News Express

Date:  2015-07-22    Autor:  ECOIVS Ruide Marketing Team

Tax risk control of the disbursement ofexpenses by enterprises to their overseas related parties

1. Background

Announcement of the State Administration of Taxation on Enterprise Income Tax Issues concerning the Disbursement of Expenses by Enterprises to Their Overseas Related Parties” (hereinafter as “No.16 Announcement” or “the Announcement”) was released on March 18, 2015. TheAnnouncement restates and clarifies the administration of transfer pricingconcerning the disbursement of expenses by enterprises to their overseasrelated parties, mainly including labor services and royalties. (Please referto ECOVIS INFO March / April 2015 for more details)

Recently, somelocal tax authorities issued some guidelines which are more operation oriented.We believe that the impact of the No. 16 Announcement will become more and morepractical. This article will further discuss the No. 16 Announcement with some fictitiouscases.

2. Implications of No. 16 Announcement

With thedevelopment of OECD’s BEPS Action Plan, the 2014 deliverables have beenachieved and announced. At present, how to make the deliverables to be appliedis the key job of tax authorities in various countries.

China alsoactively joins the BEPS Action Plan. On the one hand, the internationalcooperation is being strengthened. Standing Committee of the National People'sCongress approved “the Multilateral Convention on Mutual AdministrativeAssistance in Tax Matters” on July 1, 2015. On the other hand, laws andregulations are being modified to build up a more completed anti-tax evasionsystem.

In July 2014, SATreleased the Circular on the Anti-tax Evasion Investigation of External Paymentof Large-amount Expenses (“No. 146 Circular”), starting the investigation ofthe disbursement of service expenses and royalties to overseas related parties,and requested local tax authorities to report the results. The conclusion hasbeen announced, that the disbursement of unreasonable expenses to overseasparties often happens in China, resulting to base erosion and profit shifting.

Therefore, theNo. 16 Announcement not only provides the guidance for local tax authoritieshow to check the expenses payments to overseas related parties, but also is oneof the important actions of international anti-tax evasion made by China.

3. The six tests for the disbursement of expensesby enterprises to their overseas related parties

On June 4, 2014,in a taxation conference held in Washington, Tizhong Liao, Director of InternationalTaxation Department of SAT, said that SAT will further strengthen themanagement and examination for the disbursement of expenses by Chinese subsidiarycompanies to their overseas mother company, introducing the six tests to judgewhether it is necessary to make transfer pricing adjustments.

The No. 16Announcement basically reflects the idea of the six tests. Moreover, someguidelines issued by some local tax authorities also state the contents of thesix tests.

Following we willtry to make some analysis for the six tests with some fictitious cases.

The test of beneficiary

It is to testwhether the enterprise is benefit from the disbursement of expenses orroyalties to its overseas related parties, and test whether the cost and thebenefit are matched.

[Case] Overseasmother company A charges expenses to company B established in China. Theexpenses include strategy management, internal information system integration,and centralized management. However, the substantial services are quitelimited.

[Analysis] Strategymanagement and centralized management lead synergistic effects to the wholegroup. However, the main beneficiary is the mother company. The company B onlygains collateral and incidental benefits, so it shall not pay such expenses.

The test of demand

It is to testwhether the purchased services, technologies or brands are fit for the demandof the enterprise, and test whether they are necessary.

[Case] B is a OEMmanufacture company established in China. Its suppliers of main raw materialand customers of finished goods are all the related parties. The Overseas mothercompany A charges B the annual lawyer fee.

[Analysis] B haslittle demand for lawyer service, because all the suppliers and customers arerelated parties. It can undertake by itself the legal obligation whennecessary. So it may not pay the overseas lawyer fee.

The test of duplication

It is to examinerelated contracts and actual situation, to judge whether the enterprise pays morethan one time for the same kind of service or technology.

[Case] B is amanufacture company in China, C is the local headquarter in China, and A is theoverseas mother company. C charges B management service or royalty fee. A alsocharges B similar expenses.

[Analysis] Ifsimilar services are provided and charged by more than two related parties,usually the enterprise is required to have enough and good reason / evidence toprove that the services are different. Otherwise, it shall not pay the sameexpense twice.

The test of value creation

It is to test thelevel of contribution for royalties made by each party. If the intangibleassets are created in China, and the overseas parties only have the legalownership but did not make contribution for its value, the enterprise in Chinashall not pay for the royalties.

[Case] B is ahi-technology enterprise in China, which has strong capability of research and development,and it contributed a lot of efforts for technology, patent and brand. Theintangible asset was created in China. Company A is the overseas related party,and it charges B royalty fees for similar technology.

[Analysis] Thecompany in China shall not pay royalty fee for its own technology or brands.

The test of compensation

It is to testwhether the compensation acquired by overseas company matches the disbursementof expenses to overseas related company.

To examinewhether there are any other transactions between the enterprise and theoverseas supplier of service or royalty, in order to judge whether there are offsettransaction and whether the overseas company has been compensated by transferpricing or other methods.

[Case] Company Bin China purchased equipments from overseas related Company A. They agree thatthe installation is a part of the contract and is included in the totalcontract value. At the year end, Company A charges B the salary expenses of theinstaller again.

[Analysis]Disbursement shall not be made for the services that have been alreadycompensated by other transactions.

The test of authenticity

It is to testwhether the contracts and documents provided by the enterprise and the actualtransactions are the same, whether the services listed in the contract aretruly rendered, whether the value of intangible assets exists, and to judgewhether the overseas related parties provide the corresponding functions andundertake the corresponding risks, or the transactions are truly exist.

[Case] Company Bin China signed a service contract or royalty contract with related Company Aregistered in tax heaven. Company A does not have its own assets, actualbusiness, local employees or business location.

[Analysis] Therelated parties which do not have employees, assets or business may not haveactual transaction with the enterprise in China.

4. Our observation and suggestion

With theimprovement of international anti-tax evasion and the active participation ofChina, the deliverables of BEPS Action Plan will no doubt become a part ofChinese taxation policies step by step. The No 16 Announcement and localguidelines are the start of the procedure. We anticipate that the improvementof taxation policies, such as the revision of “Tax Administration Law” and “ImplementingMeasures for Special Tax Adjustments”, will further affect the arrangement of multinationalcorporations’ related transactions. At the current phrase, we suggest thecompanies examine the related transactions again, based on the No. 16Announcement and local guidelines. The companies shall also pay attention tothe follow-up policies, to avoid the risk of special tax adjustment and doubletaxation.

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