Many multinational companies (MNCs) have expressed frustration with China’s advance pricing arrangement (APA) program. For a country with the economy size and importance of China, the program has historically been understaffed and has never received the attention and resources that most believe it deserves.
On 18 October 2016, the State Administration of Taxation (SAT) released Bulletin 641, which introduces new rules on the administration of APAs. Bulletin 64 will supersede the current APA administrative rules, which are found in Chapter 6 of Circular 22, starting 1 December 2016. The SAT issued Bulletin 64 in response to the key recommendations under Actions 5 and 14 of the Base Erosion and Profit Shifting (BEPS) Project. Those recommendations were to include unilateral APAs (UAPAs) in the information exchange network and to provide guidance on the APA program. More generally, Bulletin 64 aims to provide comprehensive and practical guidance to enterprises and tax bureaus seeking to reach an APA. Bulletin 64 is the second bulletin released this year as part of the SAT’s ongoing plan to revise parts of Circular 2. The first was Bulletin 423, which was released in July (see our client alert in July 2016).
The key question now is whether Bulletin 64 will help to address the logjam in this process and how changes in China’s administration of APAs will be a net win or loss for MNCs seeking the certainty an APA should provide in what is now one of, if not the most, important market(s) for their business globally. There is little doubt that Bulletin 64 constricts the availability of APAs as a technical matter, but given that the key barriers to access to APAs in China have historically been more practical in nature, there is hope here.
1.Who is affected?
The tax authorities in China have been shining an increasingly bright spotlight on transfer pricing over the past several years. The BEPS Project has certainly added to that focus, and MNCs today are faced with significantly greater transfer pricing audit risk. An APA is one way of effectively managing this risk. Therefore, any MNC that seeks to manage the uncertainties associated with transfer pricing issues via an APA will be significantly affected by the new APA administration rules under Bulletin 64.
The APA program in China has suffered from a lack of resources. Many APA applications have stalled at either the APA letter of intent stage or the examination and evaluation stage. According to China’s 2014 Annual APA Report dated 18 December 2015, 90 applications were stuck at the letter of intent stage and 39 applications at the examination and evaluation stage at the end of 2014. Overall, China has concluded a relatively modest number of bilateral APAs (BAPAs) (with only 8 BAPAs signed in 2013, and 6 in 2014). Given the backlog of APAs in China, MNCs have long been hoping for greater resources and attention being paid to China’s APA program. Bulletin 64 impacts the administration of APAs by tightening the scope of availability for potential APAs, but a key question is whether these changes may be paired with greater access for those who qualify.
2. What does Bulletin 64 say?
2.1 In-charge tax authority for APAs
Bulletin 64 specifies different in-charge tax authorities depending on the type of APA involved: a UAPA, a BAPA or a multilateral APA (MAPA). A UAPA will normally be handled by an enterprise’s in-charge tax authority, whereas, a BAPA or an MAPA will normally be jointly handled by the SAT and the enterprise’s in-charge tax authority. Bulletin 64 further defines “the in-charge tax authority” as the tax authority that is responsible for an enterprise’s special tax adjustment.
From a technical reading, “the in-charge tax authority” appears to include a tax bureau at the district level. This would be a change from Circular 2, under which only a tax authority at or above the level of a municipality divided into districts or an autonomous prefecture can handle APA procedures. However, this part of Bulletin 64 has to be understood in relation to what has actually happened in practice across China. Given that most provinces have centralized the special tax adjustment function, the in-charge tax authority for an APA has been de facto elevated to the provincial level tax bureaus.
The situation is more complicated where an APA involves:
- tax authorities from two or more provincial-level administrative regions; or
- a state tax bureau and a local tax bureau.
Bulletin 64 does not change the existing rule that the APA procedure should be coordinated by the SAT in both of these situations, but Bulletin 64 moves a step further by clarifying that the enterprise should submit the APA application to the SAT and its designated tax authority when seeking a UAPA. Thereafter, the SAT or its designated tax authority may sign a consolidated UAPA with the enterprise; or each in-charge tax authority involved may sign a separate UAPA with the enterprise.
2.2 APA procedure
Bulletin 64 divides the APA procedure into six stages: (i) pre-filing meeting; (ii) letter of intent to seek an APA; (iii) analysis and evaluation; (iv) formal application; (v) negotiation and execution; and (vi) implementation and monitoring. The detailed APA procedure is set out in Diagram One:
The most significant procedural change is that Bulletin 64 officially moves the analysis and evaluation stage (called the examination and evaluation stage under Circular 2) ahead of the formal application process. This change formalizes a longstanding practice of conducting examination and evaluation before formally accepting an enterprise’s APA application. From the SAT’s perspective, this practice helps to prevent a backlog of formal APA applications and also gives the SAT greater discretion to remove an APA from the pipeline much later in the process, even after the analysis and evaluation has been completed.
Bulletin 64’s other notable changes include:
- Increased focus on value/supply chain analysis and location specific advantages (LSAs). At the pre-filing meeting stage, the enterprise is required to provide a concise explanation of whether there exist any LSAs. Next, at the letter of intent stage, the enterprise should include analysis of LSAs and of the group’s value/supply chain. Then, at the analysis and evaluation stage, the tax authority will assess whether the analysis on value/supply chain is complete and accurate and whether full consideration has been given to LSAs. This increased focus on assessing value/supply chain analysis and LSAs is consistent with new transfer pricing documentation requirements under Bulletin 42, which requires analysis of value chain and LSAs in the local file. But Bulletin 64, like Bulletin 42, fails to provide any clear guidance on how to conduct the value chain and LSA analysis.
- Frees the tax authority from application response deadlines. Bulletin 64 sets no deadlines for the tax authority to respond to the enterprise’s application at each stage. This represents a departure from Circular 2, which contained time limits for the tax authority to respond at each stage. For example, under Circular 2, the tax authority had to issue a written notice to the enterprise within 15 days from the date on which an agreement was reached at the pre-filing meeting stage. By removing these time limits, the tax authority will have full discretion and control over the timing of the APA procedure. Thus, enterprises will face increased uncertainty in the expected timeline of the APA process.
- Increases monitoring of the enterprise’s profitability. The tax authority may adjust the enterprise’s profit rate in the current year up to the median of the agreed profitability range if the enterprise’s actual profit rate falls outside of the agreed profitability range during the APA application period. Upon the expiration the APA, an enterprise with a weighted-average annual profit rate in the APA application period lower than the the median of the agreed profitability range will not be eligible to renew the APA unless it adjusts its profit rate to the median for the expired APA period. This represents a significant departure from Circular 2, which only provided for a profit rate adjustment to reach the agreed profitability range. That said, some tax authorities have imposed this profit adjustment mechanism now expressed in Bulletin 64 for years despite the lack of solid legal authority.
2.3 Prioritized list and blacklist
Bulletin 64 permits the tax authority to prioritize an enterprise’s APA application if:
- The enterprise has duly declared its related party transactions and prepared contemporaneous documentation;
- The enterprise has an A-level tax payment credit rating;
- The tax authority has already imposed a special tax adjustment on the enterprise and the case has been closed;
- The enterprise has not undergone any substantial change when an application is filed to renew an APA;
- The enterprise has submitted complete documents, which contain complete and accurate analysis on value/supply chain and LSAs and use reasonable transfer pricing principles and calculation methods;
- The enterprise proactively cooperates with the tax authority;
- The BAPA/MAPA partner country is willing to conclude the APA; or
- Other factors exist that may facilitate the conclusion of the APA.
In addition, Bulletin 64 provides that the tax authority may reject an enterprise’s formal APA application if:
- The enterprise refuses to change inappropriate pricing principles and calculation methods used in the draft APA application report;
- The enterprise refuses to provide required documents or to correct insufficient documentation on a timely basis;
- The enterprise refuses to cooperate with the tax authority during the onsite interviews; or
- Other factors exist that obstruct the conclusion of the APA.
2.4 Roll-back of APA
According to Bulletin 64, an enterprise may apply and the tax authority may agree to retrospectively apply the pricing principles and calculation methods under an APA to identical or similar related-party transactions during the previous 10 years.
Furthermore, Bulletin 64 provides that the tax authority will collect the additional tax or grant a tax refund accordingly where an APA is applied to previous transactions. This provision is the first time that an established rule has provided legal authority for tax refunds in transfer pricing situations. However, it remains to be seen how the tax refund mechanism will work in practice.
2.5 Information exchange
In response to the recommendations under Action 5 of the BEPS Project, Bulletin 64 introduces a new rule that the SAT may conduct information exchange with the competent tax authorities in other jurisdictions about UAPAs signed after 1April 2016, unless national security information is involved.
3. What should MNCs do?
As mentioned before, the APA program in China has suffered from a lack of resources. As such, MNCs have found it difficult to have their applications formally accepted by the SAT. The hope is that while Bulletin 64 narrows the availability of APAs and seems to erect additional roadblocks for MNCs seeking an APA, given how difficult access has been due to insufficient resources, the hope is that these changes will focus the SAT on what they consider higher value APAs and provide greater clarity for taxpayers on whether pursuit of an APA has sufficient merit. Of course, for this to be true, the SAT will need to make additional resource commitments to the program.
Faced with the APA procedural changes in Bulletin 64, every MNC trying to manage potential transfer pricing risks through any of the three types of APAs should consider the following:
- Evaluate the prioritized list and the blacklist under Bulletin 64 to identify and satisfy as many prioritized conditions as possible and to minimize the risk of being blacklisted;
- Develop a complete and appropriate analysis on the value/supply chain and the LSAs;
- Within the bounds of reasonableness, demonstrate an attitude of proactive cooperation with the tax authorities; and
- Understand the incentives that the local tax bureau, as well as the local government more generally, has to reach an APA and align your APA strategy with these incentives.
1 Bulletin of the State Administration of Taxation on Issues Concerning Improving the Administration of Advance Pricing Arrangements, SAT Bulletin  No. 64, dated 11 October 2016, effective from 1 December 2016.
2 Circular of the State Administration of Taxation on Printing and Distributing the Implementing Measures for Special Tax Adjustments (for Trial Implementation), Guo Shui Fa  No. 2, dated 8 January 2009, retrospectively effective from 1 January 2008.
3 Bulletin of the State Administration of Taxation on Issues Relating to the Enhancement of the Declaration of Related Party Transactions and Administration of Contemporaneous Documentation, SAT Bulletin  No. 42, dated 29 June 2016, retroactively effective from 1 January 2016.