Transfer Pricing Audits of Service Fees: Are You at Risk?

The Chinese tax officials are now more active and aggressive in the realm of transfer pricing. Multinational companies should take proactive steps to understand and shape their transfer pricing models and tackle potential risks. This article illustrates the large transfer pricing adjustment made by the Chinese tax authority pertaining to service fees paid to Singapore by drawing upon a case of Xiamen city. It also covers problems frequently faced by multinational companies during outbound service fee remittances and respective resolutions.

Large transfer pricing adjustment made by the Chinese tax authority in relation to service fees paid to overseas group companies

Transfer Pricing Adjustment

Opportunities

It is recently reported by the People’s Republic of China’s Ministry of Commerce that Singapore was the second largest source (after Hong Kong) of foreign direct investment (FDI) into China in 2013. This quite surprising statistic is a result of the fact that many global multinationals choose Singapore to establish Singapore’s principal structures to invest in China and utilise the experience and expertise of Singapore’s managers in the China’s market. This is in addition to the numerous attractions of Singapore such as a high standard of living, strong infrastructure, a good tax treaty network.

The typical management control system of a Singapore’s principal with subsidiaries in China can be classified as follows.

§ In respect of financial management, the Singapore’s principal treats their Chinese subsidiaries as cost centres, with contractual negotiations taking place in Singapore or a third place.

§ In respect of marketing, this is typically performed in Singapore, with the role of the Chinese company limited to producing for export in response to purchase orders provided by the Singapore’s principal.

§ The majority of the research & development (R&D) departments within Chinese plants act on a contract basis, receiving instructions from the R&D department of the Singapore’s principal, with the resulting IP being owned and exploited by the Singapore’s entity.

This structure offers the multinational group opportunities to explore transfer pricing techniques by taking advantage of the relatively low corporate tax rate of 17% in Singapore (the corporate tax rate in China is 25%) for optimising effective tax rates of the group. Furthermore there are opportunities to further reduce the tax rate by applying for an incentive from the Economic Development Board (EDB) of Singapore. For example, if the group is able to establish a global or regional headquarters in Singapore – including performing key functions and relocating/recruiting senior staff there – it may be eligible for a reduced corporate tax rate under the “Headquarters Award”. If significant intangibles and R&D activities are relocated to Singapore, a 5% corporate tax rate may be applicable on qualifying income under the Development and Expansion Incentive (DEI).

To protect its tax base, the Chinese tax officials are now becoming increasingly active and aggressive in the area of transfer pricing. Multinational companies should take proactive steps to understand and design their transfer pricing models and address potential risks. Otherwise, a transfer pricing investigation by the Chinese tax authorities is likely to be triggered. This is reflected in a recent audit case in Xiamen, a coastal city in Fujian province.

The Xiamen case

On 20 January 2014, the China Tax Newspaper (a newspaper organised by the SAT) published an article on a large transfer pricing adjustment made by the State Tax Bureau of Xiamen city in relation to service fees paid to Singapore. The background to the Xiamen case is that a Fortune 500 company established two subsidiaries in Xiamen in 1998 and 2004 respectively. Starting from 2008, the profit levels of the two companies have been declining while revenue was growing. The accounting records showed that the reason for the decrease in profits was the relatively very large amount of cross-border service fees of RMB3.8 billion paid by these two Chinese companies to a related company in Singapore – a company which was eligible for an EDB incentive in Singapore to make it exempt from corporate tax for a fixed period.

The Xiamen State Tax Bureau suspected that the profits have been artificially shifted from China to Singapore and commenced an investigation of the two Chinese companies in May 2010. During the investigation, the tax officials identified the following issues:

· Mismatch in allocation keys – the cost allocation between the headquarters of the Fortune 500 company and the related Singaporean company was based on the number of employees, whereas the cost allocation between the Singaporean company and the two Chinese companies was based on the sale proceeds;

· Cost sharing not consistent with economic ownership – the Singapore company has economic ownership of the intangibles in respect of information technology systems, R&D and marketing while sharing the costs with the headquarters. However, the Chinese companies do not have any ownership or entitlement to “intangible related returns” yet still contribute to the cost of developing those intangibles;

· Incorrect cost base – The Chinese companies paid the fees on the basis of the global costs allocated by the headquarters to the Singaporean company, not the portion of the costs allocated to the Singaporean company.

The tax authority claimed that that there was inconsistency in the transfer pricing method and policy, and therefore that adjustments were required in expenses incurred for business proposals, support of IT systems, R&D and marketing.

After four years of discussion and negotiation, the companies have accepted the settlement of more than RMB800 million (including interest) and the tax bureau closed the case in December 2013. This is the first large transfer pricing adjustment case on service fee payments so far in China, with substantial involvement and oversight from the SAT.

Issues/Resolutions

A multinational company can provide a range of support and management services for its Chinese subsidiary, including market research, administrative services, technical services, maintenance, design, scientific research, legal and accounting advice, technical assistance associated with transfers of intangible assets, marketing know-how and production know-how. When the Chinese subsidiary pays fees that may be deemed to be excessive for such services provided by the overseas company, the Chinese tax authorities are likely to challenge the arrangement. From our practical experience, the problems frequently encountered during outbound service fee remittances and possible resolutions include:

Issues

Resolutions

Benefit test
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/allowed.

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 the preferred methods.

Management fees
According to the PRC tax regulations, management fees paid by China subsidiaries to 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. In addition, certain services provided by the overseas headquarters such as strategic management services, internal auditing, and salaries for overseas senior executives might be viewed by the PRC tax authorities as shareholding activity in nature and consequently they would disallow a service fee deduction.

To avoid the potential risks of the service fee being viewed by the PRC tax authorities as a management fee, taxpayers should ensure that 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. Some companies calculate their service fees payable based on the percentage of profits or sales, but such fees could be considered by the PRC tax authorities as management fees. Therefore, this should be avoided.

Permanent establishment
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. If, during the provision of services, the overseas parent company sends personnel to China to participate in the service project, the PRC tax authority may regard such personnel as constituting a PE, and attribute all service fees paid by the China subsidiary to the overseas parent company to the PE's income, and thereby effectively impose a 100% withholding tax on them.

As a practical matter, even if it is quite clear to the overseas company that no PE exists as a result of the services provided, it should still prepare to defend its position to the PRC tax authorities. If, during the provision of services, the parent company dispatches personnel to China to participate in the service project, it might be prudent for them to carefully arrange the time for the dispatched personnel to stay in China to avoid the risk of being constituted a PE.

Withholding tax
As fees for services provided outside PRC are in principle 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. In practice, some PRC tax authorities may consider all or part of the service fees as royalties due to inadequate grounds for provision of services by overseas affiliates, and thus impose a 10% withholding tax there on. Some Chinese subsidiaries may need to pay both service fees and royalties to the overseas parent companies. However, if service fees are not explicitly stated in a contract, they may be subject to the risk of all being considered by the PRC tax authorities as royalties.

A service contract should avoid using the words "technical services" as much as possible, so that service fees are not regarded as royalties by the PRC tax authorities. If enterprises also need to pay royalties and service fees to their offshore parent companies, they should specify the contents, payment terms and amounts of royalties and service fees in the separately-signed contracts for royalties and service fees.

Threshold
According to the new PRC regulations, where a company pays service fees not exceeding US$50,000, it is not necessary for the company to make an advance return. However, where a company pays service fees cumulatively totalling more than US$50,000 for the services of the same nature, the company may face the risk of being identified as intentionally splitting transactions to avoid a tax return and thus being punished.

Although the new stipulation enables enterprises to make foreign payments more conveniently, there are still many potential problems that need to be managed carefully. If the company does not need to urgently make the service fee remittance, it could submit a return in advance, or consult with the in-charge tax authority on the tax items before completing the tax registration and remittances.

Conclusion

As Chinese tax officials are becoming more and more sophisticated in the area of transfer pricing, they are starting to seriously look at the arm’s length nature of service fees paid to overseas group companies. Multinational groups should take proactive steps to understand commercial reality of a business and to properly design their transfer pricing systems to address potential risks. It is of course too late to prepare transfer pricing documentation to defend a position when the company is under transfer pricing investigation or audit.

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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.

Kunda Tax Consulting (Shanghai) Limited
www.kunda-tp.com