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Transfer Pricing Tax Alert - 15 February 2012 - Special factors to consider - EY - China

Hong Kong Tax Transfer Pricing Alert : 15 February 2012

Special factors to consider

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Hong Kong

Martin Richter
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Because the SAT measures do not clearly provide specific guidance or examples related to the execution of cost sharing arrangements, taxpayers have a certain degree of freedom and flexibility when entering into the arrangements.

However, such conditions also require that taxpayers take a cautious approach and pay careful attention to the negotiation and execution stages; otherwise, they may eventually be challenged by the tax authorities’ increasingly sophisticated and rigorous review system.

Multinationals should not only analyze the general regulations but also should consider special factors related to the Chinese market when entering into cost sharing arrangements. For example, because of China’s low labor costs, a multinational company may underestimate its Chinese participant’s contribution share.

On the other hand, it is possible to overestimate the Chinese participant’s anticipated benefit when measuring using sales or units of production as proxy, should the Chinese entity enjoy market premiums—for example, due to the market’s relatively high purchasing power and low sensitivity to premium prices for certain products during the global recession.

From these examples, it is evident that China’s cost advantage and market premium need to be carefully considered as they may have an impact on the valuation of the buy-in payment and cost sharing contribution made by the Chinese participant.

Despite the rising popularity of cost sharing arrangements, the strict measures taken by large multinationals in protecting their core technology also may make implementing a cost sharing arrangement more difficult. Globalization of markets does not necessarily result in parallel advances in the globalization of intangible asset ownership, development, and exploitation.

Even though Chinese enterprises have a significant advantage in terms of R&D and personnel costs, the headquarters of multinational companies, often owners of the preexisting intangibles, typically are unwilling to contribute their technology platform and invite their global affiliates to participate in joint development and exploitation. This usually is due to the high importance they place on the confidentiality of their core technology.

For the cost sharing of service-related expenses, Article 67 of the SAT measures provides that cost sharing arrangements for the provision of services generally are applicable to group procurement and group marketing activities.

In recent years, many multinationals have significantly increased their sales and marketing efforts in the Chinese market and in turn allocate substantially higher amounts of sales and marketing service fees to their Chinese affiliates.

 Chinese tax authorities have, as a result, increased their level of audit scrutiny on outbound fee payments, making the practical remittance of outbound service fees more difficult.

To prevent certain companies from converting intercompany service arrangements into cost sharing arrangements for the purpose of simplifying their cross-border payment remittance processes, multinational companies need to be aware of the differences between the two types of arrangements.

The table below notes the primary differences.

Item Cost sharing Service provision / receipt
Concept
Basic concept Cost pooling Service exchange
Profit mark-up and tax impact
Profit mark-up No mark-up as costs incurred are considered to be of entrepreneurial nature Costs related to service provision are marked-up
Tax impact Can potentially reduce business tax and corporate income tax burden Need to pay business tax and potential corporate income tax on service fee received

According to Article 69 of the SAT measures, an enterprise should report to the SAT, through lower tax authorities, the conclusion of a cost sharing arrangement within 30 days. This record-keeping measure clearly shows Chinese tax authorities’ cautious attitude toward cost sharing arrangements.

Considering the rapid growth of the Chinese market and the changes occurring in companies’ operations in China, multinational companies should pay close attention to the actual implementation and follow-up monitoring of cost sharing arrangements.

Conclusion

The concept of cost sharing is still relatively novel in China. In terms of specific operational guidance, current relevant regulations are in need of refinement. However, as China’s economy continues to grow, and the global economy continues to integrate, more and more multinationals are expected to enter into cost sharing arrangements in the coming years.

The arrangements allow multinational companies to match their transfer pricing policy to their business strategy, expanding functional profile, and the rapid growth in business and revenue in China. In this regard, multinational companies should be fully prepared for this trend and understand both international and Chinese regulations on cost sharing, as well as their practical application.

When determining the arm’s-length value of intercompany transactions under a cost sharing arrangement, multinational companies should, in addition to focusing on the technical aspects of calculation, carefully consider China-specific factors and the impacts of business tax, withholding tax or, more broadly, corporate income tax.


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