In recent years, a key aspect or focus of China’s new tax rules and policy directions has been tax incentives and cuts, to boost the economy, and encourage investment and research and development activities. At the same time, China is also making efforts to improve its tax administration environment, in particular the administration of transfer pricing issues relating to multinational enterprises.
With respect to tax audits, while we have generally observed a comparatively calmer tax audit environment in the past three years, we expect that China will continue to focus on improving its tax enforcement. China may become more aggressive in its enforcement activities in the future, to plug the gap in tax revenue collection created by a slower economy and to make up for the reduction in tax revenue arising from various tax cut measures.
In this article, we will first discuss major tax incentives introduced over the past few years, including certain regional tax incentives and the enhanced R&D super deduction policy. We will then discuss major efforts by the Chinese government to enhance transfer pricing administration, as well as some recent developments relating to international tax (such as the deposit of China’s instrument of approval for the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, the MLI) and China’s domestic tax regime.
Tax Incentives
Regional Tax Incentives
A series of regional tax incentives has been enacted and/or extended in recent years. Notable examples include the enterprise income tax incentives in Hainan Free Trade Port, Lin’gang New Area (Shanghai), Hengqin Guangdong-Macau Cooperation Zone (Hengqin Zone) and Qianhai (Shenzhen) Deep Harbor Modern Service Cooperation Zone, where qualified enterprises engaging in certain encouraged industries (depending on the region concerned) as their main business may enjoy a reduced enterprise income tax rate of 15%.
Hainan FTP and Hengqin Zone further provide enterprise income tax exemption for income derived from new offshore direct investments by enterprises engaging in tourism, modern services, and high-tech industries, and a one-time tax deduction (if the unit price does not exceed 5 million renminbi ($741,000)) or accelerated depreciation/amortization (if the unit price exceeds 5 million renminbi) for expenses incurred on purchase of fixed assets and intangible assets.
In addition to the enterprise income tax incentives, individual income tax incentives have been offered in Hainan FTP, Great Bay Area, and Hengqin Zone, such that the effective individual income tax burden of eligible individuals can be capped at 15% of their taxable income.
R&D Super Deduction
Except for enterprises engaging in tobacco manufacturing, hotel and catering, wholesale and retail, real estate, leasing and business services, and entertainment industries (exceptional industries), China-resident enterprises are entitled to an additional tax deduction on qualified R&D expenses—the R&D super deduction. The additional deduction ratio was originally set at 50% under Cai Shui [2015] No. 119 with effect from Jan. 1, 2016.
The additional deduction ratio was increased to 75% for the period from Jan. 1, 2018 to Dec. 31, 2023, in accordance with Cai Shui [2018] No. 99 and Bulletin [2021] No. 6 jointly issued by the PRC Ministry of Finance and State Taxation Administration.
Afterwards, the MOF and STA issued Bulletin [2021] No. 13 and Bulletin [2022] No. 16 to increase the additional deduction ratio to 100% for manufacturing enterprises and small and medium-sized science and technology enterprises, with effect from Jan. 1, 2021 and Jan. 1, 2022 respectively. More recently, the MOF and STA issued Bulletin [2022] No. 28 to allow all enterprises (excluding those in exceptional industries) to enjoy an additional deduction ratio of 100% on qualified R&D expenses in the last quarter of 2022.
Efforts to Enhance Transfer Pricing Administration
Simplified Procedure for Unilateral Advance Pricing Agreements
STA Bulletin [2016] No. 64 sets out the general framework for advance pricing agreements. The standard APA process under Bulletin 64 includes the following six stages:
- pre-filing meeting;
- letter of intent to seek an APA;
- analysis and evaluation;
- formal application;
- negotiation and execution; and
- monitoring and implementation.
While Bulletin 64 is helpful in laying out the detailed process and scope of availability for APAs, the long-winded process, which calls for repetitive or redundant information submissions without a specified timeline, may have impeded the effectiveness of APAs.
On July 26, 2021, the STA released Bulletin [2021] No. 24 enabling qualified MNEs to opt for a simplified procedure for UAPAs. Bulletin 24 simplifies the UAPA process by consolidating the first three stages into a single stage called “application and assessment.”
After receiving the taxpayer’s application, the tax authority should conduct analysis and assessment and issue a tax notice within 90 days to inform the taxpayer if the application is accepted or rejected. If the application is accepted, the tax authorities should complete the negotiation and signing process within six months (excluding time spent on any supplementary submission) from the issuance of the tax notice.
In addition to the general transaction volume threshold under Bulletin 64 (i.e., annual related party transactions in excess of 40 million renminbi in each of the past three years), a taxpayer needs to satisfy one of the following conditions to be eligible for the simplified UAPA process:
- It has properly fulfilled its contemporaneous documentation obligations for the past three years;
- It has executed an APA in the past 10 years and is in compliance with the APA; or
- It was subject to a transfer pricing adjustment audit in the past 10 years and the audit has been closed.
Correspondingly, the tax authority may reject an application for the simplified UAPA process if the taxpayer has an open tax audit or has not complied with its contemporaneous documentation requirements as noted above.
In recent years, the Chinese tax authorities have been increasingly open to accelerating the APA process to confirm compliance with the arm’s length-principle. The introduction of the simplified process for UAPAs signals the tax authorities’ willingness to engage in a mutual negotiation process with MNEs over their transfer pricing matters, instead of relying heavily on more confrontational transfer pricing audits. The simplified process, if it works as intended, would enable taxpayers to obtain a UAPA within a year, to achieve tax certainty on a more accelerated timeline.
SAFE Guidelines on Cross-Border Payments for Transfer Pricing Adjustments
China’s stringent rules and complex guidelines on foreign exchange control make it difficult for MNEs to make direct transfer pricing adjustment payments. On Jan. 19, 2021, the State Administration of Foreign Exchange released the Service Trade Foreign Exchange Management Policy Q&As (part 2), which provides clarification on the bank procedures for processing foreign exchange payments and receipts for transfer pricing adjustments.
The SAFE clarification attempts to align the bank procedures and explains that transfer pricing adjustment payments should be administered under the relevant current account according to Hui Fa [2020] No. 14. Specifically:
- For transfer pricing adjustments, the payment should be processed according to the original trade category (i.e., goods or services) between related parties, and the required supporting documents should include any relevant written documents from tax authorities or customs, any profit adjustment agreements, invoices and/or any other relevant materials.
- For cost sharing adjustments, the payment should be processed as “compensation irrelevant to insurance,” and the bank shall review the authenticity, legality and consistency of the payment based on relevant supporting documents.
The SAFE clarification has been interpreted as a confirmation of the feasibility of transfer pricing self-adjustment payments. Nonetheless, it remains unclear how the local foreign exchange authorities and banks will interpret such a high-level notice, especially when the clarification does not specify what documents are required in the absence of written documents from tax authorities or customs. Companies also need to be aware of potential customs or indirect tax implications when making transfer pricing adjustments; for example, a transfer pricing true-down adjustment by raising the product import price may result in additional customs duty and/or import value-added tax.
Pilot Customs Valuation and Transfer Pricing Administration Program in Shenzhen
On May 18, 2022, the Shenzhen Customs and Shenzhen Municipal Tax Bureau jointly issued Shenzhen Customs Bulletin [2022] No. 62 which calls for better coordination and information exchange for the purposes of customs valuation and transfer pricing administration.
The major breakthrough offered by Bulletin 62 is that it provides an aligned approach for the customs and the tax authority to allow a company that has an APA with the tax authority to make retrospective adjustment to its import price of goods, most likely on a yearly basis, to ensure that the actual price meets the targeted income level set by the APA.
To participate in the program, a company should simultaneously submit the required package to both the Shenzhen customs and Shenzhen municipal tax bureau to initiate the negotiation process with both authorities. The customs and tax authorities will conduct a joint interview with the applicant and align on the agreed approach. If the authorities cannot align on the key considerations, the application for the “aligned arrangement” should be rejected.
Once the customs and tax authorities are aligned on the key considerations, they and the company will enter into a tripartite memorandum to memorialize the key terms, such that the terms become formalized and enforceable among the parties. Once signed, the memorandum will be binding for a period of three calendar years, unless the key assumptions are no longer applicable or otherwise revoked by the company.
Bulletin 62 represents a significant step forward by the local customs and tax authority in coordinating and aligning customs valuation and transfer pricing administration, although currently it still lacks the necessary implementing details. Although the scope of implementation for Bulletin 62 is limited to companies operating in Shenzhen for now, it is hoped that the regime can ultimately be implemented nationwide once it proves successful.
Other Tax Developments
The Multilateral Instrument
On May 25, 2022, China deposited its instrument of approval for the MLI with the Organization for Economic Cooperation and Development. The MLI entered into force on Sept. 1, 2022 for China.
China’s MLI positions in its instrument of approval are largely consistent with its positions at the time it signed the MLI in 2017. More specifically, China has chosen to adopt the principal purpose test to prevent treaty shopping activities; the 365-day look-back period rule for determining the minimum holding percentage for reduced dividend withholding tax rate; and the MLI provision on dual resident entities.
Meanwhile, China made reservations on the MLI permanent establishment provisions relating to commissionaire arrangements, the specific activity exemption, and contract-splitting schemes; the application of the 365-day look-back period rule for determining land-rich companies; and the MLI provision relating to tax transparent entities.
While the ultimate impact of the PPT remains unclear, MNEs should expect the Chinese tax authorities’ treaty administration to be enhanced to accommodate the changes brought by the MLI.
With respect to China’s reservation on MLI PE provisions, we note that, even before the base erosion and profit shifting project, China had developed its own domestic interpretation of PE that is aligned with the new principles under the MLI. Further, the Chinese domestic tax rules adopt a three-year look-back period for determining land-rich companies, which is more stringent than the MLI provision.
Domestic Tax Framework
With respect to China’s domestic tax legal framework, following the principle of law-based taxation, China enacted the Urban Maintenance and Construction Tax Law and the Stamp Duty Law, in 2020 and 2021 respectively, to replace the corresponding regulations issued by the PRC State Council. It is expected that the PRC VAT Law may be formally published in 2023.
In addition, China is formulating tax rules to clarify the tax treatment of new economic transactions and arrangements. A typical example in this regard is Bulletin [2022] No. 3 issued by the MOF and STA which provides special tax treatment and tax deferral treatment for asset and/or share transfers in the context of establishing a real estate investment trust.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Amy Ling is a senior tax practitioner at Baker McKenzie, based in Hong Kong, and Tingting Guo is an associate with Baker McKenzie FenXun (FTZ) Joint Operation, based in Shanghai.
The authors may be contacted at: [email protected] and [email protected]
