If an enterprise fails to report related party transactions or to submit contemporaneous documentation and other relevant information in accordance with the relevant rules, a maximum penalty of Rmb10,000 may be imposed. The authorities may also levy an additional 5% punitive interest during a special tax investigations. Taxpayers, particularly multinational companies (MNCs), should therefore ensure thorough compliance in TP documentation.

The transfer pricing impact

Announcement 42 has significant implications for companies in China. The key changes include a redefined scope of related party transactions—possibly foreshadowing the types of transactions the Chinese authorities may place emphasis on—as well as a new three-tiered TP documentation requirement consisting of a master file, local file and country-by-country (CbC) report.

CbC reporting

One prominent change in Announcement 42 is the requirement for a Chinese enterprise to fill in and submit the CbC reporting forms if it meets one of the following conditions:

• It is the ultimate holding company of an MNC group with a consolidated revenue exceeding Rmb5.5 billion in the last fiscal year; or
• It is nominated by the MNC group as the reporting entity for CbC reporting purposes.

The main content of CbC reporting is illustrated in Chart 1.

CbC reporting forms are required only when the thresholds are met. The Rmb5.5 billion threshold in China is roughly equivalent to the BEPS Action Plan's threshold of €750 million, and excludes approximately 85% to 90% of MNC groups from the requirement. It is worth noting that even if an enterprise has no cross-border related party transactions, it may still need to submit the CbC report. Additionally, even if the reporting conditions are not met, the Chinese subsidiary of an MNC may still be required to provide the report if the tax authorities initiate a TP investigation following their failure to obtain the report.

The CbC report will enable the Chinese tax authorities to better understand an MNC's global structure and overall status of related party transactions and accumulated profits, enabling them to conduct TP risk assessments, allocate tax investigation resources as well as properly determine the probe targets. It will not, however, be used as a direct basis for TP investigations. A thorough examination of specific transactions and the basis of pricing will be subject to complete analyses of functions, risks and comparability. Consequently, information disclosed in the CbC report cannot be used as conclusive evidence to question or challenge the reasonability of a TP arrangement on a standalone basis.

Master file

The information disclosed in the master file is mainly in relation to the overall status of the MNC's global business operations. The requirements set out in Announcement 42 are generally consistent with the suggestions contained in Action 13 of the BEPS plan. However, additional disclosure requirements have been set, including those for industry restructurings, transfers of functions, risks or assets occurring within the MNC, as well as for functions, risks, assets and personnel of principal research and development facilities. The master file is usually prepared by the MNC's head office, so the Chinese subsidiary must coordinate with headquarters in advance when preparing the master file.

Announcement 42 requires a separate description of an MNC's intangibles in the master file, including the overall strategy for the development, ownership and exploitation of intangibles, and relevant important agreements and transfer pricing policies. This helps the tax authorities understand the contributions made by the local entity to the development, value creation, maintenance, protection and use of intangibles, and ensures a more reasonable calculation for a local entity that contributes to the intangibles but does not own their legal titles. This requirement reflects the doctrine held by the Chinese tax authorities in recent years, namely that compensation must in line with the contribution. Specifically, income allocation must be in accordance with the economic activities and value contribution. With China's evolving role from the world's factory to a global market, the authorities have placed more emphasis on marketing intangibles, and have adopted this concept in their TP practice more frequently.

Local file

Announcement 42 has introduced in the local file a value chain analysis, which is definitely set to become a new focus of the Chinese tax authorities. The value chain analysis covers not only the value chain of related party transactions, but also the value chain and contributions of the MNC as a whole, including business, goods and capital flows within the group, latest financial statements of all the parties in the chain, quantification and attribution of location-specific factors (LSFs) in relation to the value creation contribution, and allocation principles and results of the group's profits in the global value chain.

From a tax perspective, the value chain analysis involves determining the target company's competition status and level of added value, to ensure that profit allocation is consistent with the economic activities and value creation.

Value chain analysis relies on the entire industry chain of an MNC. Normally, in the industry chain, added value is usually considered to be high at the front and back ends, such as design and sales, whereas the added value of manufacturing in the middle is relatively low. This is reflected by the smiling curve in Chart 3.

The impact of LSFs must also be taken into account when an enterprise evaluates the pricing policies for the transactions and illustrates its global value chain. However, Announcement 42 remains silent on whether LSFs should indeed be present in each local file.

LSFs include location savings and market premiums. From China's perspective, location savings mainly include lower levels of labor cost, capital, science and technology (perhaps due to weaker intellectual property protection), environmental protection, and social security. Location savings are relatively easily quantifiable and there have been several TP adjustment cases. Market premiums refer to the impact of the market itself on demand and supply, such as market size, policies aimed at stimulating particular industries, market entry, consumption propensity, and inelastic demand. These are less quantifiable, and so the concept was adopted as bargaining chips in TP negotiations or APAs only recently.

Course of action

Building on previous regulations, Announcement 42 sets much more documentation requirements for transfer pricing and has a significant impact on the reporting and accounting practices of MNCs, on both a local and global scale. These added obligations may be particularly onerous against the wider international fight against multi-jurisdictional tax avoidance under the BEPS project.

Because the new regulations put forward in Announcement 42 must be followed for the preparation of contemporaneous documentation in the 2016 fiscal year, taxpayers in China should take the following actions:

• Assess the discrepancies between Announcement 42 and the BEPS Action Plan with respect to the documentation requirements and coordinate with the group headquarters to prepare the required materials in due course.
• Revisit the current business and transaction structures and make any necessary adjustments.
• Evaluate the risks rising from the current pricing policies, and review and revise the contract terms, transaction structures and implementation in connection with related party transactions, conducting thorough analyses of the value chain, LSFs, as well as functions, risks and assets.
• Complete all documents and materials in both a factual and analytical manner for the purpose of supporting TP policies.
• Conduct a comprehensive assessment from business, regulatory and tax perspectives, including the personnel arrangement, the necessity to renew or revise related party transaction agreements or even articles of association, and the impact of tax incentives, deductions, and the VAT [value-added tax] reform.

Tao (Daisy) Duan, Partner
King & Wood Mallesons, Beijing

New rules issued by the State Administration of Taxation reflect China's localization of the Base Erosion and Profit Shifting (BEPS) Action Plan and the beginning of the nation's transfer pricing (TP) documentation and administration regime.

The BEPS, an international tax reform project endorsed by the G-20 and led by the Organization for Economic Cooperation and Development (OECD), is aimed at fighting international tax avoidance and achieving fairness in the global tax system. The Announcement on Matters Relevant to Improving the Administration of Affiliated Party Filings and Contemporaneous Documentation (Announcement 42), released on June 29, 2016, reflects not only the experience that the Chinese tax authorities have gained in recent years but also their technical positions with respect to TP practice.

Announcement 42 revokes the relevant regulations as set out in Chapters 2 [Related Party Transaction Reporting] and 3 [Contemporaneous Documentation], Article 74 [Cost Sharing Agreement (CSA) Reporting] and 89 [Thin Capitalization Reporting] in Circular 2, released in 2009, as well as the Annual Reporting Form for Related Party Transactions by Enterprises in the PRC (Guoshuifa [2008] No.114). It will be applicable starting from the 2016 fiscal year.

While adopting the major recommendations of the BEPS Action Plan, Announcement 42 brings certain Chinese flavors by adding several specific requirements.

If an enterprise fails to report related party transactions or to submit contemporaneous documentation and other relevant information in accordance with the relevant rules, a maximum penalty of Rmb10,000 may be imposed. The authorities may also levy an additional 5% punitive interest during a special tax investigations. Taxpayers, particularly multinational companies (MNCs), should therefore ensure thorough compliance in TP documentation.

The transfer pricing impact

Announcement 42 has significant implications for companies in China. The key changes include a redefined scope of related party transactions—possibly foreshadowing the types of transactions the Chinese authorities may place emphasis on—as well as a new three-tiered TP documentation requirement consisting of a master file, local file and country-by-country (CbC) report.

CbC reporting

One prominent change in Announcement 42 is the requirement for a Chinese enterprise to fill in and submit the CbC reporting forms if it meets one of the following conditions:

• It is the ultimate holding company of an MNC group with a consolidated revenue exceeding Rmb5.5 billion in the last fiscal year; or
• It is nominated by the MNC group as the reporting entity for CbC reporting purposes.

The main content of CbC reporting is illustrated in Chart 1.

CbC reporting forms are required only when the thresholds are met. The Rmb5.5 billion threshold in China is roughly equivalent to the BEPS Action Plan's threshold of €750 million, and excludes approximately 85% to 90% of MNC groups from the requirement. It is worth noting that even if an enterprise has no cross-border related party transactions, it may still need to submit the CbC report. Additionally, even if the reporting conditions are not met, the Chinese subsidiary of an MNC may still be required to provide the report if the tax authorities initiate a TP investigation following their failure to obtain the report.

The CbC report will enable the Chinese tax authorities to better understand an MNC's global structure and overall status of related party transactions and accumulated profits, enabling them to conduct TP risk assessments, allocate tax investigation resources as well as properly determine the probe targets. It will not, however, be used as a direct basis for TP investigations. A thorough examination of specific transactions and the basis of pricing will be subject to complete analyses of functions, risks and comparability. Consequently, information disclosed in the CbC report cannot be used as conclusive evidence to question or challenge the reasonability of a TP arrangement on a standalone basis.

Master file

The information disclosed in the master file is mainly in relation to the overall status of the MNC's global business operations. The requirements set out in Announcement 42 are generally consistent with the suggestions contained in Action 13 of the BEPS plan. However, additional disclosure requirements have been set, including those for industry restructurings, transfers of functions, risks or assets occurring within the MNC, as well as for functions, risks, assets and personnel of principal research and development facilities. The master file is usually prepared by the MNC's head office, so the Chinese subsidiary must coordinate with headquarters in advance when preparing the master file.

Announcement 42 requires a separate description of an MNC's intangibles in the master file, including the overall strategy for the development, ownership and exploitation of intangibles, and relevant important agreements and transfer pricing policies. This helps the tax authorities understand the contributions made by the local entity to the development, value creation, maintenance, protection and use of intangibles, and ensures a more reasonable calculation for a local entity that contributes to the intangibles but does not own their legal titles. This requirement reflects the doctrine held by the Chinese tax authorities in recent years, namely that compensation must in line with the contribution. Specifically, income allocation must be in accordance with the economic activities and value contribution. With China's evolving role from the world's factory to a global market, the authorities have placed more emphasis on marketing intangibles, and have adopted this concept in their TP practice more frequently.

Local file

Announcement 42 has introduced in the local file a value chain analysis, which is definitely set to become a new focus of the Chinese tax authorities. The value chain analysis covers not only the value chain of related party transactions, but also the value chain and contributions of the MNC as a whole, including business, goods and capital flows within the group, latest financial statements of all the parties in the chain, quantification and attribution of location-specific factors (LSFs) in relation to the value creation contribution, and allocation principles and results of the group's profits in the global value chain.

From a tax perspective, the value chain analysis involves determining the target company's competition status and level of added value, to ensure that profit allocation is consistent with the economic activities and value creation.

Value chain analysis relies on the entire industry chain of an MNC. Normally, in the industry chain, added value is usually considered to be high at the front and back ends, such as design and sales, whereas the added value of manufacturing in the middle is relatively low. This is reflected by the smiling curve in Chart 3.

The impact of LSFs must also be taken into account when an enterprise evaluates the pricing policies for the transactions and illustrates its global value chain. However, Announcement 42 remains silent on whether LSFs should indeed be present in each local file.

LSFs include location savings and market premiums. From China's perspective, location savings mainly include lower levels of labor cost, capital, science and technology (perhaps due to weaker intellectual property protection), environmental protection, and social security. Location savings are relatively easily quantifiable and there have been several TP adjustment cases. Market premiums refer to the impact of the market itself on demand and supply, such as market size, policies aimed at stimulating particular industries, market entry, consumption propensity, and inelastic demand. These are less quantifiable, and so the concept was adopted as bargaining chips in TP negotiations or APAs only recently.

Course of action

Building on previous regulations, Announcement 42 sets much more documentation requirements for transfer pricing and has a significant impact on the reporting and accounting practices of MNCs, on both a local and global scale. These added obligations may be particularly onerous against the wider international fight against multi-jurisdictional tax avoidance under the BEPS project.

Because the new regulations put forward in Announcement 42 must be followed for the preparation of contemporaneous documentation in the 2016 fiscal year, taxpayers in China should take the following actions:

• Assess the discrepancies between Announcement 42 and the BEPS Action Plan with respect to the documentation requirements and coordinate with the group headquarters to prepare the required materials in due course.
• Revisit the current business and transaction structures and make any necessary adjustments.
• Evaluate the risks rising from the current pricing policies, and review and revise the contract terms, transaction structures and implementation in connection with related party transactions, conducting thorough analyses of the value chain, LSFs, as well as functions, risks and assets.
• Complete all documents and materials in both a factual and analytical manner for the purpose of supporting TP policies.
• Conduct a comprehensive assessment from business, regulatory and tax perspectives, including the personnel arrangement, the necessity to renew or revise related party transaction agreements or even articles of association, and the impact of tax incentives, deductions, and the VAT [value-added tax] reform.

Tao (Daisy) Duan, Partner
King & Wood Mallesons, Beijing