A rapidly changing environment

On October 5 2015, the OECD publicly released its '2015 Deliverables' under the G20/OECD BEPS initiative – a package of 13 reports with recommendations on changes to domestic laws and tax treaties which correspond to the 15 Actions of the 2013 BEPS Action Plan work programme. The BEPS initiative set out certain minimum standards, agreed between the countries participating in BEPS, as well as certain best practice recommendations, on improvements to domestic laws and tax treaties. These changes aim to enhance the integrity and fairness of the international tax system by realigning jurisdictional taxing rights with the location of 'value creation' and the place where business activities are actually conducted.

With an amazing response time, the Chinese State Administration of Taxation (SAT) held a press conference in Beijing on October 10 2015 to set out its plans for China BEPS implementation in advance of China's hosting of G20 and the Forum of Taxation Administration (FTA) in 2016. At the same time, the SAT also issued the Chinese language version of 2015 BEPS Deliverables.

In fact, China has already gone a long way towards localising the BEPS Deliverables as the SAT has issued a public discussion draft on Special Tax Adjustments (the Discussion Draft) on September 17 2015, deals with localisation of the BEPS work on Transfer Pricing (TP) and Controlled Foreign Company (CFC). However, China will not adopt all of the BEPS proposals and will naturally tailor them to China's circumstances and needs. The BEPS changes also occur in parallel with other tax rules, such as indirect offshore disposal rules and a rapid succession of new guidance is promised to come in the near future.

Action 14 of BEPS Deliverables set forth a minimum standard for resolution of treated-related disputes, together with a Peer Monitoring mechanism, falling under the FTA and Mutual Agreement Procedure (MAP) forums. This work will commence in 2016, with first reports due by the end of 2017. In addition, a group of 20 Western countries have committed to mandatory binding arbitration, with the mechanism to be developed in time for its inclusion in the multilateral instrument in late 2016.

The SAT has not accepted the mandatory binding arbitration under MAP proposed in Action 14. Nevertheless, the Discussion Draft refines APA procedures and specifies the conditions where the Chinese tax authorities can prioritise and reject the APA application. Specifically, the Chinese tax authorities may prioritise taxpayers who provide complete application materials, include comprehensive and clear analysis on value chain or supply chain; consider location specific advantages such as market premium and location savings; and plan to adopt appropriate TP principles and calculation methods. Proactive cooperation by the taxpayers as well as strong focus and proactive attitude of the corresponding competent authorities would also be prioritising factors. The draft also clarifies the right of tax authorities to reject taxpayer's letter of intent, renewal application, or formal APA submission under different conditions.

It is also worth noting that the transactional volume requirement of 40 million RMB ($60 million) for APA applications is removed in the Discussion Draft.

Those proposed in the BEPS Deliverables have, among other factors, led to implementation of new domestic transfer pricing legislation, which will likely lead to differences in interpretation by individual countries.

On the other hand, the enhanced transparency measures under BEPS Deliverables, in combination with new mandatory disclosure requirements, enable tax authorities to scrutinise the allocation of global profits within MNEs.

From China's standpoint, this holds especially true in a transition period where localisation of the BEPS Deliverables in China can be best understood against the backdrop of China is becoming a net capital exporter. That said, while progressively more innovation is occurring in China, China still functions, within the global economic system, as a manufacturing hub; a very significant portion of foreign investment in China relates to processing trade. Therefore, SAT is of the view that they will continue to focus on strengthening application of source taxation rules. Changes to China's economic structure, movement by China up the global value chain, and changes to the nature composition and extent of Chinese investment in overseas will also be monitored, and if circumstances favour an adjustment in China's policies at the later stage, then the SAT would likely then consider this at that time.

It is worth noting that the Discussion Draft emphasises that in determining the value contribution of MNE group entities to intangibles assets (and the consequent TP profit allocation) emphasis is to be put on the 'middle value chain activities' frequently carried out by MNEs in China (eg, trail production, enablement of mass production) as well as China market building activities. As the OECD guidance would not consider these as the most important factors for intangibles value creation, divergent approach between China and other countries could ultimately lead to double taxation.

In addition to the existing profit split method, a new Chinese Value Contribution Method is introduced under the Discussion Draft. The latter is supported by the comprehensive 'value chain analysis' section required in the Chinese TP local file (this appears to diverge from the documentation requirements under the BEPS Deliverables). These new measures exist in parallel with new extensive information requirement for outbound service payment arrangements and demanding tax deduction provision on outbound service/royalty payments. The Discussion Draft also notably excludes the BEPS proposed low-value service simplifications.

Without any reference to the OECD's approach to 'properly delineating the transaction' by aligning risks attributions with effective risk control, and supplementing/adjusting contractual risk allocation where necessary. The Discussion Draft in fact provides barely any reference on the weighting to be given to control of risks and relevant decision making in either 'delineating transaction' or in comparability analysis.

This is reflective of a long standing scepticism, borne out in the practical allocation of TP rules by the Chinese tax authorities, towards contractual allocations of risk which are considered to be susceptible to manipulation. To this extent, the omission of the BEPS refinements to the OECD's TP risk allocation approaches from the Discussion Draft perhaps reflects a continuation of this cautious approach, which focuses more on the performance of functions.

The new Chinese TP re-characterisation provision in the Discussion Draft applies to "related party transactions unlikely to occur between independent third parties under comparable economic conditions". While the BEPS guidance point out that the mere fact that a transaction may not be seen between independent parties should not lead to its rejection (the focus being on whether it is commercially rationale), it remains to be seen whether the Chinese tax authorities will take account of this in applying the re-characterisation provision in practice.

Overall, China's rapid moves to implement the BEPS Deliverables truly put it in the vanguard among the countries of the world. The shape of the post-BEPS Chinese international tax rules is now emerging and MNEs should start to prepare for the tax risk management to fully cope in this new era of transparency.

Cheng Chi Partner KPMG China Shanghai Tel: +86 (21) 2212 3433 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 started his transfer pricing career in Europe with another leading accounting firm, covering many of Europe's major jurisdictions while based in Amsterdam until returning to China in 2004. Cheng has since led many transfer pricing and tax efficient supply chain projects across Asia, involving advance pricing arrangement negotiations, cost contribution arrangements, Pan-Asia documentation, controversy resolution and global procurement structuring. Cheng has vast experience in various industries including automobile, chemical, mechanical, 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. He is a frequent speaker on transfer pricing and other tax matters and his analyses are regularly featured in tax and transfer pricing publications around the world. Cheng has also been recommended as a leading transfer pricing advisor in China by the Legal Media Group.