One of the most promising business models that has emerged recently is the shared service centre (SSC), under which a group of affiliated companies can share marketing, information technology, finance and other administrative services. This model has been implemented by many leading multinational corporations and can lead to significant benefits, including cost savings, knowledge sharing and a standardisation of systems across business units.
In China, the sharing of services usually takes the form of a foreign-invested enterprise relying on a China investment holding company and/or foreign headquarters for the provision of various services. However, this arrangement, if not carefully structured, can lead to adverse tax consequences. In addition, there are other special factors in China with regard to service fees that many multi-nationals are unaware of, such as foreign exchange controls on non-trade remittances.
In designing a tax strategy for sharing of services, the first consideration is to ensure that the foreign-invested enterprise can deduct the fee paid to the SSC provider. The situation in China is highly ambiguous. Article 58 of the Income Tax Implementing Rules states that ?management fees paid by an enterprise to an associated enterprise shall not be expensed.? However, Article 56 indicates that labour service fees paid to an associated enterprise can be deducted if charged at arm's length price.
This means that in setting up the service contract, it is important for the multinational to avoid use of the term ?management fee.? It is also necessary to be ready to defend that the ?labour service? received is beneficial and to supply invoices and evidence of benefits received. In practice, we have come across occasions where the local tax authorities attempted to deny deduction on inter-companyservice charges that were considered excessive, and re-classified the service charges as non-deductible ?management fee.?
The Internal Revenue Service of the US is pressing multinationals headquartered in that country to charge for the services they pro-vide to foreign affiliates. If these multinationals do not charge out the costs, the IRS will deny them a US deduction, thereby increasing their US taxable income. Thus we see cases where the tax authorities in the country where the SSC is located expect the SSC to charge out its cost but the service recipient in China may be unable to pay the SSC. We even see the situation occurring within China, where, for example, the tax authorities in Hebei province may challenge the service fee paid by a Hebei enterprise to its Beijing holding company. Hence the tax situation applicable to the SSC in its home country (or home city) must also be considered in devising a recharge system.
The next question that arises is how to price inter-company services. Even if the tax authorities agree that a service is beneficial and thus deductible they may challenge the size of the fee. For example, the authorities typically suspect that the price charged for overseas services is excessive and reflects inflated Western salaries. The appropriate methodology for the pricing of service contracts is covered by the Chinese transfer pricing regulations issued in 1998 by the State Administration of Taxation (SAT).
There are basically two models for pricing inter-company fees. The first involves comparing the fee paid to the internal SSC with the fee payable for a similar service to a third party provider. In practice, this approach is difficult to use. Most of the services provided by the related party may not be available from third parties. Even when the service is available from third parties, it is difficult to obtain comparable price data.
The second model is cost-based, whereby the costs incurred by the service provider are identified and charged out, sometimes with a profit mark-up. In this model, multinationals would like to use `allocation keys' so that, for example, if the Guangzhou subsidiary accounts for two percent of worldwide revenues it is allocated two percent of the service costs. The use of allocation keys is supported by the OECD transfer pricing guidelines but in China the use of allocation keys was often disputed.
The issuance of a ruling in March 2001 by the SAT is a major step forward in that it recognises the legitimacy of allocation keys. This ruling states that expenses incurred by the Chinese companies of a US fast-food company in respect of shared services rendered to them – examples quoted include advertising costs, product tailoring and R&D, training, software development of relevance to the China operation ?would be allowed as deductible expenses. The use of appropriate allocation keys was also stated to be acceptable.
The ruling does not give a green light to simple allocation key methods. It states that proper documentation must be put in place including the service contracts, evidence of the related expenses and the basis for the allocation keys. Furthermore, the expenses shall only be claimed after the local tax bureau-in-charge has examined and agreed to the treatment.
One of the crucial issues facing foreign-invested enterprises is remitting the money out of China for non-trade-related transactions. In 1999, the State Administration of Foreign Exchange and SAT jointly issued a ruling concerning remittance for non-trade transactions such as service fees. As a consequence, banks will require a tax clearance certificate issued by the tax bureau with regard to taxes payable on the service fee. If the taxpayer does not have the certificate to demonstrate that taxes have been paid, remittance approval will be denied.
In addition to paying the taxes, taxpayers may also be required to register the contract with the Ministry of Foreign Trade and Economic Cooperation as a pre-condition for issuing the tax clearance certificate. While it has been our experience that not all tax bureaux impose such a requirement, it is still a prudent practice to get Moftec registration if possible.
In 2001, Moftec identified 10 types of technology-related contracts for which Moftec approval would be necessary in order to obtain approval for foreign exchange remittance. Technical service contracts and technical advisory contracts are among the listed contracts. The requirement to register a contract is not a common practice in other countries and should be carefully noted by foreign companies.
In setting up an inter-company service agreement, it should be noted that the taxes applicable in China on services are business tax and a deemed profit tax. Moreover, the business tax that must be paid on the service fee cannot be credited in most countries.
The table above presents four cases with regard to taxation of service fees. The results are quite different, reflecting the location of where the service was performed and, equally important, the tax authority's view of these circumstances.
Cases one and two in the table are where an offshore provider is considered to have a permanent establishment in China, defined as such if services performed by the offshore company through its employees in China last for more than six months. If there is a permanent establishment, then the service fee will be subject to a ?deemed profit tax.? If we assume that the deemed profit rate is 20 percent and the tax rate is 33 percent, then the tax is 6.6 percent of the fee. Since there is also a business tax of five percent, the total tax burden is 11.6 percent. In addition, the employees of the foreign-related party will be subjected to Chinese individual income tax based on their stay in China.
Case four is the most favourable in that the service is considered to have been per-formed entirely outside China and as such no tax is payable on the service fee.
If services are performed both inside and outside China, it may be appropriate to enter into multiple service contracts – one for each type of service. This way, tax exemption can be received on at least some service activities.
In seeking to minimise taxes payable on service fees, it is also important to consider the use of alternative business arrangements. There are certain structures that can reduce, or even eliminate business tax. Effective from August 1999, Moftec has allowed foreign-invested China holding companies to expand their business scope, enabling them to source the products of their underlying subsidiaries and sell them to domestic or overseas customers. Thus, if we have a China holding company that was formerly providing marketing services to its subsidiaries, that marketing fee would have been billed to the subsidiary and subject to a five percent business tax. Now, the company does not need to charge a fee since it is undertaking the marketing for its own trading activities – thereby eliminating business tax.
Many multinationals are surprised by the complexities in China associated with the pricing of inter-company services. There are certain special factors in China with regard to service fees that do not exist in their home country, including the registration of the contract with Moftec, the problems of foreign exchange remittance and the business tax levied on the fee.
Therefore, it is strongly recommended that multinational corporations should consider the different alternatives and examine the experiences and best practices of other multinationals in China. Such analysis should come into play when deciding the corporate form of the service provider and where it should be based. Only by taking such factors into account will it be possible to achieve the business efficiencies of shared services in the most tax-effective manner.
Written by Cassie Wong, tax partner with Pricewaterhouse Coopers in Hong Kong and Glenn Desouza, tax director and economist with PricewaterhouseCoopers in Shanghai.