The Chinese government is closely monitoring all outbound payments from China businesses to overseas parties. After three years of pandemic, China, as well as many other countries, is ensuring that companies comply with its tax regulatory framework before authorizing dividend repatriation or payback.
Outbound payments are under the scrutiny of the Chinese tax and foreign exchange authorities. Foreign companies operating in the country should evaluate their repatriation strategies and ensure that they are compliant with local tax laws.
It is common that subsidiaries of a foreign company in China interact with the overseas headquarters and pay royalties, brand licensing fees, technology services fees, and service fees for management to the parent company. In addition, under the centralized administrative management set up by the group company, the China entity should also pay for administrative services it received.
Once the subsidiary starts generating positive cash flow and profits, the headquarter may decide that the local entity shares the cost of the group company paying franchise usage fees, consulting service fees, or repayment of advances prepaid by the headquarter.
Outbound Payments
Outbound payments are categorized under current account items and capital account items, from a foreign exchange management perspective:
Capital account items are transactions causing changes in external assets and liabilities, including direct investments and loans.
Current account items are transactions involving goods, services, income, and frequent transfers in the balance of payments.
China Customs keeps track of foreign exchange payments involving goods transactions, which are relatively straightforward. On the contrary, non-trade transaction payments involving services, royalties, dividends, etc. are more complicated.
From the tax perspective, transfer pricing (TP) adjustments have become more common. Both the State Tax Administration and the State Administration of Foreign Exchange offer guidelines on how to process TP adjustments.
Companies may face certain challenges regarding outbound payments, especially when operating at a loss. In that situation, a company will face more challenges to make outbound payments in the form of service fees, royalties, or sharing group-allocated expenses.
In this context, there are several critical factors for the taxpayer’s consideration:
Reasonableness and Commercial Purpose: it is important to assess the reasonableness of the outbound payments of service fees and royalties. These transactions must undergo rigorous evaluation, including passing the six transfer pricing tests regarding intercompany service fee payments.
Regarding allocated fees, it is important to determine whether service fees are calculated based on a globally consistent service analysis and whether this information is disclosed in the group's master file. Additionally, if the service fees do not have external comparable uncontrolled transactions, the company should consider whether the allocated service fees are reasonably distributed among the relevant beneficiaries based on their scope of benefit.
Goods Import-Related: Regarding agreed-upon royalties, it must be determined whether they are related to the import of goods, in which case they must pay customs duties. Planning ahead can improve tax efficiency.
DEMPE+P Test: Besides the reasonableness and independence transaction principles, companies must consider whether royalties can pass the DEMPE+P test. DEMPE (Development, Enhancement, Maintenance, Protection, and Exploitation of intangibles) is a concept introduced by the Organization for Economic Co-operation and Development (OECD) in 2015 to determine the arm’s length return of intangibles in transfer pricing cases.
Under this concept, members of the multinational company (MNC) group are to be compensated based on the value they create through functions performed, assets used, and risks assumed in the DEMPE of intangibles.
The extra P, for Promotion, applies only to China, and it means that the tax authority also recognizes the value created by marketing activities of China entities. Passing the DEMPE+P Test involves assessing whether the royalty rate is reasonable and whether it fluctuates in correspondence with the changing industry environment or other factors.
Cumulative Deferred Payments: a company should know if payments are cumulatively deferred and, if these are delayed payments, investigate the reasons behind the delays and whether a more recent payment plan aligns better with the current situation.
It should also ensure that the corresponding expenses are calculated based on the contract, properly invoiced, and accurately recorded in the company's book of operating income and expenses. If the company is operating in a loss-making position, it must distinguish between short-term fluctuations and long-term financial burdens.
Impact on Group Tax Burden: it should be considered how these payments and settlements impact the overall tax burden of the group and ensure that there are no special tax arrangements that may raise concerns or legal complications.
Other Challenges
Related party prepaid expenses on behalf of the domestic entity include salaries paid by the headquarter or other parties on behalf of the China entity to the foreign employee at the foreign employee’s home country, commercial insurance premiums paid for the group company, overseas travel expenses, training expenses, and logistics expenses paid by the headquarter.
Several issues should be considered when managing related party prepaid expenses and transactions on behalf of the domestic entity.
Proper Recording of Liabilities: In cases of prepayment, liabilities to the payee should be correctly recorded on the balance sheet and the services corresponding to the prepayment are recognized properly. Prepaid expenses should align with the services received or costs incurred.
Preparation of Supporting Materials: When preparing for outbound payments, taxpayers should:
1) explicitly state the reasons for the prepayment in the agreement; 2) clearly specify that the overseas company retains the obligation to provide payment vouchers and proof; 3) emphasize the dominant role of the domestic company in the matter, rather than the overseas company; 4) provide additional supporting materials that further substantiate the nature of the transactions and the justification for prepayment.
Related Party Relationships: Payments for expenses prepaid on behalf of related parties can affect the tax implications and compliance requirements.
Internal Agreements: Internal agreements, which are the base for compliance, should specify the nature and terms of the prepaid expenses. According to foreign exchange business guidelines, it should generally not exceed 12 months from the signing of such agreements to the payments.
Completeness of Payment Records: To ensure transparency and compliance, complete and thorough records of expense assumption and payment are necessary. This documentation helps demonstrate that the transactions represent prepaid expenses, not service fees, thus avoiding tax liabilities.
Well documented prepaid expenses on behalf of related parties are important and can help companies ensure compliance with tax requirements, as well as maintain financial transparency.
Transfer pricing adjustments
Transfer Pricing adjustments are transactions between related entities to ensure compliance with tax regulations and accurately reflect market conditions. Since the global transfer pricing landscape has grown more complex in recent years, it can be challenging for multinationals to stay compliant.
Companies can follow certain steps to deal with transfer pricing adjustments:
Review and update regularly the company’s transfer pricing policies to align with changing regulations and market dynamics.
Engage transfer pricing experts to conduct thorough transfer pricing risk assessments and recommend appropriate adjustments.
Maintain detailed documentation and records of transfer pricing adjustments to demonstrate compliance and reasoning.
Common mistakes
Companies tend to make common mistakes in outbound payments, exposing themselves to compliance risks for both the subsidiary and parent company.
Tax authorities won’t recognize the authenticity and rationality of a contract, in the absence of certain elements or incomplete contents, creating a serious tax risk:
Contracts contain only names of the parties, contact information, and prices, but no basic terms such as the object of the contract, the time limit for performance and the place, and there is no supplementary agreement.
The contract lacks signatures and seals of both parties, and the date of signing is not filled in.
The Chinese and English versions of the contract are inconsistent, for example the Chinese contract is an engineering service agreement, while the English contract is the management service agreement.
There are no specific provisions on the charging standard and settlement basis.
Large contracts
A strategy that some companies use to avoid tax filing and supervision is to split large contracts into smaller payments.
For instance, a domestic company signs a US$ 200,000 lease contract with a foreign entity and divides the payments into five transactions, so that each one is below the US$ 50,000 threshold for outbound payment tax filing. However, tax authorities monitor such activities and may impose penalties and sanctions on the taxpayers.
Withholding tax
By law, the withholding agent shall withhold the tax on the date of actual payment and declare and pay the withholding tax to the local competent tax authority within seven days from the date of occurrence of the withholding obligation. If the agent fails to withhold the tax, the tax authority can order them to make up the withholding tax and may hold them accountable for any associated consequences.
Some businesses deliberately change the outbound payment method to reduce tax burden, which represents a serious tax risk.
For example, a foreign invested enterprise (FIE) has made profit distribution resolution but never actually remitted the fund abroad and withheld taxes. Instead, it transferred the money to a domestic third party, who is the creditor of the overseas shareholder. In this case, the tax authority may decide that the foreign party has received the dividend and thus is subject to corporate income tax retrospectively.
Another instance can be when an overseas shareholder withdraws or reduces its investment in a domestic enterprise, but only recovers the original investment cost, without reporting any income from the reduction or withdrawal.
Under tax laws and regulations, when non-resident enterprises withdraw or reduce their investment, tax authorities require that the equity value corresponding to the withdrawal or reduction should be measured at fair value, and the recovered amount should be recognized in accordance with the prescribed order as investment cost, dividends, and income from equity transfer.
Where the fair value of the equity corresponding to the divestment far exceeds the initial investment cost, and the dividend and equity transfer income are not recognized, which reduces the China withholding tax, the foreign invested resident company and the overseas non-resident company might be subject to legal repercussions and financial penalties.
Improper income reporting
Tax compliance risks can come from failing to report income properly as agreed in the contract.
If a subsidiary pays royalties to an overseas company and it is agreed in the contract that the tax is to be borne by the domestic company, and the royalties fee stated in the contract is net profit for the overseas company, then the income amount to calculate and declare withholding tax should be the pre-tax amount restored, rather than the royalties fee stated in the contract.
Genuine commercial activity
Payments made to foreign companies as business costs or expenses before tax deduction, should be based on genuine business activities. Payments lacking a genuine commercial basis may be deemed false and lead to potential tax adjustments.
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