Meaning
Tax circular governs the deductibility of outbound payments made by Chinese subsidiaries to foreign affiliates for royalties and service fees. Foreign-invested entities must comply with State Taxation Administration public notice 2015 number 16 to ensure that payments sent to offshore group companies are tax-deductible. The circular focuses on preventing base erosion through payments that lack economic substance or do not benefit the local taxpayer.
Expense Scrutiny
Regulatory scrutiny targets payments to offshore entities that perform no active operations or hold only legal ownership of intangibles without adding value. The regulation forbids deductions for royalty payments made to foreign affiliates that have not contributed to the creation or maintenance of the intangible asset. Service fee payments to group entities for shareholder services or stewardship activities are also disallowed.
Deductibility Standard
Verification criteria demand that outbound payments correspond to actual and beneficial services that an independent enterprise would be willing to pay for or perform in-house. Taxpayers must provide clear evidence that the received services or royalties directly enhanced the operational efficiency or profitability of the local subsidiary. Without this documentation, the payments are treated as non-deductible distribution of profit.
Audit Outcome
Enforcement of this regulation has resulted in numerous transfer pricing investigations and the disallowance of massive outbound payments across China. Taxpayers must often pay substantial back taxes along with interest penalties when their offshore service fees are deemed non-compliant. To minimize these risks, multinational firms must prepare comprehensive service agreements, timesheets, and deliverable reports that substantiate the economic benefit of every outbound payment.
This administrative demand raises the standard of proof required during tax audits, making compliance a key priority for foreign parents with subsidiaries in China. Failure to satisfy these conditions leads to irreversible tax losses and double taxation.
