Circular 146 was a follow-up of the SAT’s response to United Nations’ (UN) request for comments on intra-group services and management fees. In the response, the SAT reaffirmed its stance that service fees paid and received by related parties must be in compliance with the arm’s length principle. In particular, as regards management fees, the SAT stated that these expenses, generally, are related to shareholder’s benefit and therefore should not be deductible for Enterprise Income Tax (“EIT”) purposes.
Upon the issuance of Circular 146, we expected that the PRC tax authority would likely make reference to this circular’s principles in their future scrutiny of overseas intercompany charges. The SAT now put this into action and recently issued its SAT Public Notice  No. 16: Public Notice Regarding Certain Enterprise Income Tax Matters on Outbound Payments to Overseas Related Parties (“Bulletin 16”) to strengthen its control of payments to overseas related parties. The principles laid down by the SAT in its response to UN and Circular 146 are observed in the contents of Bulletin 16 and will be demonstrated in the next paragraphs.
ARM’S LENGTH BASIS
Outbound payments by an enterprise to its overseas related parties should be regarded as the enterprise’s ordinary business operation and could be paid upon completion of designated procedures. Nevertheless, the independent transaction principle i.e. arm’s length basis of carrying out transactions between related parties has been emphasized throughout Bulletin 16:
- Enterprises’ payments to overseas related parties should be in line with arm’s length basis. Otherwise, the PRC tax authority can raise adjustment on the payments within 10 tax years subsequent to the occurrence of the transactions.
- The in-charge tax bureaux can request the enterprises to submit the contracts or agreements concluded with overseas related parties in relation to the payments, as well as information for substantiating that the transaction is genuine and in line with arm’s length basis.
- If the tax authority concludes that the overseas related recipient does not perform any function nor bear any risk, or without any genuine operating activity, the corresponding expenses will be non-deductible for EIT purpose.
The above requirements are elaboration of various articles in the EIT Law and the Detailed Implementation Rules regarding expenses paid to overseas related parties. Above all else, the reiteration of the time limit of tax adjustment may hint the coming of another wave of review of enterprises’ overseas payments for the past 10 years.
Bulletin 16 has also specified those situations that service fees or royalty payments are non-deductible for EIT purpose, which we will recap in next sections.
FOUR TYPES OF PAYMENTS WHICH ARE NOT DEDUCTIBLE FOR EIT PURPOSES
1. Payments to Unqualified Overseas Related Parties – Not Deductible
Under Article 3 of Public Notice 16, payment to an overseas related party which does not undertake functions, bear risks or has no substantial operation or activities shall not be deductible for EIT purpose.
Nevertheless, there are no guidelines as to what constitutes having substantial operation or activities. For example, it is not clear as to whether an overseas entity having a sub-license on certain IP’s will be captured as an unqualified overseas related entity.
2. Unqualified Service Fee – Not Deductible
Under Article 4 of Bulletin 16, when enterprises pay to overseas related parties in return for services, such services should result in direct or indirect economic benefits to the enterprises. The following situations are pinpointed by Article 4 of the Bulletin as not deductible for EIT purpose.
- The services are irrelevant to the functions, borne risks, or operations of the enterprises.
- The services, such as control, administration and supervision on the enterprises, are carried out by the related parties for the protection of the investment interests of the enterprises’ direct or indirect investors.
- The services rendered by the related parties have already been procured by the enterprises from third parties or conducted by the enterprises themselves.
- Although the enterprises, as part of certain group, obtain additional benefits, the enterprises have not received specific services from the related parties in the group. For example, the no-tional service charges are incurred by virtue of passive association.
- The services have been compensated in other related parties transactions. For example, the charges could have been included in the price in purchasing goods from the related party.
- Other services that cannot, directly or indirectly, generate economic benefits to the enterprises.
Readers may notice that the above services resemble those situations identified by the SAT in Circular 146 for focused review.
3. Unqualified Royalties – Not Deductible
Article 5 of Bulletin 16 also specifies the prerequisite for EIT deductibility of overseas royalty payments. When enterprises pay royalties in return for use of the intangible assets provided by their overseas related parties, the contribution of each related party in the value creation of these intangible assets should be considered in determination of the economic interests enjoyed by each party. Payment of royalties to related parties that only have legal ownership of the intangible assets but without any contribution to the intangibles’ value creation is not in line with arm’s length basis. Such royalties are not deductible for EIT purpose. In determining the value creation and contributions, each party’s functions performed, assets employed and risks assumed in the intangible asset development, enhancement, maintenance, protection, application and promotion must be considered and analyzed.
4. Unqualified Royalties – Not Deductible
Under Article 6, if an enterprise establishes a holding company or finance company outside China for listing or financing purpose, and pay royalties to their overseas related parties incidental to the listing or financing activities, such royalties are also not deductible for EIT purpose.
We cannot emphasize more on the importance for enterprises to review whether their payments to overseas related parties will be challenged according to Bulletin 16, and revisit the charging basis when necessary. After all, with China’s expressed interest in adopting OECD’s Base Erosion and Profit Shifting (BEPS) initiative, China tax authority’s additional policies and / or review of enterprises’ different transfer pricing arrangements are foreseeable. Enterprises in doubt of their situation are highly encouraged to discuss with their professional tax advisors.