BEPS - Profit allocation models with Chinese companies

During the transfer pricing conference in Paris on 14 March 2016, representatives from the OECD, tax authorities, corporate leaders and transfer pricing consultants discussed, amongst other things, profit allocation models with Chinese companies within the framework of the BEPS Actions 8-10.

As was evident from the discussions during the conference, China is of the opinion that a multi-national group’s distribution company located in China owns local intangible rights, such as know-how regarding the local market and local client lists. As a consequence, Chinese distribution companies should be entitled to a part of the group’s residual profit, instead of a so-called routine return, why profit allocation models (such as the profit split method) should be applied. A previous officer at the Chinese tax authorities stated at the conference that the Chinese tax authorities often take this view, as they believe that other transfer pricing methods do not provide a reliable result due to difficulties in identifying appropriate comparables for Chinese companies.

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In contrast with, for example, the transactional net margin method, which, in practice, is one of the most commonly, used transfer pricing methods applied to distribution services, the profit split method entails that the total profit generated by both parties in the transaction is allocated between those parties based on the respective party’s contribution to that profit. Generally, the application of this method also presumes that both parties contribute with valuable intangible assets, such as the brand of one of the parties and unique distribution methods from the other party.

However, difficulties which can arise in applying the profit split method to “routine functions” such as distribution, and something that was also addressed by OECD’s representatives is that in similar transactions between independent companies, it is likely that such independent companies would not choose to share their profits with a “routine player”. That a routine player has knowledge of the local market and has local client lists should not, in general, imply that that party should be entitled to a portion of the group’s residual profit. However, to determine this, a company should perform a so-called functional analysis. The OECD guidelines recommend that consideration should be taken to unique, local market conditions based on local comparables studies and not through the application of profit allocation models. A different approach in this context risks leading to situations in which double taxation can occur.

Feel free to contact us for a discussion regarding how this can influence your operations in China and how other changes in the framework of BEPS can affect your company’s business operations.