Legal flash – Shanghai office – March 2015 – Announcement of the State Administration of Taxes concerning enterprise income tax on fees resident enterprises pay to overseas related parties

In recent years, the State Administration of Taxes (“SAT”) has paid closer attention to fees resident enterprises pay their overseas related parties, concerned that multinational groups have shifted profits away from China through aggressive tax planning and by paying unreasonable service fees and royalties overseas.

Following PRC’s active participation in the OECD Base Erosion and Profit Shifting Project, and SAT’s call in July 2014 (Circular [2014] 146) requesting all-level tax authorities to (i) investigate resident enterprises paying substantial service fees and royalties to overseas related parties from 2004 to 2013 and (ii) submit their preliminary reports, on March 18, 2015, SAT released Announcement [2015] No. 16 (“Announcement 16”), which became effective on the date of issue.

Based on article 41 of the Enterprise Income Tax (“EIT”) Law, under Announcement 16, any fee payment to overseas related parties must meet the arm’s length principle. Otherwise, the tax authorities can make tax adjustments and deny the payment’s deductibility for EIT purposes. Announcement 16 specifies that the following fee payments do not meet the arm’s length principle and cannot be deducted for EIT purposes:

1. Fee payments to overseas related parties that do not perform functions or bear risks, and do not engage in any substantive business activities.
2. Fee payments to overseas related parties for services that do not imply a direct or indirect economic benefit for the service recipient, such as:
a. irrelevant services – services unrelated to functions and risks assumed by the parties to the transactions, or to the business operations they carry out;
b. shareholding monitoring activities –activities related to controlling, managing and supervising the resident enterprise, and to protecting investors’ direct or indirect interests;
c. duplicated services – services provided by the overseas related parties that the resident enterprise has purchased from third parties or has covered internally;
d. services paid through other related-party transactions;
e. benefits for belonging to a group, which are not accepted as a specific service provision; and
f. other services that do not directly or indirectly benefit the resident enterprise.

Based on the above, resident enterprises should conduct a “benefit analysis” for all services received from their overseas related parties. If these services bring direct or indirect economic benefits, service fees will be considered compliant with the arm’s length principle. Otherwise, service fees cannot be deducted for EIT purposes.

3. Royalty payments for using intangible assets provided by overseas related parties that are not consistent with the specific risks and functions performed by all parties in relation to these intangibles, irrespective of their formal ownership (the parties must consider who has created or increased the intangible’s value to determine the economic interests each related party is entitled to).
4. Royalty payments to overseas related parties for incidental interests or fringe benefits derived from financing or listing activities through an overseas holding or financing company.

Under Announcement 16, the tax authorities can request resident enterprises to provide agreements and materials to prove that overseas related-party transactions took place and that they complied with the arm’s length principle. The tax authorities have 10 years to review the transactions and carry out any special tax adjustments.

Considering when Announcement 16 was issued, the latest tax developments and the Chinese tax authorities’ will to fight aggressive tax planning resulting in base erosion and profit shifting, local tax authorities could initiate formal transfer pricing inspections on enterprises making substantial payments for services fees and royalties to overseas related parties, investigated in the third quarter of 2014 following SAT’s call. Announcement 16 gives local tax authorities guidelines on how to identify challengeable service fee and royalty payments.

As we have underlined in recent months, enterprises that have made substantial payments under these concepts should (i) make sure that their policies are consistent from a transfer pricing and arm’s-length principle perspective, (ii) keep available for the tax authorities’ review all relevant materials, contracts and agreements that back their transfer pricing practices, and (iii) be prepared to address any questioning on the matter. This is particularly relevant for enterprises that are not required to keep up-to-date transfer pricing documents (such as loss-making enterprises), as they may still undergo an investigation into these payments.