Avoiding the China Cash Trap

Although Announcement 40, promulgated in July 2013, simplifies outbound remittance procedures, some issues still await to be addressed. In this article, we explore the tax implications of outbound service fee and royalty payments, and examine the authenticity and reasonableness aspects and present the remittance procedures and supporting documents required with respect to service fee and royalty charges.

Introduction

Profit repatriation – and the potential for significant cash traps if not planned and implemented carefully – have always been a primary concern of multinational companies (“MNCs”) operating in China. Particularly in times of budgetary tightening and declining profitability of MNCs globally, ensuring cash is used as efficiently as possible on a global level is paramount, and China is critical in this equation.

To ease foreign exchange controls and to simplify foreign exchange administration, on 9 July 2013, Notice Regarding Certain Issues Related to the Documentation Filling with Tax Authorities for Foreign Exchange Payment under Service Trade Items (Announcement [2013] No. 40) was jointly promulgated by the State Administration of Taxation (“SAT”) and the State Administration of Foreign Exchange (“SAFE”). “Announcement 40” cancelled the requirement to obtain a tax payment certificate, which was previously required to prove that the correct amount of tax has been paid before the funds can be remitted abroad. The release of Announcement 40 is a welcome development to simplify outbound remittance procedures. However, there are some issues yet to be addressed. For example, the verification of the documents and tax assessment will still be conducted within fifteen days after the PRC tax authority receives these documents and therefore the company might face more risks of being challenged in the future if the tax authorities deem the remittances are not based upon genuine transactions and that the tax withholding has not been done correctly.

Let’s begin with a simple case: a European company has a wholly foreign-owned entity (“WFOE”) in China. The WFOE imports branded watches from the parent company and sells to third party retailers in China. Given the functional and risk profile of the WFOE, it is determined that the entity operates mainly as a limited risk distributor and should therefore achieve low but stable returns. Thus, it is considered reasonable to benchmark the results of the WFOE based on this profile.

After the WFOE is properly remunerated some of the residual profits may potentially be remitted to the parent company by means of royalty or service fee payments assuming it is in line with the services or intangible assets being provided. However, when the WFOE actually applied for tax deductions of the relevant fees, the PRC tax authority challenged the nature, relativity, and reasonableness of such expenses and also claimed that the withholding taxes had not been properly calculated, even if the fees had already been remitted to the overseas parent company. In practice, this case is not uncommon in China. In the following sections of this article, we will explore the tax implications of outbound service fee and royalty payments, examine the authenticity and reasonableness aspects with respect to the service fee and royalty charges, and present the remittance procedures and supporting documents required with respect to such payments.

Tax Treatment

In the planning of intercompany service fees and royalties paid by an affiliated company in China, MNCs should take the following three major tax objectives into consideration：

•the China subsidiary (the payer) can claim a deduction against its corporate income tax –

service fees paid to overseas related parties are deductible for corporate income tax purposes provided they are charged at normal market rates. However, management fees paid by the China subsidiaries to the overseas parent companies are not deductible. As the PRC tax regulations do not explicitly define the meaning of “management fees”, it is possible that the PRC tax authorities may view the relevant charges for undertaking certain activities as management fee and hence should not be deductible for corporate income tax purposes. If the taxpayer insists that the fee is indeed a service fee, the PRC tax authorities may request the taxpayer to provide further evidence to clarify the nature of the services provided. It is advisable, therefore, for the taxpayer to ensure a detailed service agreement is in place and review the service items, the nature, and location of the services provided as well as the associated service descriptions closely, to avoid the potential risks of the service fee being viewed by the PRC tax authorities as a management fee.

In addition, according to the OECD Guidelines, the charges for services provided by the overseas parent company should exclude expenses relating to shareholder activities. The PRC tax law and SAT administrative guidelines do not explicitly address the scope of fees for shareholder activities. However, certain services such as strategic management services, internal auditing, and salaries for overseas senior executives might be viewed by the PRC tax authorities as shareholding activity nature and consequently they would disallow a service fee deduction. 

In the area of royalty payments, royalties are deductible for corporate income tax purposes provided they are charged at normal market rates. However, if the royalties are related to the importation of goods, they may be considered as part of the import value by the PRC customs authorities and subject to customs duty and import Value-Added Tax (“VAT”). It is also worthwhile to note that although the PRC does not formally cap royalty rates, in practice the PRC tax authorities may still limit the rates that a foreign investor can charge. For example, some PRC tax authorities may limit royalty rates to 5% of revenue resulting in royalty payments above this level being challenged and disallowed by tax authorities;

•the overseas-related party (payee) is not subject to excessive withholding tax and business tax (or VAT) in China –

the table below presents the tax implications on the applicability of the service fee and royalty payments from a Chinese company to an overseas-related party.

*In some locations, the local tax bureau may levy EIT based on a simply method, e.g., Service revenue×10%.

**Some local tax bureau may deem 100% of the services as onshore service which is subject to the EIT calculated on the deemed profit rate (10%~40%).

*** In 2012, the Chinese government introduced a pilot program arrangement in Shanghai to replace the business tax (“BT”) in transport and some modern service sectors with a value-added duty. Starting from 1 August 2013, the VAT pilot arrangement has been extended on a nationwide basis.

****If the license fee is paid pursuant to an arrangement which results in a technology transfer, then the business tax (or VAT) is exempt.

In the area of service fees, if the service fee is attributable to a permanent establishment (“PE”) in China, then the enterprise income tax (“EIT”) will be imposed at the rate of 25% on profits for the PE. It is a quite common practice for the PRC tax authority to simply ask that EIT be withheld based on a presumption that a PE exists. As such, as a practical matter, even if it is quite clear to the overseas company that no PE exists due to the services provided, it should still prepare to defend its position to the PRC tax authorities.

As fees for services provided outside PRC are arguably not taxable in the PRC for corporate income tax purposes, the offshore services that the Chinese company will receive should be specifically identified and the company may need to clarify the nature of the services received, otherwise the PRC tax authority may consider the service charge or part of the service charge should be regarded as royalty fees and a 10% withholding tax will be applied. Also, pursuant to the Notice of the State Administration of Taxation about the Issues Relevant to the Execution of the Royalty Clauses of Tax Treaties (Circular No. 507 [2009]), during the transfer or license of technical know-how, if the licensor charges service fee for assigning personnel to provide such services as support and guidance to the licensee for using the technical know-how, be it charged separately or included in the technology price, such service fee shall be deemed as royalty fee and is subject to the royalty provisions of double tax treaties.

In the area of royalty payments, the statuary withholding tax rate is 10%, which can be reduced to a lower rate if a tax treaty is applicable. However, in order to enjoy the treaty benefits for receiving payment of royalties from the affiliated China Company, Circular 507 and Circular 601 require that the non-resident company receiving the royalty be the beneficial owner of the royalty (on 29 June 2012, SAT released Announcement 30 providing further clarification on how to assess the beneficial ownership status). It is advisable, therefore, that foreign licensors who seek to enjoy the treaty benefits relating to receipt of royalties should carefully review their current status, and make sure that they are the beneficial owners of the royalties; and

•the paid tax in China by the overseas related party (payee) can be credited against its home country tax –

to avoid double taxation, many countries employ a foreign tax credit system. Under such a system, a tax credit is granted to the payee company for tax paid in host countries by its subsidiaries provided that the home country and the host countries have concluded a double tax treaty. Currently, China has concluded double tax treaties with more than 90 countries/jurisdictions. For resident companies of these jurisdictions, withholding tax paid in China could be claimed against the income tax payable in respect of the same income in the home countries if the foreign tax credit system is applicable in those countries. Moreover, an unused foreign tax credit may be carried forward. Foreign tax credits therefore have some tax planning implications for MNCs in China.

Authenticity and Reasonableness

In China, an enterprise is usually requested to provide evidence to support its tax deductions when the PRC tax authority raises concerns on the authenticity, nature and reasonableness of such service expenses.

According to the OECD Guidelines, the first step in determining the arm’s length nature of intra-group services is to determine whether services have actually been rendered. A critical issue in determining whether a service has been rendered is whether a benefit has been provided, that is, whether the service activity provides a respective group member with economic or commercial value to enhance its commercial position. In other words, the activities performed by the service provider must be examined to ensure they pass the “benefit test”. If not, a charge for their provision is not necessary.

There is no explicit application of the benefit test in China. In practice, however, it is reasonable to presume that it is part of the consideration in determining if the arm’s length principle is complied with. Generally speaking, this question of whether a benefit has been received can be answered by considering whether an independent enterprise in comparable circumstances would have been willing to pay another independent enterprise for the performance of the activity or would have performed the activity for itself or engaged an unrelated party to do so. If these tests are satisfied, the next stage will be to select the most appropriate method to set the arm’s length rate of the service charges.

In practice, comparable uncontrolled price (“CUP”) and cost-plus are probably the preferred methods.

The CUP method is likely to be used if external or internal CUPs can be identified. As is normally the case, external CUPs tend to suffer from lack of comparability. Internal CUPs could be available where the enterprise provides similar services to third parties, however.

Where no CUPs can be identified, the cost plus method will normally be applied. In order to determine whether the price is within an arm’s length range a comparability/benchmarking study should be performed using a third party database.

Due to the limited financial information in available databases at a gross margin level, the profit mark-up on total costs shall be calculated as operating profit/loss divided by total costs. This method is also known as the modified cost plus method or transactional net margin method (“TNMM”). An economic analysis shall then be applied to determine an “arm’s length” range of profit percentage (expressed as a mark-up).

When applying the (modified) cost plus method, a mark-up for profit must normally be applied. The “plus” can be determined by performing a comparable search, which determines the mark-up on total costs that third parties earn by performing similar activities.

If a cost plus mark-up method is adopted in determining the service fees, the company is required to justify the reasonableness of the calculation of the cost base (it may contain the cost of materials used in providing services, cost of salary and personnel cost, and other costs attributable to the provision of services) as well as the mark-up, by preparing a transfer pricing study.

In the area of royalty rates, there are a number of approaches that can be taken to the benchmarking of royalty rates:

• the CUP method –

once the facts and circumstances of the licence agreement have been clarified, the ideal method to test the arm’s length nature of the royalty rate would be to compare it to the rate charged between unrelated parties for the identical property. This might be the case where the developer has licensed a third party to use the same intellectual property under terms that are at least similar to those granted to the related party, or where the licensor has received the same property on at least similar terms from a third party. If reliable adjustments can be made for any differences in the terms and conditions of the two licence agreements (eg geographical markets), then it might be possible to use the third party royalty rate to confirm the arm’s length nature of the related party royalty rate.

In the likely scenario that it is not possible to identify such “perfect” comparable transactions, it may be possible to identify licence agreements between two unrelated parties for economically similar property and to use these agreements to benchmark the royalty rate used in the tested transaction.

This can be done by searching several specialised financial databases that are available to the public, albeit largely by subscription, for licence agreements in the same or similar industry and in respect of similar intellectual property, with broadly similar terms and conditions. The search and selection criteria that would be applied to these databases would typically include the Standard Industrial Classification (“SIC”) codes that are considered to be representative of the tested transaction, and the use of selected keywords, followed by a qualitative assessment of the potentially comparable licence agreements.

The royalty rate information for the licence agreements identified from this search and selection process can be used to create a range of arm’s length results, and if there are enough of them, an inter-quartile range (excluding the bottom 25% and top 25% of the results or observations) can be produced to increase the reliability of the results;

•the TNMM method –

the TNMM is another method approved by OECD for the benchmarking of royalty rates. This method has the advantage of analysing the arm’s length nature of the royalty rate from the perspective of the licensee as well as of the licensor, since it enables a calculation to be carried out of the benefit (in terms of the additional net margin) that can be said to be derived by the licensees from the use of the intangibles in question.

The application of a TNMM would involve identifying independent companies which are engaging in functions and bearing risks similar to those of the licensee, but which do not have a significant brand name or other marketing intangibles assisting them in their businesses. The net margins of those companies would then be compared with the net margins achieved by the licensee (naturally, for these purposes, the historical data of the licensee would be adjusted to exclude the impact of the payment of royalties).

The difference between the margin of the licensee and the independent comparables may be argued to be attributable to the benefit being derived by the licensee from the use of the intangibles that are the subject of the royalty agreement. In this analysis, adjustments to the data of the licensee and the comparables identified may be required to improve the quality and reliability of the results (for example, by excluding the impact of one-off or extraordinary events).

The end result of the TNMM analysis will likely be an inter-quartile range that could be used to calculate an implied arm’s length range of royalty rates. It should be noted, however, that the comparability standard needed for such a method to be accepted would be very high in practice, and for this reason is often used as a secondary method in support of a CUP, rather than in isolation; and

•the profit split method (“PSM”) –

The OECD Guidelines state that the PSM may be applied in cases involving highly valuable intangible property where it may be difficult finding enough data to apply one of the other methods. This is particularly the case where both parties to the transaction own valuable intangible property or unique assets that are used in the transaction and that distinguish the transaction from those of potential competitors. This may be the case where the local affiliates of the licensor have carried out marketing activities in their local markets sufficient in nature and amount to give rise to economic ownership of local marketing intangibles. Another example is where two entities have merged, both of which bring intangible property to the merged operations.

If on the facts and circumstances it is possible to identify and value the routine (ie basic) functions that may be carried out by the licensees and the licensor, it may be possible to carry out a “residual” profit split analysis. Under this method, the routine functions are assigned a routine return (which would be capable of being benchmarked from a search of financial databases), to whichever entity that carries them out, and the residual profit (ie the returns left over) is assumed to relate to the impact of the intangibles contributed by the other entity.

Due to the difficulty inherent in identifying and valuing the routine functions that may be carried out by the licensees and licensor, it is often not reliable to apply a residual profit split analysis. However, in such cases, it may be possible to apply PSM using a “contribution” analysis. Under this method, the combined profits from the controlled transactions under examination are divided between the associated enterprises based on the relative values of the functions performed by each of them. The difficulty lies in determining the relative value of the contributions made by each party, so a multi-layered approach is common. One basis would be the amount, nature, and incidence of the costs incurred in developing or maintaining the intangible property, although this may not provide much assurance if there is a poor link between costs and value. As far as possible, reference would be made to external market data to indicate how independent enterprises would have divided profits in similar circumstances.

The arm’s length royalty would be the difference between the split of profits as it should be according to PSM and the actual split of profits, before payment of any existing royalties.

PSM can be a very data-intensive exercise, but in the right circumstances it can provide additional evidence of the arm’s length nature of royalty payments between related parties.

Remittance Procedures and Supporting Documents

The PRC has extremely strict regulations governing the payment of “non-trade expenses”. If an overseas company wishes to recharge a cost to a Chinese affiliate it must enter into a contract with the Chinese entity in question directly. This contract must be entered into prior to the commencement of any services for the Chinese entity. Once the services had been provided, further backup documentation must be provided with the invoice to the Chinese entity. This documentation would include:

1. a detailed breakdown of the cost of the services including the hourly rate and number of hours worked;
2. number and names of personnel who undertook the services; and
3. location where the services were performed, and if the services were performed in China, copies of the visa page of the individuals who visited China.

It is advisable that the relevant supporting documents, eg the service agreement, internal sheets or intercompany correspondence relating to advice on specific technical/legal issues should be well prepared and maintained. The service agreement should include: the objective of the service provided; and the service scope, with items described in detail so that the services appear as specific as possible rather than just general in nature. The Chinese entity would then use this information to demonstrate to the PRC tax authority where the services were provided and the benefit that the Chinese entity received from the services.

In the area of royalty payments, if an overseas parent company is charging its Chinese subsidiary royalties related to the use of technology and know-how, the underlying royalty agreement will have to be registered with the local branch of the Ministry of Commerce (“MOFCOM”). If the royalty is for the use of trademarks, either the trademark owner (the overseas parent company) or the trademark user (the Chinese subsidiary) should register the trademark with the State Administration of Industry and Commerce (“SAIC”).

In China, the previous system for tax administration on outbound remittance under service trade items was set out in two circulars:

1. Circular No. 122 [2008] – Notice of the State Administration of Taxation on Issuing the Administrative Measures for Issuing Tax Certificates for Foreign Payments under Trade in Services and Other Items; and
2. Circular No. 64 [2008] – Notice on issues concerning Requirement of Tax Certificate for Foreign Currency Payments under Various Items including Service Fees.

From the enforcement of Circular 64, tax clearance certificate for outbound remittance has become one of the major tools for PRC tax authorities to monitor tax sources and strengthen tax administration on cross-border transactions.

On 9 July 2013, Announcement 40 was jointly promulgated by SAT and SAFE. Announcement 40 abolished Circular 64 by cancelling the requirement to obtain a tax payment certificate. Also, effective from 1 September 2013, no prior approval for outbound remittance is required but submission of a filing form and relevant transaction documents is generally sufficient.

Final Remarks

This new records filing system greatly simplifies the procedure for handling overseas service fee and royalty payments. Instead of having to apply for a tax clearance certificate before they can make payments overseas, companies now only need to complete a filing form and provide valid contracts of the transaction or other relevant transaction documents. This is a welcome development for MNCs operating in China. However, as illustrated in the case at the beginning of the article, there are still some issues remaining to be addressed. It is therefore very important for companies to be able to provide robust documents/evidence to support their position when the PRC tax authority raises concerns on the authenticity, nature and reasonableness of such cross-border payments.

No reproduction is allowed without permission.

Dr Jian Li（Kunda Tax Consulting (Shanghai) Limited）
MOBILE： +86 1391 815 5492
EMAIL：j.li@kundachina.com
Jian is a Senior Partner at Kunda Tax Consulting (Shanghai) Limited with more than 15 years’ experience in transfer pricing consulting. He provides transfer pricing services in the Greater China region, in both English and Chinese.