Application Of Value Creation Principle In Transfer Pricing Of Intangible Assets

Base Erosion and Profit Shift(“BEPS”) is a special terminology referring to the situation that multi-national corporations(“MNC”) minimize their global overall tax burden, in some extreme case, even reach double non-taxation status, by taking advantage of tax system differences and the holes in tax administration to encroach their taxes bases in respective countries.In practice, BEPS is always concomitant with transfer pricing arrangement.In order to deal with the challenges from BEPS, the BEPS Project appeared on the scene.This project, being the international tax reform program whose purpose is to combat with international tax evasion and to jointly establish the international taxation rules as well as administrative cooperation mechanism in favor of global economy growth, is endorsed by G20 countries leaders and commissioned to Organization for Economic Co-operation and Development(“OECD”) for draft.BEPS Action Plan includes 5 major categories of 15 actions.The ultimate goal is to achieve the match between tax revenue and real economic activities as well as value creation.At present, the tax distribution rule of “income sources” in the international taxation principle leads to the mismatch between taxation rights and real economic activities, under which the economic location retains nil profit for taxation.Also, the cross-border allocation of production factors has been distorted, tax fairness is facing challenges, and the international tax order is under serious threat.Among all these reasons, transfer pricing arrangements relating to the cross-border usage of intangible assets is one of the most important.In this regard, it became a part of the BEPS Action Plan, i.e. Action Plan No. 8 “Value Creation Intangibles”Action No. 8 aims to develop an overall rule to prevent tax base erosion and profit shift between group members of one MNC by transferring intangible assets.This action is committed to re-define the scope of intangible assets, to ensure the correct match between profit allocations derived from intangibles transfer/utilization and value creation, to develop the transfer pricing rules or special measures, and to update the guidance for the cost sharing arrangement.For example, some part of contents includes the addition of the new factors of the intangibles to ensure the correct allocation among transfer/utilization of intangibles.The new ideas and methods in Action No. 8 will inevitably impact on the global transfer pricing(especially on intangible assets related activities) and related laws and regulationsAs a big country for manufacturing and export businesses, China has been facing serious threat from tax base erosion. In this regard, in addition to participation in OECD BEPS Project, China has been gradually strengthening its tax administrative management on transfer pricing issues.The governments draw the experience from international conventions to limit the tax-avoidance activities from MNC so as to realize the match between tax revenue and real economic activity through which it can protect the country’s tax rights and interests. For example, the State Administration of Taxation(“SAT”) promulgated “Administrative Measures for the General Anti-Avoidance Rule(for Trial Implementation)”(“General Anti-Avoidance Rule”) and “Announcement of the State Administration of Taxation on Enterprise Income Tax Issues concerning the Disbursement of Expenses by Enterprises to Their Overseas Related Parties”(“Circular No.16”) on December 2, 2014 and March 18, 2015 respectively to reiterate and clarify the treatment on the general anti-avoidance work procedures as well as the basic principles/requirements of the tax treatment of payments to foreign related parties.These rules represent the important initiatives of China’s participation in the global anti-tax-avoidance work frame.Meanwhile, from SAT to local tax authorities, tax officers all actively studied the tax-avoidance phenomenon and did/released a series of speeches/study results.These speeches/study results include “International tax compliance management Plan for Yr2014-2015 by State Administration of Taxation of Jiangsu Province”, “Six Tests Principles” and “2014 BEPS Project Outcome Talks by SAT”.It is noteworthy that in September 2015, SAT issued a Draft version for Discussion on revision of “Implementation Measures of Special Tax Adjustments”.This draft comprehensively uses the advice and special tax adjustment principles as stipulated by BEPS action plans and adds a chapter for “Intangibles” to regulate the intangible assets related transfer pricing arrangements.By analyzing these tax regulations and guidance, China tax authorities’ view towards BEPS is clarified.It is observable that with the active development of transfer pricing arrangements in China, Chinese tax authorities are also increasingly strengthening their supervision form central to all local levels to unify the regulatory caliber, refine regulatory standard and to gradually transit from broad qualitative criteria to quantitative criteria.However, despite that the Chinese tax authorities have been aware of the seriousness of the BEPS issue and begun to take action to circumscribe the relevant transfer pricing arrangements from regulatory perspective, relevant international conventions and regulations are still in the exploratory stage, these newly promulgated regulations are incomplete from detailed perspectives. In this regard, primary level tax authorities are not able to touch the core of the case due to the lack of comprehensive rules to safeguard the tax base in China. Such “lack of legal basis” create controversy between tax authorities and MNCs when dealing with intangible related transactions(i.e. either over-strict, or weak enforcement).In this article, two intangibles-related cases are analyzed to show the interaction game regarding BEPS issues between Chinese tax authorities and MNCs, based on which, the author will try to explore the method of solving the divergence on a more objective ground.In the case of royalties, MNC-M charges royalties on manufacturing technology and process to its subsidiaries all over the world. Although such arrangement does have suspicious of BEPS(i.e. transfer of domestic profits), it was not ultimately investigated. It is because Circular No. 16 does not provide further quantitative measurements in additional to the general rules of contribution of value creation of intangibles. Hence, even if Chinese tax authorities carry out the investigation, its focus will be the financial status of the company by referring comparable entities through benchmarking study. However, such method is not that suitable to royalty fees. Therefore, local tax authorities can only assess the royalty fees in an isolated view(e.g. reviewing the supporting contract, etc.) instead of the overall value chain of the group view, which cannot help protect the tax base of China.Meanwhile, in order to deal with the divergence between MNC-M and local tax authorities, relevant experiences by India were introduced in this article. Indian tax authorities investigate similar cases by three steps to reflect the spirit of contribution of intangible assets value creation. Firstly, they judge if the intangible-assets related transactions are related party transactions. Secondly, they measure the degree of value creation of intangibles from personnel, development and environmental factors; finally, they require tax adjustment based on their own measurements. These steps are simple, coherent and are commonly used by Indian tax authorities to safeguard their national tax sovereignty. They are also can be regarded as examples for Chinese tax authorities.In marketing case, the local tax authorities pointed out that H Company’s China domestic marketing activities have already constructs the “Marketing Intellectual property ”(“Marketing IP”).Towards this claim, H Company and the tax authority argued a lot on the excessive marketing expenses. This shows that Chinese tax authorities have begun to recognize the importance of intangible value creation in transfer pricing activities, and try to use the value of intangible assets in transfer pricing investigation. However, detailed rules and theoretical basis need improvements. To clarify the applicability of legal origin and relevant laws and regulations, the author analyzes the intangible value creation issued during the marketing activities by referring to "transfer pricing guidelines for intangibles" and points out the flaws of the relevant treatments by tax authorities under the current tax and regulatory framework. It is believed that in order to solve this problem, relevant laws and regulations must be enacted/improved immediately. Moreover, the interaction between tax authorities and other authorities(such as customs) must be enhanced to guide the protection of China tax base.Against the above cases, on one hand, the Chinese local tax authorities already have started to have international tax view and to practice the value creation principles of intangibles in real-life cases. However, due to the lack of detailed legal guidance, they always not able to touch the core of the issue(i.e. they can discover the fact but cannot perform adjustment on a reasonable and effective way) and turn to “negotiation” with the tax payers, which lead to the infringing upon China tax benefit. On the other hand, some tax officers cannot view the transfer pricing arrangement of MNC from a global point of view but only a separated individual point and got eclipsed by the so-call supporting documents. So eventually, they can only start to negotiate with the tax payer by referring to these supporting documents but miss the important BEPS arrangements. Therefore, being the country suffering from tax base erosion and profit shift, China should take action as soon as possible to transfer the advantageous part in BEPS action plan to domestic law(including specific implementation details) to guide the tax practice.