Meaning
Tax audit methodologies used by Chinese tax authorities evaluate the allocation of intangible asset returns among multinational corporate entities. Conducting a DEMPE functions analysis helps the State Taxation Administration determine whether a local subsidiary is receiving an arm’s length return based on its actual activities rather than legal ownership alone. The methodology defines the boundary where passive intellectual property registration is separated from active local value creation.
Regulatory Power
Administrative guidelines issued by Chinese tax bureaus allow auditors to adjust corporate tax liabilities if transfer pricing does not match local contributions. Through a DEMPE functions analysis, the bureau examines which entity hires the engineers, funds the research, and manages the brand protection. Taxpayers must present contemporaneous documentation that justifies the allocation of royalty payments to offshore parents.
This evidence must show that the offshore entity exerts actual control over the risk of development, a requirement that cannot be met by simple contract clauses or passive board resolutions.
Assessment Process
Audit steps require the taxpayer to compile detailed timesheets, employment contracts, and functional questionnaires for key personnel. When the local bureau runs a DEMPE functions analysis, it scrutinizes who holds decision-making authority over the research budget. If the local engineers run the development and the offshore parent merely funds it, the bureau will attribute more profit to the local subsidiary.
Financial Risk
Tax adjustments can lead to double taxation if the tax authority increases the taxable income of the Chinese entity. To manage the risk associated with a DEMPE functions analysis, foreign-invested companies must maintain functional contracts that align legal ownership with operational reality. This measure protects the group from unexpected transfer pricing penalties.
