared by the taxpayers for 2008 (note: Circular 2 provides an extension to 31 December 2009 for completion of the 2008 contemporaneous transfer pricing documentation).
    
  

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• Transfer pricing investigations and adjustments
  
  
  One of the popular questions from the participants was how to determine the level of transfer pricing risk if the profit level of the tested enterprise was within the interquartile arm's length range but below the median profit level of the comparable enterprises.  The SAT officials commented that, depending on the transfer pricing method used, if the profitability of the tested enterprise was consistently below the median (albeit within the interquartile range) in the long run, there should be risk of transfer pricing investigation and adjustments.  However, the Chinese tax authorities may still accept the transfer pricing policies if the tested enterprise's profitability was below the median in a single year (but still above the lower quartile of the range), while the profit levels over multiple years were generally close to or above the median.
    
  

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• Use of APA to manage double taxation risks
  
  
  The SAT officials reiterated that an APA is considered a very good tool for the taxpayer to manage their transfer pricing adjustments and double taxation risks.  In the eyes of the tax officials, this is also considered a more collaborative and efficient approach compared to the adversarial tax audit approach.
    
  

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• Thin-capitalization
  
  
  Many taxpayers expressed concern over the prescribed debt-to-equity ratios (i.e., 5:1 for enterprises in the financial industry and 2:1 for non-financial enterprises), in particular for Chinese holding companies and companies under a cash-pooling scheme.  The SAT responded that (as per Circular Cai Shui [2008] No. 121) the prescribed thin capitalization ratios will not have any impact on the group entities in China if the effective tax rate of the borrowing enterprise is not higher than that of the domestic lending enterprise.  Furthermore, they reminded the participants that if the additional contemporaneous documentation can demonstrate the related party borrowings to be of arm's length, the taxpayer would still be eligible to deduct the otherwise "excessive interest" despite the exceeding of the prescribed debt-to-equity ratios under the thin capitalization rules (please refer to our News Flash 2008 Issue 10 for the details relating to the thin capitalization ratios).
    
  

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• Cost sharing arrangements
  
  
  The SAT officials said that the introduction of the concept of cost sharing arrangements to the CIT regime will be helpful in attracting more advanced intellectual property and sophisticated services from overseas parties.  However, this may also come with a potential abusive application of cost sharing for tax purposes.  To prevent possible abuses, the SAT will closely scrutinize all the cost sharing arrangements to determine whether a Chinese participant in such an arrangement would be made to bear any unreasonable costs or expenses allocated to it by its overseas headquarters and/or related parties.  The SAT officials recommended that Chinese taxpayers put forward evidence and reasoning that the anticipated benefits from the intangible assets or services under the cost sharing arrangements are reasonable and quantifiable (as per Article 66 of Circular 2).  Furthermore, they also reiterated that, at this stage, service-related cost sharing arrangements should be limited to group procurement or group marketing services (as per Article 67 of Circular 2).  Once the Chinese tax authorities gain more practical experience with cost sharing arrangements, the SAT should be more receptive to other types of service-related cost sharing arrangements.  The SAT officials also recommended that the taxpayers should secure the benefit of cost sharing arrangement through application of APA, which should make the process more collaborative and efficient.
    
  

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• Channel to get further clarity
  
  
  The SAT officials realised that Circular 2 does not answer all the questions that taxpayers may have.  Taxpayers do need further guidance on how to fill out the "Annual Report Forms for Related Party Transactions"; on how to prepare contemporaneous transfer pricing documentation; and other documentation required under Circular 2.  The International Taxation Department of the SAT plans to set up additional channels to answer questions raised by taxpayers and will issue further circulars to clarify their positions in due course.
    
  

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PwC observations
   
We fully agree with the taxpayers who presented at the SAT Seminar that Circular 2 marks a milestone in China's anti-tax avoidance framework.  Doubtless to say, there are many new concepts and new requirements which are necessary for improving the China's tax administration.
  
Based on the publicly available information so far and our continuous dialogue with the SAT, we have realised that different SAT and local-level tax officials hold different views and interpretations on specific articles of Circular 2.  It may take a while before the SAT formulates consistent positions and then releases further guidance or clarity on the anti-tax avoidance measures in writing.  This has put more time pressure on the taxpayers who are keen to seek clarity to achieve full compliance with the requirements.
  
The SAT Seminar in March 2009 was welcomed by all taxpayers who participated and clearly heard the official views of the SAT on most issues.  We are glad to see the International Tax Department of the SAT is working on more channels of such communication with taxpayers.
  
Considering this is the first year for taxpayers to prepare contemporaneous transfer pricing documentation and the deadline for annual CIT filing is approaching, we suggest the following action points for taxpayers' consideration:

• A transfer pricing risk assessment should be conducted in order to form a practical and cost efficient strategy for disclosure of related party transactions (due in May 2009) and the preparation of the 2008 contemporaneous transfer pricing documentation (due in December 2009).  For enterprises with low transfer pricing investigation risks, their management may consider establishing simplified contemporaneous transfer pricing documentation to satisfy the time-sensitive compliance purposes only.
    
• The "Annual Report Forms for Related Party Transactions" should be completed and reviewed carefully by the management to ensure the information disclosed on those forms is consistent with:
1. the audited financial reports;
2. the contemporaneous transfer pricing documentation (if required); and 
3. the information filed by their other related parties in China.

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