Profit-shifting among associated companies within multinational enterprises (MNEs) is sometimes effected by intercompany charges of management and service fees, but as the 2007 China Enterprise Income Tax (EIT) law and its implementing regulations (collectively, EIT Laws) make clear, intercompany management fees generally are not deductible from EIT.  As a result, MNEs sometimes impose intercompany charges for services in the form of consulting fees and general service fees in their transfer pricing arrangements, in the hope that those charges will be eligible for deduction in computing China EIT.  China’s national tax authority, the State Administration of Taxation (SAT), recently has been scrutinizing these charges and disallowing deductions where it concludes that the charges were for the purpose of inappropriate profit-shifting (i.e., mainly for shifting taxable profits from China overseas) as opposed to a legitimate business purpose.

Service Fees in General 

The SAT has adopted certain tests for determining whether an intercompany charge in the nature of a service fee is reasonable and, for EIT purposes, deductible, and has indicated that additional guidance may be forthcoming.  In a recent document entitled “Views on Service Fees and Management Fees,” the SAT responded to a United Nations Tax Committee request for comments on this issue.  A summary of the SAT’s position follows. 

Benefit Test – Who Principally Benefited?

For the purpose of assessing compliance with the arm’s length principle, a “benefit test” will be applied to both the service provider and the service recipient to determine whether intercompany services warranting a charge have been rendered.  For example, if management consulting services provided by a parent company to its subsidiary will benefit the parent company more than the subsidiary (even if the subsidiary also benefits from the services), the service fees paid to the parent company may be non-deductible.

Necessity Test – Were the Services Necessary?

Taking into account the nature of the purported services recipient’s activities and incorporating a cost-benefit analysis, if the SAT deems high-end services (e.g., sophisticated advisory or legal services) unnecessary, the fees charged for such services may not be considered deductible.

Anti-Duplication Test – Has a Charge for the Services Already Been Imposed?

If a parent company already has been remunerated through, or benefited from, a separate transfer pricing arrangement (e.g., a profit-sharing arrangement) with regard to any specific service it renders to a Chinese subsidiary, the parent company may not be permitted to charge any further service fee to the subsidiary for that service.

Management Fee Test – Are the Fees for Management Services?

From the SAT’s perspective, most subsidiaries of MNEs in China have their own management teams.  Therefore, the legitimate management function that the parent company performs for its subsidiaries is considered very limited.  Many of the pertinent management services being performed are duplicative and unnecessary, with the result that the Chinese tax authorities are likely to challenge the deductibility of fees imposed for parent-subsidiary services of a management nature.

In order for the preceding guidance to be implemented effectively, the Chinese tax authorities must address a number of issues:

• Because of the lack of clear rules under the existing EIT Laws, tax authorities have too much discretion in the course of enforcement.

• Given the wide variety of intercompany services, the authenticity of intercompany service charges is difficult to verify.

• Tax authorities often have difficulty determining whether certain allocation methods for intercompany services comply with the arm’s length principle when an indirect charge method is applied with various allocation key factors.

• Offshore structures and overseas businesses obscure an MNE’s overall intercompany service arrangements, and existing international tax information exchange treaties do not provide a mechanism sufficient for the Chinese tax authorities to obtain the necessary information.

Technical Service Fees 

In addition to service fees charged for management functions, the SAT recently has focused on technical service fees.  Under EIT Laws, payments for the licensing of intangible assets such as proprietary technologies (e.g., royalties) are subject to withholding tax—typically 10 percent in the case of cross-border transfers.  In comparison, service fees paid by a subsidiary in China to its overseas parent company likely will not have any Chinese income tax implications (except for turnover taxes) if there is no permanent establishment created in respect of the provision of the services in question.

The SAT has noted that, because it is difficult to draw a clear line between the provision of services and the transfer of intangible assets or licensing of technologies, MNEs tend to provide technical assistance services in tandem with the transfer or licensing of technologies, resulting in lower taxes.  The SAT has developed principles and testing methodologies for management-related service fees, but the Chinese tax authorities are still seeking guidance from international organizations such as the United Nations and the Organisation for Economic Co-operation and Development in respect of technical services arrangements.

Conclusion 

In summary, MNEs doing business in China face increasing difficulties in sustaining the deductibility of intercompany service fees without a strong demonstration of the value and necessity of the services in question.  As the Chinese tax authorities become more sophisticated, technical service fees and similar arrangements currently passing muster may face increasing challenges, however well crafted they may be.  As a result, it is critical that MNEs doing business in China continue to develop tax-efficient intra-group arrangements.

This article was written with contributions from Lacoste Qian, an associate at MWE China Law Offices based in Shanghai.