By Diheng Xu
As a non-OECD member country, but a member of the G20, China is actively involved in the whole process of developing the BEPS Action Plan. China’s attitude towards the BEPS Action Plan is positive, as it considers its involvement as an opportunity to strengthen its role within the international tax community. However, the Chinese tax authorities also take into account China’s specific circumstances when integrating the measures. For example, China’s claim on profits allocated to location specific advantages (LSAs), including location savings and market premiums, deviates from the BEPS standard.
Considering the large amount of foreign direct investment (FDI) inflows, transfer pricing is a major issue in China. According to data from the World Bank, China’s gross domestic product (GDP) ranked second in the world in 2016, with the country ranking as a top destination for MNEs to invest in over the past 10 years, a position it will maintain for the foreseeable future. As a main FDI recipient, China suffers from transfer pricing problems. China is widely known for goods “made in China”, which reflects China’s role as the “factory of the world” in terms of manufacturing. MNEs normally set up manufacturing entities in China due to a comparatively low cost of production. The most frequently adopted forms of manufacturing in China are contract manufacturing and toll manufacturing, which mean that the Chinese affiliate does not own intangibles, technology or the final products. They only function as manufacturers.
On the other hand, with the fast-growing economy, China is also considered a major “market of the world”. Accompanied by the increase in income, Chinese consumers hold a growing purchasing power. For instance, China has surpassed the United States in becoming the world’s largest car market. As pointed out by China, Chinese consumers have a general preference for foreign brands and imported products. The increasing middle class represents more purchasing power in luxuries, travelling, e-commerce wellbeing, etc. Many MNEs have increased investment in China by distributing foreign-made products directly to consumers at a retail level. Some of them have even had to localize and cater to Chinese consumers’ preferences. Moreover, in addition to transferring from “made in China” to “sold in China”, China is also growing as a word centre for research and development (R&D), i.e. “created in China”.
China announced that, in transfer pricing, value creation is not aligned with economic activities. It pointed out that MNEs in China enjoy location-specific advantages (LSAs), which arise from assets, resource endowments, government industry policies and incentives in China.
To clarify, LSAs manifest themselves as location savings and market premiums. Location savings are the net cost savings derived by an MNE through its operations in China. The savings are realized by lower expenditure on items such as raw materials, labour, rent, transportation and infrastructure. Location savings are a typical problem for products “made in China”. Market premiums are defined as additional profits derived by an MNE via its operations in China where there are unique qualities influencing the sale and demand of a service or product. Market premiums are particularly prevalent in the luxury goods sector in China. For instance, in the luxury auto industry, the sale price of the same type of automobile in China is much higher than those sold in other markets, while the sale volume is also much higher in China. A main reason is that demand outweighs supply, due to various complex factors. Thus, market premiums are an essential issue for products “sold in China”. Another aspect relates to intangibles. Chinese affiliates are normally not entitled to intangibles from MNEs. With the use of the intangibles, Chinese affiliates can actually contribute to the improvement of the original intangibles but cannot receive additional profits. Even when MNEs set up R&D centres in China, the intangibles developed or enhanced by these centres do not belong to them, but to the MNEs abroad. Therefore, the problem of intangibles is implicit in the stage of products “created in China”.
As a result, China claims that the traditional methods based on the arm’s length principle lack reliable comparable transfer pricing analysis and do not take into account China’s contribution to LSAs and intangibles. Hence, the transfer pricing outcome is not aligned with the value creation in China. This represents China’s attitude towards the harm derived from transfer pricing, since China believes that the inappropriate allocation of profits indeed erodes the tax base in China.
China’s claims on LSAs are not unique, since India has similar views, and other emerging economies are considering to adopt it. Moreover, LSAs can actually find justifications. Firstly, China’s approach offers a method to solve the problem of double non-taxation on profits derived from location savings, which the OECD’s approach cannot solve. Secondly, China’s approach is in line with the arm’s length principle and the main objectives of BEPS Actions 8-10 on aligning transfer pricing outcomes with value creation. Thirdly, it finds support from the rationale of source-based taxation. Additionally, the doubts on China’s approach are debatable and do not prove any irrationality in China’s claims. China’s claim should not be considered a unilateral action against the OECD approach, but should have more references for other emerging economies in similar situations. It actually reveals the limit of the arm’s length principle (treating MNE groups as separate legal entities) and provides a solution to the problem. By treating MNE groups as a single firm, the Chinese affiliate should be entitled to tax the profits from its LSAs. This claim should also gain endorsement from other non-OECD member countries.
Nevertheless, concerns do exist, given China’s specific legal circumstances. The discretion of tax authorities to enforce China’s own approaches and uncertainty for taxpayers are the primary concerns. Moreover, if other countries follow China’s approach and still cannot reach consensus on an appropriate way to allocate profits, harmful tax competition will increase. It could also trigger problems of treating foreign MNEs equally to Chinese domestic enterprises under WTO law. Another concern arises from China’s political economy. The economic growth is slowing down, so China faces more stress to stimulate its economy. The degree and effect of China’s implementation measures is yet to be seen.
What conclusions can we draw? The basis for these implications is their common objective to combat tax avoidance via international tax cooperation. China should clarify rules on the application of transfer pricing issues related to LSAs. A further implication is in respect of its legal system. By introducing more legal control over tax authorities, China will integrate into and benefit from the world economy more effectively. As for the OECD, as an emerging leader of international tax cooperation, it should also hear and adopt China’s and other developing countries’ reasonable aspirations seriously in order to achieve its objectives via international tax cooperation.
D. (Diheng) Xu, The Convergence and Divergence between China’s Implementation and OECD/G20 BEPS Minimum Standards, 10 World Tax J. (2018), Journals IBFD.