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Transfer Pricing Tax Alert - 15 February 2012 - Tax implications - EY - China

Hong Kong Tax Transfer Pricing Alert : 15 February 2012

Tax implications of cost sharing in China

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Hong Kong

Martin Richter
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Taxpayers generally choose to enter into a cost sharing arrangement from an operational perspective. With the Chinese government proactively encouraging them, Chinese enterprises gradually are moving up the global value chain.

Recognizing China’s vast supply of well educated, low-cost personnel, many multinational companies are transferring certain R&D and service functions to China, establishing global R&D and shared service centers. Additionally, the booming domestic consumer market that is sustained by China’s huge population base and growing disposable income makes China a desirable market for MNCs to pursue.

After introducing foreign-made and branded products into the Chinese market, many Chinese affiliates of multinational companies will continue to carry out comprehensive marketing and promotional campaigns to gain brand recognition in China. These characteristics suggest that Chinese affiliates may contribute more value-added functions to the value chain in today’s global marketplace.

Another business rationale for pursuing cost sharing is to better allocate business risks among its participating entities. Multinationals often need to invest significant amounts of capital or effort when conducting large-scale R&D or marketing activities and the accompanying risks can be more appropriately allocated through a cost sharing arrangement.

As for the tax implications, in the absence of a cost sharing arrangement, the cross-border payment of royalty fees and service fees can result in complications involving business tax and withholding tax issues in China, which in turn could increase the overall tax burden for the multinational companies.

Cost sharing can significantly reduce intercompany royalty and service payments, as participants are independently responsible for developing their share of the intangible assets or providing their share of services, while in turn receiving the associated benefits. Such a simplified intercompany transaction scheme helps to lower the business tax and withholding tax that multinationals pay in China.

Further, under a cost sharing arrangement, the multinational could (with reasonable business rationale) arrange for participants to be located in low-tax jurisdictions. This would help reduce the corporate income tax paid on nonroutine profit attributable to the cost-shared intangibles, reducing the company’s overall effective tax rate.

Regulatory background

China began to regulate cost sharing arrangements from a legal perspective in the Corporate Income Tax Law (CITL) and its Implementation Regulations (CITLIR), which became effective Jan. 1, 2008. Article 112 of the CITLIR specifies that enterprises can, in accordance with Article 41, paragraph 2 of the CITL, share costs and reach a cost sharing agreement with its related parties that is in line with the arm’s-length principle (16 Transfer Pricing Report 725, 1/31/08).

Further, Chapter 7 of Implementation Measures for Special Tax Adjustments (Trial) issued by the State Administration of Taxation (SAT) Jan. 8, 2009 (the SAT measures), provides relatively detailed regulations on the administrative management of cost sharing arrangements in China. For example, Chapter 7 of the SAT measures provides guidance on topics such as types of the arrangements, allocation of costs according to anticipated benefits, adjustments needed in cases of change in participants or termination, and documentation requirements (17 Transfer Pricing Report S-3, 1/22/09).

Although the SAT measures cover certain aspects of cost sharing and stress that transactions need to be made at arm’s length, they do not provide guidance on how to employ specific methods to arrive at an arm’s length transaction value. Chinese tax authorities are still exploring different treatments and methods for evaluating the arm’s-length transaction value related to cost sharing arrangements. When examining the arrangements, the tax authorities generally refer to internationally accepted methods of economic analysis, leveraging knowledge from well-known cases—notwithstanding their consideration of special factors related to the Chinese business environment.

The next section further details trends and challenges specific to China as well as the requirements under the Chinese regulations for determining the arm’s length payment of intercompany transactions in connection with cost sharing arrangements.

A cost sharing arrangement typically entails two primary intercompany transactions:

  • A buy-in payment made by the cost sharing participants to the related-party contributor(s) for the right to use and further develop preexisting intangible assets
  • Cost sharing payments made by the participants related to the development of the cost shared intangible assets or provision of cost shared services

Buy-in calculation

Typically, prior to the commencement of a cost sharing arrangement, some intangible assets already have been developed by one or several parties. Hence, an arm’s-length buy-in payment must be made by the participants to the owner(s) of the contributed intangible assets for the right to use and further develop said assets.

Method used
Applying the comparable uncontrolled price method in evaluating arm’s-length buy-in payments usually is not the tax authorities’ preferred method because a preexisting intangible asset is often unique in nature and the comparable transaction identified often lacks similar profit potential. Alternatively, the income method is widely accepted by the Internal Revenue Service in the United States as a primary or corroborative method used to evaluate arm’s-length buy-in payments.

With the income method, the value of the buy-in payment can be measured by calculating the net present value of the future stream of nonroutine cash flows resulting from the exploitation of preexisting intangible assets. The IRS generally favors the income method because of the ability to determine, in aggregate with the buy-in payment, the payment for other aspects of a company’s preexisting intangibles; for example, make-sell rights.

However, Chinese tax authorities may not welcome the income method due to unfavorable views on the use of assumptions and of reliance on financial projections.

The SAT measures do not list specified methods for the calculation of arm’s-length buy-in payments. Based on experience, Chinese tax authorities typically request that methods relying on publicly available data—which require the least amount of subjectivity and assumptions and seldom necessitate extensive adjustments—be used as a primary or corroborative method in calculating buy-in payments.

Components of residual profit, routine return
When applying certain valuation methods, the routine return of comparable companies is often subtracted from the operating profit of the entity using the intangible assets to arrive at the excess returns of the entity attributable to the intangibles.

The aggregate of intangible assets generally is regarded by developed-market tax authorities to consist of firm-related intangible assets such as technologies, brands, and customer lists. Chinese tax authorities often declare China-specific factors such as location savings and customer proximity to be nonroutine contributions made by the Chinese participants.

The tax authorities believe these contributions are capable of generating nonroutine profit, given China’s special market conditions, and therefore claim that such factors be included in the valuation of the buy-in payment. This is not the case, however, if the routine comparable companies used also enjoy similar external factors or if these factors are the primary profit drivers of the comparable companies.

The solution often will vary, depending on the value chain of the participants and on the industries in which they operate. Generally, cases are separately and carefully examined in detail.

If these special intangible assets are considered part of the Chinese participant’s nonroutine platform contribution, the residual profit split method may be applied as an adjustment to the original valuation method in dividing the residual profit between the Chinese participant(s) and its foreign affiliate(s).

Typically, when performing a residual profit split contribution analysis involving special factors, such as location savings, where the return is not positively correlated with capital investment, an opportunity cost analysis, rather than a capital investment method, may be applied. The opportunity cost analysis can be applied to measure each party’s contribution, by calculating the additional investment needed to be made by the opposing party, should it want to achieve a realistic alternative arrangement with a third party.

Other areas of consideration
Also worth noting is that the SAT measures do not provide guidance on several key areas related to the buy-in payment, such as consistency of evaluation with realistic alternatives, discount rates used, and forms of buy-in payment. Chinese tax authorities tend to focus on the accuracy and reliability of forecasted data and assumptions used in the arm’s-length valuation of buy-in payments.

Calculation of payment, income

The costs associated with developing intangibles and providing services are allocated among the participants according to each participant’s anticipated share of the benefits received from the cost sharing arrangement. As it is often difficult to directly estimate each participant’s anticipated shared benefit, many taxpayers use indirect proxies such as units used, produced or sold; sales; or operating profit.

Article 71 of the SAT measures states:

[W]here, during the period in which an agreement for cost sharing is performed, the portion of cost assumed by any party thereto is inconsistent with benefits obtained by any such party, compensation adjustments shall be made in light of actual circumstances.

However, it does not recommend any specific methods for the calculation of balancing payments, nor does it provide any related safe harbor rules. Likewise, the SAT measures do not provide specific proxies for measuring anticipated benefits or offer concrete guidance for determining intangible development or service provision costs. The Chinese tax authorities generally evaluate the above considerations on a case-by-case basis, usually based on the examination of value drivers for the enterprise and the related industry.

Chinese tax authorities focus particularly on how:

  • The anticipated benefit is measured
  • The classification of the cost pool is allocated (for example, the exclusion of stewardship and nonbeneficial expenses)
  • The participants are determined (that is, participants in the arrangement should both make a contribution and benefit from the arrangement, while service providers make contributions for a certain fee but do not actually share in the benefit)
  • The arrangement is implemented and managed

For cost sharing arrangements involving intangible development activities, Chinese tax authorities also question how the territorial rights to the cost shared intangibles are defined—that is, how and to whom the interregional sales should be made outside of an entity’s responsible region.


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