In its latest attempt to tackle Base Erosion and Profit Shifting (“BEPS”), China’s State Administration of Taxation (“SAT”) has ordered extensive tax audits on service fees and royalties paid out of the country. On 29 July 2014, the SAT issued a directive (“the Directive”)(Shui Zong Ban Fa [2014] No.146) to tax authorities at all levels to carry out extensive tax audits on large sum payments of service fees and royalties paid to related parties outside of China. Tax authorities should report back their findings by 15 September 2014.
The focus of the tax audits is on enterprises which paid, in large sums, service fees and royalties to related enterprises in a tax haven or a low tax jurisdiction between 2004 and 2013. Tax authorities are expected to assess the reasonableness of the payments, by analyzing the reasonable commercial purposes and the economic substance of the underlying transactions, or the lackthereof. This article attempts to understand how the SAT’s really thinks by reference to its openly expressed views towards service fee and royalties.
Service fees
With respect to service fees suspicious enough to come under the radar, the Directive directs the attention of tax authorities to:
(1) payments to shareholders for their services provided, including the strategic planning, administration and supervision of the operations, finances and personnel of the Chinese enterprises;
(2) payments for the central management of the group;
(3) payments for services provided which the Chinese enterprises could have performed by themselves, or payments double charged for services which a third party had provided;
(4) payments for services which are not related to the functions and risks assumed by the Chinese enterprises, or are related but were not commensuratewith the actual or current scale of the Chinese enterprises’ operations;
(5) payments for services which concurred with other transactions, the remuneration for which had included that of the former.
If paid as “management fees” instead of “service fees”, the first two types of payments above have already been disallowed in China’s domestic income tax law, regardless of whether they are paid to related parties. The Implementation Rules for the Corporate Income Tax Lawof China provide in Article 49 that “management fees paid between enterprises, rental and royalties paid between business establishments within enterprises and interest paid between business establishments within non-bank enterprises shall not be deductible”. The disallowed management fees shall be interpreted as related to shareholder activities charged on the basis of an associated relationship between investors and investees, and shall instead be charged as “service fees” at arm’s length.
Examples for the types of service fees above can be found in the commentary the SAT provided to the United Nationsin April 2014, “Views on Service Fees and Management Fees”.
An example for the first two types is where “services provided by a parent company that are associated with its own strategic management […]Although the subsidiary may benefit from such services, the parent company will benefit more. Therefore, the parent company should not charge service fees to the subsidiary merely because the subsidiary may benefit from such services.”
An example for the third type: “Various advisory and legal services provided by a parent company may indeed confer some benefit to a manufacturing subsidiary in China. However, these high-end services may not be needed from the perspective of the subsidiary given its functions and a cost-benefit analysis.”
An example for the fourth type cannot be located in the commentary. But one example we can think of is where a Chinese enterprise which undertakes the research and development functions with its research personnel and facilities in China will not need technical services from its overseas group companies.
An example for the fifth type is when “the parent company charges the subsidiary service fees related to purchasing raw materials on behalf of the group […] the subsidiary sells finished goods to the parent, and the transfer prices of the finished goods are determined on a full cost plus mark-up basis […] the final beneficiary of the reduced cost of raw materials is the parent company. Therefore, the subsidiary should not pay service fees to the parent for the provision of intra-group purchasing services.”
Royalties
The Directive singled out the following areas of concern for royalty payments which smelled of tax avoidance:
(1) royalties paid to a tax haven;
(2) royalties paid to related parties outside of China which assume no or trivial functions;
(3) royalties in large amounts for the use of intangible assets, to which Chinese enterprises had made significant contribution, or which had droppedconsiderably in value.
The first two types of royalties are easy to understand. Attempts to shift profits into tax havens or to shell companies, or both will be scrutinized more stringently. The third type can be understood by reference to an example in the SAT’s China Country Practices chapter in the United Nations Practical Manual on Transfer Pricing for Developing Countries in 2012:
“If a Chinese affiliate was charged a 3% royalty for the use of a manufacturing process when the Chinese operations were established 10 years ago in 2002, then it may not be reasonable for the Chinese affiliate to continue paying the same royalty in 2012 without revisiting whether the intangible has continued to provide the same value over time. This is particularly the case if the Chinese affiliate has improved a manufacturing process provided by its parent company, through a process of trial and error and conducting manufacturing operations over a 10 year period. We would question whether the Chinese affiliate should continue to pay a royalty to the parent company for the manufacturing process, or whether the Chinese affiliates should be entitled to a return on the intangibles that they have developed and shared with the group companies.”
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