New challenges for HNTEs with cross-border royalty payments

By Kelvin Lee / Winnie Di, PwC Tianjin

HNTEs and royalty payments: the dilemma?

In China, the reduced 15% tax rate for High and New Technology Enterprises (“HNTE”) is one of the most attractive tax incentives for Chinese companies. In fact, HNTEs are becoming more and more popular in China and there has been a stable increase of 6,000 HNTEs in recent years.  To become a recognised as an HNTE requires companies to meet certain criteria, including its business scope being falling into a required industry, R&D expenses meeting certain percentage of revenue, certain percentage of R&D staffs, ownership of core intellectual property, etc.

Among these requirements, the ownership of IP (or an exclusive IP use right) echoes with the Chinese government's intention to upgrade the industry and encourage companies to enhance productivity and effectiveness. Although quite a number of MNCs have concerns about keeping IP in China, many foreign-invested companies are taking action in pursuing core IPs through self-development or purchase from overseas related or non-related parties in the attempt to enjoy the tax incentives on offer.

Many foreign invested companies, especially in the manufacturing field, have cultivated technological reliance on overseas IP owners, as evidenced by a common commercial phenomenon - intra-group royalty for IP licensing. Accordingly, these China licensees need to pay technology royalty fees to overseas parties.

Based on our experience, both the state-level and local-level tax authorities are paying more and more attention to HNTEs if they pay overseas parties for technology royalties.

Such concern from China’s tax bureaus should be expected. On the one hand, HNTE qualification attaches huge importance to the ownership of core IPs. On the other hand, royalty fees paid by an HNTE imply the importance of overseas technological support, leading outsiders to picture the indispensability of the licensed IP.

SAT’s checks

Back in 2012, a notice issued by Finance Department, State Administration of Taxation (“SAT”) and Science Committee requested to put more checks for HNTEs.

Some local tax bureaus took the opportunity and targeted those HNTEs who have a large amount of technology royalty payments to overseas parties. In a nationwide assessment on cross-border intra-group payment under Circular Shuizongbanfa [2014] No. 146 last year, these HNTEs paying technology royalties became easy targets.  Further, Public Notice [2015] No. 16 released by SAT provided the legal basis and more detailed guidance for local-level tax authorities in scrutinising the outbound payments including technology royalties.

Challenges from tax authorities

SAT’s checks echo the global Base Erosion and Profit Shifting (“BEPS”) wave. Following the current discussions regarding BEPS on deliverables related to intangible sections, China tax bureaus started paying more attention from tangible assets transactions to intangible assets transaction arrangements among MNCs. It is not a surprise for tax bureaus to raise questions such as: Being a HNTE which should own core IP (or exclusive IP use right), is it necessary to pay high technology royalty fees? If the answer is yes, to which extent is the self-owned technology applied in the production? If there are huge royalties involved, does it deliver the message that the said HNTE has not obtained core IP at all?

Formal challenges from tax bureaus are not rare. They tend to raise challenges from two angles.

Firstly, tax bureaus would question IP status of a HNTE. Below are some typical questions raised by tax bureaus:

− What is the relationship between the overseas licensed IP and the IP reported for HNTE application?

− How to prove that the licensed IP is actually the core IP used for production?

− How to prove the necessity of the licensed IP within the production?

− How to prove that the licensed IP plays a subordinate role in the production?

Secondly, tax bureaus also challenge how reasonable the royalty payment is from a transfer pricing perspective:

− Is the royalty paid to overseas related parties which don’t undertake functions, bear risks or have no substantial operation or activities? Does the royalty payment correspond with the functions and risks undertaken by the royalty recipient?

− Does a HNTE get higher profitability than an ordinary contract manufacturer as the HNTE bears more function/risk? Doesn’t royalty payment reduce the profitability of a HNTE?

− How to figure out the price of the royalty? Should the charging base be calculated on the full payment? Should the rate of the royalty be updated after obtaining HNTE qualification?

− When a HNTE shares its technical IP to related parties, is there any arrangement for compensation?

These two angles usually form a trade-off relationship with each other, which makes it more difficult for taxpayers. Without a well-prepared response to the above questions negative tax impacts could follow: (1) a HNTE may be revoked or could not be qualified as a HNTE going forward due to its 'weakness' in IP requirement; or (2) the technology royalties paid by this HNTE may have to be reduced or even disallowed for deduction under income tax law.

The takeaway

Under the even more stringent supervision on cross-border payments by China’s tax authorities, HNTEs who pay technology royalties to overseas related parties are advised to assess any potential conflict between the HNTE IP position and the royalty substance. Although China’s tax authorities do not have a clear instruction on the compliance materials to defend the position of taxpayers, an early review of internal documentation would be helpful.

It should also be remembered that tax impacts may not only affect the HNTE itself, but also involve other stakeholders including overseas investors, domestic partners (in a joint venture), overseas licensors, etc. Different commercial interests of such parties may escalate the complexity of the situation. For instance, overseas licensors may be reluctant to decrease royalty charges, overseas investors may prefer the HNTE status in view of the higher profit level brought by the 15% rate, and the HNTE itself may be more concerned more about both the lower CIT rate and the cost deduction issues of the royalties.

In view of the above, it is advised that HNTEs with royalty payments start to pay more attention to potential challenges.

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