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China in a number of international tax surveys has been found to have one of the toughest tax authorities when it comes to review and enforcement of transfer pricing regulations.

Recently, China is reported to have introduced an even stricter regime of reviews and consequent adjustment of taxable income in China. This trend is also seen in a recent response to the United Nations where China has clarified its view on management charges.

China has adopted a general rule that bars companies from deducting management charges from the taxable income in China. The rationale is that these services are activities performed by foreign companies as a shareholder in the Chinese subsidiary and, consequently, no charge should be levied on the Chinese company. The purpose, of course, is to increase the taxable income base of companies operating in China.

China has in a response to the United Nations acknowledged that many companies are “hiding” fees that should qualify as non-deductible management fees under intra-group service fees. In the response China confirms to abide in general by OECD’s transfer pricing guidelines including the “arm’s length” and “benefit” principles, but then goes on to suggest that a number of other circumstances should also be taken into account.

Roughly speaking, the “arm’s length” principle is that you should charge a fee in intra-group transactions at the same level as if the transaction had occurred with a third party, while the “benefit” principle will only allow fees to be charged if the services that are charged enhance the commercial position of the recipient.

Double benefit?

China is suggesting a double benefit test, so that benefits for the recipient as well as for the provider side should be considered. To exemplify this matter the Chinese response discusses whether a foreign shareholder should be able to charge fees to its Chinese subsidiary for general strategic management. And China says that even if the China subsidiary should benefit from this, the overall group (and thus the foreign shareholder) will benefit more. In consequence fees should not be deductible from the Chinese taxable income.

Are services necessary?

Secondly, China proposes to ask the question if the services are really necessary? China again gives an example stating that a number of manufacturing subsidiaries in China are receiving and are being charged for legal and other advisory services. When reading the response it is an obvious conclusion that China might in practice take a view on whether such high-end services – even if they may provide a benefit – from a cost/ benefit view (including in view of the actual needs of the Chinese entity) will be permissible.

Is it already paid for?

China is also suggesting that multinational companies should be obliged to submit information on their global intra-group transfer pricing principles. The view is that there is a risk that services charged under one name, may in fact already have been charged under another name. Again, China exemplifies its position: A foreign company provides intangible assets to a Chinese subsidiary and receives a royalty. This, in China’s view, precludes the foreign company from also charging a service fee since it already receives the residual profit.

Another example is a foreign company charging a fee to run a global raw material sourcing scheme, including in order to secure lower prices for its China manufacturing company. If the Chinese subsidiary then sells back products derived from the cheaper raw materials on a “full costs plus” mark-up basis – then the real beneficiary of the reduced raw material prices will be the foreign company and no fee should payable.

China also maintains the view that if a Chinese company has been set up with a full local management team, then any efforts off-shore China to service the Chinese entity will be duplicating work – with the consequence of fees not being deductible for tax purposes.

Companies operating in China should stay vigilant and verify if current transfer pricing principles and documentation are conform to the Chinese requirements. Both the “double benefit” test and the “is it really necessary” question will likely work to increase the burden of proof for companies in China making it more difficult to convince the Chinese tax authorities that service fees are deductible for tax purposes in China.

Companies should ask themselves the same questions as China has now communicated to the United Nations it will ask.

About Magnusson China Desk

Magnusson’s China Desk has more than 10 years of experience in working with Chinese customers. We advise more than 150 Chinese clients across the Baltic Sea Region, including AAC Acoustic Technologies, Air China, Asus, Bank of China, China National Electric Engineering Company, China Railway Tunnel Group, Denim Group, Minmetals North- Europe AB, Youngman Automobile and ZTE.

We provide our clients with services in for instance the following fields:

• Corporate set-ups and other greenfield investments

• Mergers and acquisitions

• IT and telecom projects

• Commercial contracts

• Joint Venture projects

• Public and private placements

• Public procurement

• International arbitration and litigation

• Migration law


Related People:  Nikolaj Juhl Hansen, Carl Fredrik Hedenström, Wenpeng Niu

Related Service Areas:  China Group

Related Countries:  Denmark, Sweden

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