IP Tax Management in China – Navigating the Thicket in Light of Global Tax Reforms

This guest posting from KPMG looks at the evolving Chinese tax environment for multinational enterprise (MNE) management of IP tax issues.   KPMG China has prepared a detailed overview of these issues, alongside setting out how KPMG China tax service lines may assist.  Read more here.  KPMG also actively participated in the recent programs PTO conducted on licensing IP issues in China by providing a background to the changing tax environment.  The first such program is described here.

A radically changed China tax environment for IP management by MNEs

Recent years have seen far-reaching changes to the Chinese tax law and administrative treatment of foreign MNEs operating in China. Most notably in the field of transfer pricing (TP) but also in other areas of tax law, the Chinese tax authorities have progressively taken a far more assertive approach to taxing MNEs.  Underlying this is a perception amongst the tax authorities that insufficient Chinese tax is being imposed, as the authorities consider that underappreciated value is being generated by MNEs’ Chinese operations, driven by special attributes of the Chinese business environment.  This has occurred against a backdrop of the G20/OECD Base Erosion and Profit Shifting (BEPS) global tax reform initiative, which commenced in summer 2013, and which is directed, in broadly the same manner as the Chinese tax authorities’ initiatives, at ensuring the alignment of taxation with the locations of economic activity and value creation.  The BEPS project is being leveraged by the Chinese tax authorities to bolster and support their own efforts.  In tandem with the planned finalization of the two-year BEPS project work in October 2015, the Chinese tax authorities are set to release their own guidance in the near future, which will have significant implications for MNEs.

These trends and developments are having, and will continue to have, an outsized impact on the arrangements under which MNEs manage how their Intellectual Property (IP) is used in relation to their Chinese operations.  IP taxation has long constituted one of the most challenging areas of China tax management and planning, with a plethora of tax issues arising in relation to the conduct of IP development in China, the licensing of technology cross-border into China, and the co-ordination of MNE global IP portfolios through IP management hubs.  The rapid development of the Chinese economy and its relationship to the global economy has, by changing the ways in which MNEs deploy their IP in China, been adding to this tax complexity.

In this regard, the steady increase in the sophistication of China’s economy has been matched by a move away from low cost production in China. There has been a move towards the seizing, by China, of the higher value-added, innovative stages of activity within MNE global value chains for production of high technology products.  In parallel, the rapid expansion of the Chinese market has led to a substantial ramp up, by MNEs, of their marketing and promotion activities in China, alongside the customization of products and brands to meet the needs of the Chinese customer base. These fundamental business conduct changes have led the Chinese tax authorities to take the position that historic approaches to taxing MNE activity in China are now invalidated, and this is compounding the already significant pre-existing challenges of China IP tax management.

China TP challenges and likely greater future reliance on innovation tax incentives

  • China has reacted to the shift in MNE China activity towards penetration of the China market and towards the conduct of higher value-added activity in China by using novel TP concepts (differing from those used in many developed countries) to require that more profit from MNE global value chains be booked and taxed in MNE Chinese subsidiaries.  These concepts include the notions of ‘market premium’ and ‘cost savings’ (so-called ‘Location Specific Advantages’), as well as the notion that, separate of any consideration of the legal ownership of IP, Chinese subsidiaries of a foreign MNE may have developed and possess (in an economic sense) ‘Local Market Intangibles’
  • The emerging OECD BEPS TP guidance (while, in principle, of uniform application across countries) looks set to be adopted by China in a manner which reinforces the current Chinese TP trends and preserves the unique Chinese TP concepts.  Ultimately this may largely put an end to the historic MNE practice of using ‘limited risk’ manufacturing, distribution and contract R&D arrangements in China, which had the effect of limiting profits booked to China and consequent China Corporate Income Tax (CIT)
  • The shift towards more MNE global value chain profits being taxed in China is also anticipated to be bolstered by heightened enforcement of the rules under which foreign MNEs are treated as having a ‘tax presence’ in China.  This expected change, following the OECD BEPS work on ‘permanent establishment’ (PE), may see many offshore sales hubs, currently used to sell into China, restructured as onshore buy-sell subsidiaries
  • The likely need, going forward, to book more profits ‘onshore’ into China subsidiaries, and the continued divergence in Chinese and foreign TP practices, may give rise to a greater risk of double taxation. It might be noted, in this regard, that upcoming enhancements to the TP documentation available to the Chinese tax authorities will provide them with a radically enhanced overview of the allocation of MNE profits across jurisdictions. It may emerge that the focus of MNE TP work in future will be less on limiting MNE profit attributions to given jurisdictions and more on ensuring that all countries, in which a MNE operates, accept a ‘unified narrative’ on why profit has been allocated as it has throughout the MNE’s global value chain.  Achieving agreement on such unified narrative is likely to require greater use of bilateral/multilateral Advance Pricing Agreements (APAs) and Mutual Agreement Procedures (MAP) in future
  • Against this backdrop of increased profits booked to China from MNE value chains, the focus of China tax management efforts may shift from limiting ‘tax contact with’ and ‘tax presence in’ China to ensuring that the greater quantum of profits allocated to China may benefit from the best effective tax rate which can be achieved.  As such the various Chinese innovation tax incentives, such as the High and New Technology Enterprise Incentive (HNTE), accelerated depreciation, and the R&D super deduction, are likely to become significantly more sought after than may have been the case in the past, when the difficulties of reconciling MNE global TP strategies to obtaining such incentives may have led some MNEs to shy away from HNTE.  At the same time, the very shift towards MNEs conducting more innovative, value-adding activity on the ground in China, which spurred the change described above in the tax authorities’ TP approach, may equally put MNEs within reach of obtaining the innovation tax incentives in the first instance
  • This being said, MNEs need to be aware of the challenges involved in obtaining Chinese innovation tax incentives.  The HNTE incentive requirements in particular can be quite challenging given the ambiguity concerning when an applicant might be viewed as owning ‘core IP’ and there can also be difficulties in maintaining the R&D expenditure-to-turnover ratio when enterprise sales are increasing.  Furthermore, the variability across China in the application of the qualification criteria by local tax authorities, and the heightened tax audit scrutiny of HNTE applied by tax authorities in recent times, also need to be factored into planning.  

Managing the ‘tax friction’ arising from flows of technology into China

  • The seizing, by China, of the higher value-added, innovative stages of activity within MNE global value chains for production of high technology products happens at a time when China’s domestic market for technology transfer is becoming both more active and more formalized, as Chinese enterprises become vectors of innovation.  Technology transfer, and the licensing arrangements that enable it, are increasing between domestic firms, outwards from China to foreign enterprises, as well as inwards from MNEs to their China subsidiaries and China third parties.
  • For foreign MNEs this means that the existing flow of foreign technology, foreign know-how, and foreign expert services into China (much of it being inputs into Chinese high-tech exports) is set to steadily expand.  This will further increase the need to be aware of and manage effectively the related ‘tax friction’ on the licensing of technology into China and related service fee payments, including CIT withholding tax (WHT) and TP issues, as well as Customs Duty and VAT issues.

.Global management of MNE IP portfolios

Taxchart

  • The modern MNE increasingly draws its firm value from the complex portfolio of IP assets, ranged across the globe, which it has amassed.  Many MNEs have seen a strategic value to concentrating the coordination of IP development, protection and deployment in a single IP management centre, from which IP is then licensed to MNE operating subsidiaries around the world
  • Various jurisdictions, particularly in the EU, have provided for ‘patent’ or ‘innovation’ box regimes allowing for low effective taxation of IP license income received from group companies.  Incentivised income streams range from patent royalties, to license income from unpatented know-how and software, and even so far as income from marketing intangibles such as brand rights/trademarks.  Royalties paid from China, tax deductible at 25% where the standard CIT rate applies, may benefit from a lower level of taxation on receipt by such MNE IP management companies.  Tax treaty reductions for the Chinese WHT on royalties may also be available
  • This being said, the recent G20/OECD BEPS agreement on when such IP regimes constitute a ‘harmful tax practice’ will see such regimes be remoulded to only provide reduced taxation where substantial IP development work is conducted/coordinated through the IP management company. This may mean that many MNEs must decide whether commercial and strategic imperatives necessitate the retention of such companies (which may require the injection of additional ‘commercial substance’) or whether such entities are better dissolved and removed from the MNE structure
  • For MNE groups using such IP holding arrangements in connection with their China IP management, these must also reckon with the Chinese anti-treaty abuse rules and specific targeted TP provisions
  • China’s 2009 domestic law rules limit the benefit of treaty WHT reductions solely to those foreign companies with significant staff, premises and other business operations in their country of tax residence.  These rules are now being finessed to bring them more in line with the trend of BEPS developments. In this regard, China is relying more on treaty-based anti-abuse rules.  Furthermore, a new system of post-treaty relief, tax authority ‘follow up procedures’, based on the general anti-avoidance rules (GAAR), is set to be rolled out in place of the old treaty relief pre-approval system, potentially expanding access to treaty WHT relief, but also creating new administrative challenges
  • On the TP side, new March 2015 rules deny completely deductions  for royalty and service payments to low function entities overseas, in particular hitting royalties where the IP holding company did not ‘contribute’ to IP development
  • Use of IP management hubs, conforming to the new BEPS requirements, for China IP management should still be possible in future, but much greater preparation and planning may be necessary than was the case in the past.
Obviously, for company-specific tax advice, please consult tax professionals such as KPMG.

This article prepared by Conrad Turley at KPMGThanks again to KPMG for this guest posting!

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