2016-2017 Transfer Pricing Developments Review

The past year witnessed ground-breaking changes in the Chinese transfer pricing landscape. In the wake of BEPS, China moved rapidly to overhaul its TP and anti-avoidance legislation. The new Chinese legislative framework incorporates aspects that can be directly traced to the OECD's BEPS project, while at the same time emphasising Chinese-flavoured issues that have historically been in the State Administration of Taxation (SAT) agenda, such as location specific advantages (LSA), relative contribution of Chinese operations to global value chains, comparability shortcomings etc.

With the release of the 2017 version of the United Nations Practical Manual on Transfer Pricing for Developing Countries ("UN Manual"), China has contributed a new country practice chapter, suggesting policy trends that are expected to steer transfer pricing administration and enforcement in areas such as audit-targeting and controversy, transfer pricing risk management and taxpayer monitoring, competent authority procedures and tax administration infrastructure and resources.

Throughout the past year, China has vigorously stepped up transfer pricing enforcement: audit activity soared and is expected to grow significantly in the near future, especially when taxpayers are unwilling to perform self-initiated adjustments. Moreover, it has been reported by SAT officials that in 2016 the materiality of transfer pricing adjustments increased, on average, threefold in comparison with average amounts in 2011 – i.e., from an average of app. RMB 12 million ($2.8 million) per assessment in 2011 to app. RMB 37 million in 2016.

Until 2016, the main legislative source for transfer pricing matters in China had been the Implementation Measures of Special Tax Adjustments (Guoshuifa nº 2), issued in January 2009 (Circular 2). Circular 2 had in practice served as a consolidation of special tax adjustment rules covering the breadth of transfer pricing, including related party filing, contemporaneous documentation, primary adjustments, audit activity, transfer pricing methods, advance pricing and cost sharing agreements, Controlled Foreign Corporation (CFC) regime, thin capitalisation, general anti-avoidance and corresponding adjustments and Competent Authority matters. In the past year, the SAT has moved to issue separate, topical guidance on substantive issues that superseded relevant sections of Circular 2 instead of releasing consolidated legislation.

The first part of that initiative resulted in the Announcement on the Enhancement of the Reporting of Related Party Transactions and Administration of Contemporaneous Documentation, released in July 2016 (Announcement 42), discussed below.

In October 2016, the SAT released the Announcement on the Enhancement of Administration of Advance Pricing Arrangement (Announcement 64). Announcement 64 formalises some longstanding practices in APA administration and introduces key BEPS Action 5 recommendations, as discussed below.

In March 2017, Announcement on Special Tax Investigations, Adjustments and Mutual Agreement Procedures (Announcement 6) was issued to regulate the tax audit process, special tax adjustments and to provide guidance on many of the substantive issues related to transfer pricing. Announcement 6 concludes China's TP legislation overhaul. It consolidates previous SAT guidance on self-adjustments and outbound payments from China, and writes into formal guidance some of the existing administrative practices adopted in Chinese transfer pricing audits. Announcement 6 includes provisions on intangibles, intra-group services (discussed in greater detail below), as well as TP methods and comparability, TP adjustments, outbound payments to low-substance entities, MAP and penalties applicable to TP adjustments – People's Bank of China benchmark interest rates plus 5% punitive interest, which can be relieved if the compliance obligation has been fulfilled.

In the context of BEPS Action 8-10, Announcement 6 introduced new guidance regarding intangible assets and intra-group inbound services.

The new guidance on intangible assets adopts the OECD's distinction between legal and economic ownership of intangible assets and emphasises that benefits derived from intangible assets are to be allocated based on economic substance. Drawing on the so-called DEMPE functions which are relevant for the attribution of economic ownership and entitlement to intangible related returns, Announcement 6 puts forward the concept of DEMPEP – the additional "P" standing for "promotion", which indicates SAT focus on the importance of local marketing activities in the value creation process. Moreover, royalty rates should be adjusted when the value of the IP or when functions, assets and risks have changed over time or when DEMPEP functions are not properly reflected in the remuneration.

In the area of high-risk transactions, outbound payments for non-beneficial or low-substance activities are expected to be subject to more rigorous scrutiny and may be disallowed under certain circumstances. Those include shareholder activities, duplicative services, incidental benefits and, broadly, irrelevant or non-beneficial services. Announcement 6 also leaves out the safe-harbor provision for low value-adding services advocated by the OECD.

Announcement 42 sets forth the three-tiered transfer pricing documentation standard (i.e., master file, local file and country-by-country reporting) devised in the context of BEPS Action 13 and goes beyond the OECD standards by introducing Chinese-flavoured requirements, such as LSA analysis, but also complex requisites such as value chain analysis, with substantial level of entity-specific information requirements throughout the global supply chain. In addition to the three-tiered documentation standard, Announcement 42 reintroduces the special issues files that must be prepared when the taxpayer has entered into costs sharing agreements or the thin capitalisation special file, due when the taxpayer exceeds the statutory debt-equity ratios – currently set at 2:1, or 5:1 for financial institutions.

It is expected that Chinese tax authorities will increasingly rely on digital analytics and big data in order to monitor taxpayer activity and compliance. In the China Country Practice of the UN Manual, reference is made to the China Taxation Administration Information System (CTAIS), which combines individual taxpayer screening with industry analysis and data trends for specific markets or types of businesses. The system is based on red-flag indicators of risk and the following criteria will likely be used to select audit targets:

• Materiality of transactions or significant number of different categories of related-party transactions;

• Consecutive losses, low profitability or fluctuating profitability over a long period;

• Profit level below industry average;

• Mismatch between functional profile/profitability or benefits/costs allocated;

• Enterprises which have transactions with related parties in tax havens;

• Enterprises that failed to submit related-party filings or prepare transfer pricing documentation as per relevant regulations; and

• Enterprises that exceed the statutory related-party debt-equity ratios.

Through 2016, the SAT continued to invest in capacity building. Consistent with the increase in transfer pricing audits and competent authority procedures post-BEPS, the SAT hired 16 new resources in 2016 and 26 more are expected in the coming years. This will result in a dedicated team of approximately 50 resources at the SAT headquarters and approximately 500 inspectors involved in anti-avoidance across the country. In July 2016, the SAT set-up a new division (Unit 3), which will also support Units 1 and 2, primarily on APA and national joint-audits.

With Announcements 64 and 6, China has introduced new guidance on both APA and MAP procedures, respectively. On APA, Announcement 64 introduces a revised, front-loaded procedure (with examination and evaluation processes being conducted before the formal application) and includes a priority list for acceptance of applications. The new regulation sets forth a 10-year limit for APA roll-back. In line with BEPS Action 5, Announcement 64 also includes an information exchange clause, according to which in unilateral APA signed after April 1 2016, the SAT is empowered to exchange information with tax authorities in the other country concerned, save for national security information concerns. Regarding MAP, Announcement 6 provides that applications may be denied for enterprises undergoing special tax investigations or which have not cleared tax payables after the conclusion of special tax investigations. Differently from Circular 2, which provided that applications must be made within three years of receiving transfer pricing adjustment notices, Announcement 6 makes general references to double tax treaties signed by China regulating the specific time limit on mutual agreement procedure applications. MAP cases which have been accepted but not resolved by May 1 2017, will be subject to the provisions in Announcement 6.

In light of the material changes in the TP legislative framework, growing SAT anti-avoidance focus and increased level of transparency under BEPS, it has become even more critical to properly monitor and manage taxpayers' compliance with transfer pricing regulations, including timely and appropriate preparation of TP documentation and disclosure forms. Moreover, multinationals are advised to establish internal risk monitoring mechanisms and develop a consistent risk mitigation approach. Going forward, the main pressure points for multinationals operating in China are expected to include: (i) mismatch between management accounts, tax accounts and group consolidated financial statements, (ii) overseas entities that retain a relatively high profit but have limited economic substance or with actual activities wholly or partly performed in China, (iii) significant outbound payments such as service charges, royalty payments or interest payments, (iv) disclosure and analysis for related party financing arrangements and equity transfers, and (v) insufficient documentation or supporting materials.

Cheng Chi

Partner KPMG China 1 East Chang An Avenue, 8th floor, Oriental Plaza Beijing 100738 Tel: +86 10 8508 7608 cheng.chi@kpmg.com Cheng Chi is the partner-in-charge of KPMG's Global Transfer Pricing Services for China and Hong Kong S.A.R. Cheng has led many transfer pricing and tax efficient supply chain projects in Asia and Europe, involving advance pricing arrangement negotiations, cost contribution arrangements, pan-Asia documentation, controversy resolution, global procurement structuring, and headquarters services recharges for clients in the industrial market including automobile, chemical, and machinery industries, as well as the consumer market, logistic, communication, electronics and financial services industries. In addition to lecturing at many national and local training events organised by the Chinese tax authorities, Cheng has provided technical advice on a number of recent transfer pricing legislative initiatives in China. A frequent speaker on transfer pricing and other matters, his analyses are regularly featured in tax and transfer pricing publications around the world. Cheng has been recommended as a leading transfer pricing advisor in China by the Legal Media Group. Cheng started his transfer pricing career in Europe with another leading accounting organisation covering many of Europe's major jurisdictions while based in Amsterdam until returning to China in 2004.

Rafael Triginelli Miraglia

Senior Manager KPMG China 266 Nanjing West Road, 50th floor, Plaza 66 Shanghai 20004 Tel: +86 21 2212 3176 rafael.miraglia@kpmg.com Rafael Triginelli Miraglia is a senior tax manager with the Global Transfer Pricing Team of KPMG China and a member of KPMG International's BEPS Centre of Excellence. His practice focuses on design and implementation of transfer pricing systems, business restructuring advice, value chain analysis and planning and outbound investments. Rafael graduated in Law (Universidade Federal de Minas Gerais, Brazil, 2004) and has obtained the degrees of Master of Laws (PUC-MG, Brazil, 2008) and LL.M. of Advanced Studies in International Tax Law (ITC – Leiden University, Netherlands, 2011). He is a transfer pricing lecturer at the ITC-Leiden University and has taught courses in tax and constitutional law at PUC/MG and Customs Law at UNA/MG. Rafael has been a member of the Brazilian Bar Association (Ordem dos Advogados do Brasil) since 2005. Before joining KPMG China, Rafel worked as tax associate with a global law firm in the Netherlands between 2011 and 2015 and, prior to that, as head of tax with a Brazilian law firm.