Intra-group outbound payments

Local-level tax authorities taking actions

By Kelvin Lee, PwC Tianjin

In brief

We have reported several times in the last two years on the official views and position of the State Administration of Taxation (SAT) regarding outbound payments to overseas-related parties as well as Public Notice 16 which puts the SAT's views and positions into action. Following Public Notice 16, we have observed inconsistent practices in interpreting and enforcing it among different local-level tax authorities which results in potential transfer pricing issues and risks for multi-national corporations (MNCs).

Recently, the State Tax Bureau of Zhejiang Province (Zhejiang STB) - the first tax bureau at the provincial level - released the (the "Guideline"), providing a supplementary interpretation of the major tax risks stemming from outbound payments to overseas-related parties, and putting forward relevant suggestions on risk controls as well as measures to tackle these risks. It is expected that tax authorities at the local level in various regions will take actions accordingly and bolster their efforts to monitor and scrutinize the outbound payments to overseas-related parties.

Here, we will share our observations on the Guideline, and the local practices of local-level tax authorities in other regions on the outbound payments to overseas-related parties, and put forward feasible recommendations to MNCs, in order to optimise their intra-group charge structure and reduce relevant tax exposure.

In detail
Focus on the outbound payments to overseas-related parties

In recent years, the SAT has taken a prudent attitude towards outbound payments of MNCs to their overseas-related parties. In the environment of gradually implementing base erosion and profit shifting (BEPS) action plans by countries all over the world, the SAT has expressed its views and position on China's administration of outbound payments to overseas-related parties in its official Response to the United Nations and the subsequent Shuizongbanfa [2014] No.146 (Circular 146) and Public Notice 16 respectively.

Based on the request of the SAT in Circular 146, the local-level tax authorities launched a comprehensive tax examination on significant payments made by the Chinese subsidiaries of MNCs to their overseas-related parties last year, and reported their findings to the SAT. Subsequently, according to the views further elaborated in Public Notice 16, the local-level tax authorities have strengthened the tax administration of these outbound payments.

Zhejiang STB released the Guideline on the administration of outbound payments to overseas-related parties

Against this backdrop, the Zhejiang STB released the Guideline based on China's tax law and regulations, deliverables of BEPS action plans as well as local practices on tax collection and administration. The Guideline lists out the following major tax risks in relation to outbound payments to overseas-related parties, and provides corresponding recommendations on tax risks control as well as the measures to tackle these risks.

- Deductibility of the Chinese payer on payments for Corporate Income Tax (CIT) purpose

Following the fundamental in Public Notice 16, the Guideline stipulates that any unreasonable outbound payment made to overseas-related parties shall not be deductible for CIT purposes. It:

1) provides certain key focus areas on how to assess "whether the overseas-related party undertakes functions, bears risks or has any substantial operation or activities" as stipulated in the Public Notice 16
2) provides specific examples of "payments for services that could not provide enterprises with any direct or indirect economic benefits" specified in Public Notice 16 to facilitate local-level tax authorities' assessment
3) outlines certain types of unnecessary outbound payments made to overseas-related parties in compensation for indirect benefits to the payer
4) reiterates that outbound payments to overseas-related parties shall be in compliance with the "arm's length principle", and specifies how to determine whether the amount of an outbound payment made to an overseas-related party exceeds the amount of payment made to an independent third party for the same transaction, etc.

- Six tests

The Guideline provides certain tests to determine whether profit is being shifted or the tax base is being eroded through outbound payment by enterprises, including 1) authenticity test; 2) necessity test; 3) benefit test; 4) value-creation test; 5) duplication test; and 6) remuneration test. These six tests are the same as those highlighted by a senior official from the International Tax Department of the SAT in his speech at an international conference last year. The tests are used to assess the nature of the outbound payments to overseas-related parties which are not deductible for CIT purposes specified in Circular 146 and Public Notice 16 respectively. The Guideline provides examples to explain each of the six tests and supplements with certain clarifications. For instance, the value-creation test is further explained as one on who creates value and one on where value is created.

- Potential taxability issues of the overseas-related party

The Guideline also expands its examination scope to the potential taxability issues in China for the overseas-related party. For instance, whether the services are rendered onshore or offshore China; whether the nature of the payment is passive royalty fee vs. active service fee; and whether the service provider creates a permanent establishment in China, etc.

- Measures for local-level tax authorities to address tax risks (a list of required documentations for outbound payments to overseas-related parties)

With cooperation among tax authorities at all levels in different regions, Zhejiang STB will apply multiple measures to comprehensively tackle the tax risks arising from outbound payments to overseas-related parties. For instance, to enhance the information collection and administration of annual reporting forms for related party transactions and record-filing of outbound payments; to promote province-wide usage of information technology systems to identify key targets; and to fully leverage all types of information exchange with other jurisdictions to enhance the supervision of the tax revenue of cross border payments, etc.

The Guideline stipulates that the tax authorities could request a suspicious taxpayer to provide relevant documents. On the other hand, taxpayers could also voluntarily submit other supporting documents to reduce the tax risks during their record-filing for outbound payments. The Guideline also has a list of required relevant information in its Appendix which sets out five categories of information to be provided. Among them, information relating to the following three categories: transaction information in relation to the outbound payments to overseas-related parties; relevant analysis of outbound payments to overseas related-parties; and the selection of TP methods, may all require additional analysis and sufficient preparation.

It is likely that the local-level tax authorities in Zhejiang province will take follow-up actions following the release of the Guideline, such as collecting relevant information on intra-group outbound payments by local enterprises from their internal database, and identifying key targets with potential tax risks for further investigation. MNCs should pay close attention to such developments in a timely manner and be well-prepared for risk controls.

Challenges faced by MNCs

Although the SAT has affirmed its position in relevant tax circulars, the inconsistent tax administration practices of tax authorities at the local level and a lack of unified implementation guidance and procedures would inevitably result in tax controversies between the Chinese tax authorities and MNCs. For instance, the assessment standards taken by tax authorities in different regions may not be consistent, as some of the items under Public Notice 16 require subjective judgement. Some local-level tax authorities may disallow the deduction of the outbound payment merely because the overseas-related party is located in a tax haven or a low-tax jurisdiction based on the literal meaning of Public Notice 16. Some may simply consider any service fee payment made by Chinese local subsidiaries to overseas parent companies as a management fee related to the shareholder's activities and disallow the deduction of such an outbound payment. Some may require enterprises to provide relevant information and to apply the six tests. However, there is not a set of unified standards regarding valid evidence and how to apply the six tests.

The Guideline is intended to provide clearer implementation guidance for both local-level tax authorities and MNCs and also to bring more certainty to MNCs in managing their tax risks. It is expected that local-level tax authorities in other regions may also release public or internal implementation guidance in future.

The takeaway

As one of the most important measures in the enforcement of the BEPS action plan in China, there is no doubt that outbound payments to overseas-related parties has become the centre of attention of the Chinese tax authorities recently. It is expected that local-level tax authorities would take relevant actions, such as screening and selecting key targets to carry out tax investigations. In order to reduce the relevant tax risks, it is advisable for MNCs to take the following measures:

- As a good starting point, a comprehensive tax health-check is necessary to better understand the Chinese subsidiary and the group's current intra-group outbound charges status. Take immediate actions to rectify any issues identified and build up a doable and sustainable intra-group charges structure and system which may involve both the overseas parent company / related parties and Chinese local subsidiaries.
- Based on our understanding, when the in-charge tax authority determines whether the outbound payments to overseas-related parties could be deductible for CIT purposes, a formal TP investigation procedure should be launched to make the special tax adjustments. MNCs should prepare TP documentation and adequate justification in advance and efficiently manage the on-going TP risks.
- Meanwhile, MNCs should consider the China tax exposure for overseas-related parties during the step of outbound remittance and, at the same time, the deductibility issue of outbound payments for the Chinese local payer during the post-remittance stage, so as to avoid any potential conflict between the tax treatment of outbound payments and the current and on-going TP arrangements.
- Tax authorities may require MNCs to provide a comprehensive set of documents (e.g., the documents specified in the list of sample documentations attached in the Guideline) as early as in the step of outbound remittance. As such, it is recommended that MNCs actively take actions to prepare for tax and TP risk assessments for the relevant transactions.
- Effective and efficient communication should be maintained between MNCs and their in-charge tax authorities. Outbound payments to overseas-related parties may involve various internal departments in tax authorities, such as the Departments of Income Tax, International Taxation, Anti-tax Avoidance. In this regard, MNCs need to coordinate with these tax departments, so as to resolve any potential tax controversy and mitigate any tax dispute.

In light of the latest requirements in this Guideline, we observe that local-level tax authorities in various regions have recently increased their efforts in investigating and adjusting on transactions related to outbound payments to overseas-related parties. With more and more cases, we can see the complexity and uncertainty of the CIT deductibility and TP issues arising from these cases. Based on our recent experience of dealing with similar cases, MNCs should closely focus on the SAT's analysis framework for outbound payments to overseas-related parties during their discussion with tax authorities. Also, according to the detailed provisions in the Public Notice 16, MNCs should pay more attention to explaining the reasons for the outbound payments from the aspects of TP and the group's value chain. Moreover, they should diligently perform the authenticity test and benefit test respectively based on the arm's length principle, and consider the specific regulation and guidance for outbound payments set forth by the local-level tax authorities in various regions.

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