Cost Contribution Agreement in China

By Larsen Lüngen from ECOVIS Cologne and Krefeld

General

Cost Contribution Agreements are contractual agreements for the provision of common services within associated enterprises with a common interest. The basic idea is to share costs with associated enterprises to harness synergies. .
In this regard it is necessary that the shared costs generate an advantage for all members of the Cost Contribution Agreement and that the costs are allocated according to the usage for each member of the contract. Furthermore, the agreement is just relevant if the cost allocation is processed without any mark-up and advantages can be expected by sharing the services (cost reduction, revenue increase). The Cost Contribution Agreement is one of the favored instruments within enterprises to allocate especially head-office-costs and research and development costs to affiliates
Cost Contribution Agreement in China until 31st December 2007

China did not have any statutory regulations for Cost Contribution Agreements until 2008. Up to this time, just some individual regulations existed. In general payments based on Cost Contribution Agreements were not deductible for tax purposes or just by meeting very strict documentation requirements.

Cost Contribution Agreement in China since 1st January 2008

In January 2008 the Chinese corporate tax law was harmonized concerning the legitimacy of the Cost Contribution Agreements. Now, the Cost Contribution is regulated in clause 6 of the corporate tax law and regulates the general acceptance of Cost Contribution Agreements. In general the requirements for the acceptance of a Cost Contribution Agreement are identic with other countries. Nevertheless, costs for management services are still not accepted and are still not deductible for tax purposes. The only problem in this regard is the fact, that the term “management service” is not defined, so that there is some space for interpretation. Explicit management costs are all overhead and stewardship costs, and therefore not deductible.

The new regulations are largely orientated to the OECD model conventions for Cost Contribution Agreements.

Noteworthy is the fact that the agreement has to be forwarded to the local tax authorities 30 days after the conclusion of the agreement. After examination, the decision of the local authorities is provided to the national tax authorities. As the decision is normally not forwarded to the taxpayer, it is possible to request for a binding statement to receive legal certainty. Furthermore, the transfer-price-documentation for the Cost Contribution Agreement has to be forwarded to the authorities until the 20th of June of each year.

Fiscal treatment

In case all requirements are met and the Cost Contribution Agreement is accepted by the tax authorities and is in accordance with the arm´s length principles, the costs are operating expenditures within the corporate income tax ascertainment of profits. The intangible assets are special with respect to the fact that payment receipts are treated as initial costs and pay-outs for intangible assets are treated as payments for the disposal of assets.

With focus on the corporate income tax, also the Tax Clearance Principles have to be considered. According to these principles the Chinese tax authorities verify each payout from a Chinese affiliate to the parent company in another country (e.g. Germany). Special focus here is the reason for a payment as in general all payments from an affiliate to the parent company are expected as payments for management services, so that these payments are not part of the Cost Contribution Agreement and therefore not deductible for tax purposes. Furthermore, the authorities check the corporate income treatment of the payment.

Normally, the tax authorities charge payments from the affiliate to the parent company with taxes. For the calculation of the tax amount, the Chinese authorities use the so called Deemed-Profit-Method. Within this method 60 percent of the payment to the parent company is treated as Chinese earnings and 20 – 50 per cent of these earnings are treated as profit which is taxed with 25 per cent corporate income tax. This tax amount is deducted from the source.

The problem of this method is that the Chinese authorities feign a branch from the foreign parent company. As there exists definitely no branch, the amount is taxed twice, as for example in Germany the double tax treaty just allows a consideration or tax exemption if there exists a branch. Nevertheless, the double taxation can be tackled by the usage of the mutual agreement procedure.

Conclusion

With the release of the new regulations for Cost Contribution Agreements, the Chinese regulations are now very close to the OECD model conventions and therefore the handling is quite easier than in the past. Nevertheless, to avoid any problems the agreements should be pursuant to the Chinese regulations and terms like “management” should be avoided completely. Furthermore, it is absolutely recommendable to request for a binding statement of the authorities, that the Cost Contribution Agreement is in accordance with the law, so that the taxpayer has a maximum of legal certainty.