China – Transfer Pricing and Outbound Payments

In 2014 the State Administration of Taxation (SAT) issued an internal circular (circular 146) as a crackdown on services fees and royalties paid to related foreign parties – especially where they reside in low tax jurisdictions. The crackdown was to review transactions between 2004 and 2013. As a follow up to this, SAT has recently issued Announcement No. 16. which again focuses on outbound payments to related parties.

The Announcement states that all related party outbound payments must be subject to arm’s length principles and tax authorities can request documentation in support to substantiate whether or not the payments are truly arm’s length. If not, the tax authorities will have the power to make a special tax adjustment and whilst the transactions cannot be invalidated, they will not be deductible for corporate income tax purposes. 

Payments will not be allowed to be deductible in circumstances where:

1. The foreign related party performs no function, bears no risk and has no substantive operational activity.
2. The local party receives no benefit from the services.
3. The foreign related party receives royalties on intangibles which it contributes nothing to its value.
4. The foreign related party receives royalties in exchange for incidental benefits flowing from fundraising or an IPO.

International businesses operating in the PRC where there are outgoing service payments between group companies should be on alert for potential enquiries from the Chinese tax authorities.