China -  Chinese law firm

Chinese tax authorities step-up audits of intangible transfers on October 2007

1.  What is the tax audit exercise focusing on?

The nation-wide tax audit exercise focusing primarily on royalty payments made by Chinese companies to overseas affiliates.  These companies are generally from retailing and consumption goods and services industries.

2.  What is the situation before the audit set up?

There are a number of tax audit cases that have involved investigations into royalty payments that the Chinese tax authorities perceive to be too high.  In one case, the Chinese tax authorities considered that the royalty paid by the taxpayer in China to its overseas affiliated entity was too high, resulting in an unduly high expense incurred on the books of the Chinese taxpayer company. 

3. What adjustment did the State Administration of Taxation (SAT) make in respect of the royalty payments?

The authorities made a TP adjustment to disallow a substantial part of the royalty payments.  Notably, the SAT consider that an intangible attached to a royalty payment should generate a material benefit for Chinese licensee and as such, that licensee should not be in a loss making position or be earning only thin profits.

4. Will the business tax and withholding income tax paid on royalties be refunded?

No. The Chinese TP regulations also provide that business tax and withholding income tax paid on royalties, albeit disallowed for income tax deductions under a TP adjustment, will not be refunded.  Therefore, there is an exposure of double taxation within China.

5. What is the impact of the new tax audit of intangible transfers on multinational companies in China?

Multinational corporations should approach the transfer pricing of intangibles in China in the same careful and planned manner that they should approach it in any other developed tax jurisdictions.  Intangible arrangements should be structured according to commercial business needs, whereby the benefits of the use of the intangible are clearly recognized and measured.  An arm's length compensation should be paid to the owner to reflect this value.  The arrangement should be properly documented following Chinese TP regulations.  Additionally, a commercial agreement should be in place which clearly assign ownership, risks and rewards. 


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