China's State Administration of Taxation (SAT) has been encouraging taxpayers to use the profit split method for a long time. However, outside of advance pricing agreements (APAs), the profit split is not a practical transfer pricing method. Even in the case of APAs, the profit split is used in less than 3 percent of concluded APAs. The biggest barriers to more widespread use of the profit split method have been different expectations regarding methodology and difficulties in gathering information.
Under the orthodox approach, taxpayers considering the method will look to use a residual profit split, aiming to allocate all or almost all of the residual profit to the entrepreneur or the entity that owns intellectual property. The SAT generally takes a different position, and expects taxpayers to disclose the overall profit in the entire supply chain and analyze how the overall profit should be split between China and the rest of the supply chain participants – more akin to a contribution analysis.
Many of the differences are a result of the information asymmetry between taxpayers and the SAT. In the majority of reviews, one of the main requests from the tax authorities is for copies of global documentation, and details of the global supply chain transactions to be provided. This request comes from a desire to fully understand the supply chain and associated profits so that the profit being returned in China can be measured against profits in other countries given their respective functions, assets, and risks.
In the future, the SAT is expected to require a higher level of disclosure of foreign information through the amendments to Circular 2 – China's transfer pricing regulations. Although the details had not been made public as of September 2015, it is widely expected that disclosure of the global supply chain and associated profits will be required to meet the minimum documentation requirements. Taxpayers may need to make the same jurisdictional arguments to support why they don't include details in their documentation in the future – leading to questions about whether documentation omitting the requested information may fail to meet the minimum requirements.
As more global supply information will be available in the future through the country-by-country reports (depending on the extent to which China participates), the tax authorities may be able to avoid having to request information from the taxpayer and just get the information directly from other tax authorities. This means that taxpayers may need to consider alternative strategies for managing the flow of information to the tax authorities.
How these strategies are developed will depend on the reasonableness of the tax authorities' approach to reviewing the profitability of the global supply chain from a China perspective.
China practitioners have long known that detailed information about global supply chains is of great interest to the Chinese tax authorities, particularly because of the concern that central entrepreneur structures have transferred the majority of profits away from countries that manufacture and consume products, in particular the Chinese market. These concerns contributed to the SAT's official views on location-specific advantages – putting emphasis on the local-country market factors to argue against intercompany allocations of functions, assets, and risks that were considered either artificial or contrived to deprive China of tax revenue.
In the post-BEPS world, many of China's concerns about global supply chains that aren't aligned with the value-creating functions, assets, and risks should be addressed. Already, taxpayers are planning to change elements of their tax planning structures that have been deemed either unacceptable by tax authorities, or where the new result is unacceptable to the taxpayer. For example, marketing service providers in China are expected to close down as the permanent establishment rules are tightened, transforming into in-country distributors.
The SAT's next moves to review global profits and determine China's share should align more closely with the positions taken throughout the OECD member states. From an optimistic perspective, this should make it easier to look at a profit split approach for related-party transactions. But despite the positive outlook, we still have concerns about how taxpayers and authorities will be able to reach agreement on the contentious issues arising in profit splits.
The SAT has focused on the profit split method throughout the BEPS initiative, with officials previously referring to the absence of valid comparable companies in China as a reason for using profit splits. Without reliable comparable companies it becomes more difficult to assess routine profits; when issues such as location-specific advantages and other China factors are factored in, a two-sided profit split analysis will still run into difficulty for the same reasons as before, as the tax authorities and taxpayers seek to establish precedents for how profits should be split, and how much should be attributed to various factors. Perhaps the OECD will release useful advice on this last point, but that remains to be seen.
Overall, the environment for using a profit split in China should improve following the BEPS changes and increased transparency of global supply chains. While residual profit splits will not become the new transactional net margin method (TNMM), it is highly likely that taxpayers will need to give more serious consideration to whether the method provides a more reliable arm's length result, especially when China factors play some part in the taxpayer's success.