Since China began opening up its financial services sector many multinational banks, insurance companies and investment managers have set up representative offices, joint ventures, branches or locally incorporated subsidiaries to operate in the Chinese market. These businesses often are involved in significant cross-border related-party transactions and in some cases their primary purpose actually is to advise their overseas affiliates on investment or business opportunities in China. Even at the more autonomous end of the spectrum, where a business is established to serve domestic retail or corporate customers, its overseas related-party transactions may be significant as it relies on overseas affiliates for funding, oversight, support and execution.
As other recent articles have noted, in 2008 China introduced a new corporate income tax law that expanded its transfer pricing rules, incorporated the requirement for contemporaneous documentation and introduced the concept of transfer pricing related penalty interest.
In this article, the authors analyze transfer pricing from the perspective of the international financial services industry investing in China by examining typical cross-border financial services transactions as well as considering some of the challenges that the branches and subsidiaries of financial services institutions will face when complying with the new transfer pricing regulations.
Related party financial services transactions
Despite the recent move towards financial reforms, the financial services industry in China remains highly regulated, particularly for foreign financial institutions. That means that the range of cross-border financial services transactions that between entities in China and their overseas shareholders is narrower than it might be in other similar sized countries. It also means that they may take a slightly different form. With financial services deregulation continuing and domestic financial services institutions expanding overseas, the number and complexity of related-party transactions involving the financial services industry in China is expected to increase exponentially.
In 2008, the most common financial services related-party transactions in China include marketing and sales, support services, back- and middle-office support, funding, and research and sub-advisory services.
Marketing and sales 
Many subsidiaries and branches of multinational enterprises sell products in China that are executed overseas by related parties. The authors have seen a range of cross-border marketing and sales services provided by Chinese entities ranging from information dissemination and customer relationship management to full origination of deals. In the securities industry, for example, Chinese branches, subsidiaries or representative offices often are involved in identifying and serving as liaisons with potential customers and referring them to an overseas affiliate that ultimately explains, negotiates, and sells the group's services. Alternatively, for foreign exchange or interest rate derivatives products, the Chinese entity may perform a full sales/origination function with overseas support only in structuring and trading. Since the relative value of different sales activities differs and since different comparables may be available for different sales activities, the challenge for the taxpayer is to identify the most appropriate transfer pricing method and the benchmarking data that is relevant to the particular type of sales function and product under review. In most cases transactions of this type are priced in China using the comparable uncontrolled price (CUP), profit split, or transactional net margin method (TNMM) utilising a markup on full costs.
Support services
Most multinational groups have regional hubs or head offices providing support and assistance to their Chinese branches or subsidiaries. This support can take the form of accounting, human resources, legal, regulatory, administrative or management assistance. Many multinational groups have global policies determining their pricing of support service and head office support and in many cases there is also global transfer pricing documentation describing the pricing mechanism. In China at the moment, however, many subsidiaries and branches of overseas financial services companies are not charged for the management services that they receive because the extra costs could cause them to make losses or because they have not received regulatory approval to pay the fees. Where this is the case and there is no charge, transfer pricing and cost deductibility must be considered in the country of the service provider as the local transfer pricing rules may require it to impute a service fee or restrict it from deducting the costs relating to the China entity. Where management service fees are indeed are charged to a China entity, on the other hand, it is important that specific Chinese transfer pricing documentation is compiled to support the service fee since this is often one of the biggest intra-group transactions for financial services entities in China and it is an easy transaction for the tax authorities to challenge. In most cases transactions of this type in China are priced using the TNMM (utilising a markup on full costs) and the biggest challenge for the taxpayer is demonstrating the local benefit from the services provided to a fairly sceptical tax bureau. In addition, if the service providers send their staff to China to render such services, then, depending on the application of the relevant double tax agreements (for example, 180 days under the agreement between China and Hong Kong), there is a risk that the service provider maybe deemed to have a permanent establishment in China and any fees maybe subject to additional tax.
Back office and middle office support
To enhance operational and commercial efficiency, some multinational financial institutions outsource back- and middle-office support activities to China or outsource the functions supporting some China-based businesses to a specialist domestic or a regional hub outside of China. Services outsourced may include processing of contracts, information technology support, product support, and product-specific accounting and finance support. The transfer pricing issues associated with back- and middle-office support are very similar to the transfer pricing issues associated with management services.
Funding
Many Chinese subsidiaries and branches of multinational enterprises are funded by their overseas parents or head offices through a mixture of long-term loans and short-term facilities. The provision of capital is a cross-border transaction that falls within the scope of the transfer pricing regulations, but for funding transactions the transfer pricing challenge is twofold. Firstly, the taxpayer must demonstrate that the interest rate charged on the funding is appropriate and secondly it must demonstrate that the quantum of debt that it has borrowed is not excessive. In relation to the second point, the State Administration of Taxation recently issued a circular confirming that financial services companies with a related party debt-equity ratio of less than 5:1 are within a safe harbour and are not required to document proof that their debt quantum is reasonable. However, regardless of whether a taxpayer is within the 5:1 safe harbour, if its funding transactions are significant, the onus is on the taxpayer to demonstrate that the interest it pays has been charged on an arm's-length basis. For interest rate pricing in China, in most cases the CUP method is used to defend and document the pricing applied.
Research and sub-advisory services
Many overseas investment management and banking businesses employ groups in China to collect information on potential investment opportunities or deals, to develop research on alternatives, and to provide commentary and advice to the overseas group. In addition, personnel from regional offices often travel to China to oversee the local operations and to perform their own research to supplement the activities of the local office. In almost all cases, the activities performed in China are limited whilst outside of China there is detailed oversight, direction, scrutiny, and decision. From a transfer pricing perspective, if the transactions are significant, the key challenge for a taxpayer is to select and document the application of an appropriate transfer pricing method whilst keeping in mind the permanent establishment risk associated with overseas personnel travelling to China. In most cases a TNMM utilising a markup on full costs is used to price services of this kind but the authors are expecting to see an increasing number of CUP and profit split analyses as Chinese taxpayers catch up with international best practice. In addition to these common types of intra-group transactions and despite the regulatory restrictions on some types of business, other types of related-party transactions frequently seen in the rest of the world are less frequently seen in China. This is particularly true in the largest domestic financial services institutions which are subject to fewer regulatory restrictions than their overseas affiliates and are branching out overseas. For example, transactions involving intra-group reinsurance, credit guarantees, and transfer and risk participation are all sometimes seen in China and may be subject to transfer pricing requirements.
Compliance challenges
The unique nature of financial services transactions, the developing nature of the financial services, and the developing of the transfer pricing regime in China mean that preparing Chinese transfer pricing documentation is not without its challenges. The final release of the regulations offers additional clarity over and above the draft but it is widely acknowledged that the regulations were written with manufacturing businesses in mind and do not take into account specific fact patterns associated with financial service transactions. This is clearly evident in the "Table of Entity's Functions and Risks" form that must be completed by the taxpayer and submitted with their transfer pricing documentation. This form is difficult for a financial services company to complete in a meaningful way because it currently contains fields which are mainly irrelevant to taxpayers to the financial services industry.
A separate challenge is the lack of clarity in the regulations whether they apply to branches as well as subsidiaries. The authors understand that the transfer pricing rules are intended to apply to branches and PEs at the very least of overseas companies. This is a significant issue in the banking industry, where many international groups still operate through branches rather than locally incorporated subsidiaries. Unfortunately, however, there are technical complications in performing transfer pricing for branches that have not been addressed in the regulations.
It is a matter of fact, for example, that a branch is not legally distinct from its head office and that the entities share the ownership of any assets, such as capital, and exposure to risks. The application of transfer pricing principles in this context has been the subject of years of work at the Organization for Economic Cooperation and Development, which published its findings in its "Report on the Attribution of Profits to Permanent Establishments" last year. Unfortunately since China is not an OECD country, it is unlikely these principles will be applied in China and taxpayers will face uncertainty in pricing transactions between branches and their head offices.
A further problem is that the regulations do not provide for the use of multiple methods when no single transfer pricing method is applicable, and they place no emphasis on the sequential order in which taxpayers or tax authorities should select the method to set the pricing for related-party transactions. Combined with the fact that the tax authorities are empowered to select appropriate adjustment methods at their discretion and the fact that there is little guidance on the methods that ordinarily would be applied in the financial services arena, this puts significant pressure on taxpayers to justify the reasonableness of a single transfer pricing method.
This is particularly an issue for the financial services industry because situations often arise in which there is no perfectly applicable transfer pricing method and it is often normal to recognise the limitations of multiple methodologies and to apply them in conjunction with each other. A related concern is that although the regulations permit the use of "other methods" there is no guidance on the circumstances under which the five primary methods can be set aside and an other method may be used. This may frequently be an issue in the insurance industry, for example, where reinsurance often is priced using an other method.
Another feature of the regulations that is not unique to the financial services industry but is fundamental in its implications is the application of the interquartile range in analysing and assessing the profitability of the enterprise under investigation, the tax authorities have the authority to make adjustments to the median or above if the profit level of the taxpayer is lower. This interpretation of the arm's-length range makes it more difficult to apply globally consistent transfer pricing policies and may lead to some incongruous results whereby lower-value-adding services performed in China may be rewarded with higher markups than higher-value-adding services performed overseas.
The Regulations stipulate that group financial statements must be retained as part of taxpayers' transfer pricing documentation. In the financial services industry, however, many privately owned financial services companies, particularly in the investment management sector, do not create consolidated financial statements or do not have them independently audited and verified. It is not clear whether failure to retain consolidated accounts constitutes a failure to comply with contemporaneous documentation requirements or whether it would be overlooked if the taxpayer complies with the remainder of the regulations.
Because the financial services industry is still relatively new to China and it is still developing, the Chinese tax authorities still have relatively little experience of financial services businesses and the unique challenges they face in complying with their transfer pricing obligations. The tax authorities are, however, keen to develop their understanding of financial services-related transfer pricing issues and it is known that in 2008 they ran significant national and regional financial services transfer pricing training sessions and conferences for their inspectors.
There also are signs that they have begun to question the transfer pricing arrangements of financial services institutions. In the long term, this focus on developing an understanding of the financial services industry undoubtedly will be helpful as the tax inspectors and their investigations become more focused and efficient. In the short term, however, the recent focus on financial services transfer pricing training may indicate that the tax bureaus are gearing up to look at the financial services industry in more detail and that they will look to develop their knowledge further by taking up specific test cases.
Conclusion
The introduction of the new corporate income tax and the expansion of transfer pricing in China comes at a difficult time for the financial services sector. Undoubtedly, challenges exist for financial services taxpayers attempting to comply with the transfer pricing regulations in China. However, with the 31 May deadline for submission of the 2008 tax returns and related-party transaction forms and the 31 December deadline for completion of documentation, taxpayers should be focusing on transfer pricing now so that they are adequately prepared in time.
This article is reproduced from its original publication entitled "Financial Services Transfer Pricing in China," in the Vol.17, No.19 - February 2009 issue of BNA Tax Management's Transfer Pricing Report. Copyright 2009 by The Bureau of National Affairs, Inc. Reprinted with permission.
|
 |
