Guidance for Charging Management Services Fees to Chinese Affiliates
Author: Elizabeth Hazzard
The Chinese State Administration of Taxation (SAT) often denies the deduction of management fees paid from Chinese affiliates to related parties. Management fees are incurred when an entity performs management services on behalf of its Chinese affiliate(s). Typical management services provided are human resources, legal, finance, information technology, etc. Under the arm’s-length principle, i.e., as if the parties were unrelated, tax authorities expect the costs associated with such services to be appropriately allocated to the entities that receive the management services. However, issues arise when the recipient—in this case, a Chinese affiliate—claims a deduction for the cost of the services it remits to its related-party service provider, and the SAT denies deduction of the management fee. The SAT often disallows this deduction based on the idea that services performed don’t provide a clear and discernable benefit to the management services recipient, i.e., the Chinese affiliate.
What the Law Says
Article 41 of the Chinese Income Tax Law (CITL) states all intercompany transactions must take place at arm’s length. However, in contrast to the arm’s-length standard, Article 49 of the CITL Implementation Rules says, “management fees paid between enterprises … shall not be deductible.” At the North American Transfer Pricing Conference hosted by Bloomberg BNA in Washington, D.C. last June, Tizhong Liao, a high-ranking SAT employee, clarified that Article 49 indicates management fees related to stewardship (or shareholder) activities aren’t deductible by the Chinese affiliate.
What the SAT Does in Practice
Even if management services provided to the Chinese affiliate consist solely of nonstewardship costs, the SAT may argue the costs charged are stewardship or don’t provide a benefit to the Chinese affiliate and, therefore, aren’t deductible. The SAT routinely performs benefit and remuneration tests to judge whether or not the management fee deduction is allowable. The benefit test analyzes the services received by the Chinese affiliate to determine if it receives a direct economic benefit from the services. To pass the benefit test, it’s necessary to detail the benefit(s) the Chinese entity receives from each functional area allocated as part of the management services provided by its affiliate. This is when a robust, descriptive functional analysis in the transfer pricing documentation study is critical. Without demonstrating the benefit received by the Chinese entity in the functional analysis section of a transfer pricing documentation study, the SAT likely will disallow the deduction of the management fee. In addition, the SAT may perform a remuneration test to determine whether certain management services costs allocated to the Chinese entity also are included in other intercompany transactions. Detailed cost information is helpful to prove costs associated with the provision of the management services aren’t double-charged to the Chinese affiliate.
Sustaining Management Fee Deductions in China
To increase the likelihood of sustaining the deduction of management services fees charged to Chinese affiliates, multinational companies with Chinese entities should meticulously document the nature of the services included in the management services fee to demonstrate that stewardship costs aren’t included in the cost allocation and that services provide a distinct and identifiable benefit to the Chinese entity. It’s also essential to clarify and document the methodologies used to allocate the management services costs. The detailed description of the services and methodology for allocating costs should be addressed in the intercompany management services agreement, transfer pricing documentation and any other transfer pricing policy documents. This will serve to validate the uniqueness and authenticity of the services rendered and the reasonableness of the allocation methodologies.
Here are some helpful points when implementing and monitoring a management fee allocated to a Chinese affiliate:
- The SAT doesn’t prefer allocation methodologies based on the risk incurred by each entity; rather, it requires a discreet quantitative measurement, e.g., headcount or revenues.
- The SAT requires an intercompany agreement documenting the intercompany transaction. It must be in place and approved by the SAT before the management fee payment can be remitted by the Chinese entity to its foreign affiliate.
- If a Chinese affiliate manages its own business and the U.S. interacts only from the perspective of approving strategies, the SAT wouldn’t consider the charges associated with the approval process acceptable, as the nature of the services would be considered stewardship.
If your business has a Chinese affiliate that receives a management services fee from a related party, please contact your BKD advisor to determine if your documentation is adequate to withstand possible scrutiny from the SAT.