Hong Kong: The Need To Review Royalty And Technology Transfer Agreements

Last Updated: 21 October 2015
Article by Anthony Kerr, Jun Zhao, Cecil Leong, Sydney H. Mintzer and Paulette Vander Schueren
Most Read Contributor in Hong Kong, September 2019

On October 5, 2015, the Organization for Economic Cooperation and Development ("OECD") released its final report on the 15 key elements of international tax rules set out in its Base Erosion and Profit Shifting ("BEPS") Action Plan.

The OECD launched the BEPS Action Plan in 2013 at the request of the G20 to address the growing problem of multinational companies ("MNCs") moving profits to low- or no-tax jurisdictions to avoid taxation. Over the past 12 months tax authorities around the world, including China, have been focusing their attention on the implementation of BEPS-related measures. One major challenge faced by China is the current direct and indirect tax planning practices of MNCs, which involve the use of various types of fee structures, including royalties and franchise fees, to transfer profits out of China.

Tax Authority's Focus on Transfer Pricing & Related-Party Payments

With the March 18, 2015 release of its Public Notice Regarding Certain Corporate Income Tax Matters on Outbound Payments to Overseas Related Parties (SAT Public Notice [2015] No.16, hereinafter referred to as "Public Notification 16-2015") and its official Interpretation the following day, China's State Administration of Taxation ("SAT") demonstrated its intent to vigorously police transfer pricing and the payments made between related parties.

Public Notification 16-2015 brings together SAT's views on intra-group outbound payments, including those relating to intra-group services and management fees as stated in China's official response to the United Nations ("UN") in March 2014. In that response the SAT reaffirmed its view that service fees paid and received by related parties must be in compliance with the "arms-length" principle. It also stated that management fees are expenses generally related to shareholder activities and, as such, the SAT would limit or not allow their deductibility for corporate income tax ("CIT") purposes. Public Notification 16-2015 also takes into consideration an internal circular, Shuizongbanfa [2014] No. 146 ("Circular 146"), in which the SAT requested all local level Chinese tax offices to launch comprehensive tax examinations of taxpayers with significant outbound service fee and royalty fee payments to related parties overseas.

The tax authority will analyze and determine whether payments to related overseas parties are actual and reasonable, using six types of tests: beneficiary testing, demand testing, repetitive testing, value add testing, compensatory testing and authenticity testing.

If a payment made to a related party overseas is found not to be in accordance with the arms-length principle, the tax authority can require tax adjustment to be made any time within 10 years from the date of the transaction. The adjustment may result in the payment not being allowed for CIT deduction.

Articles 3 to 6 of Public Notification 16-2015 specify the types of payments that are not deductible for CIT purposes, including:

  • Article 3 – Payments to overseas related parties not undertaking functions, bearing risks or having no substantial operations or activities.
  • Article 4 – Service fee payments to overseas related parties for services which do not enable the taxpayer to obtain direct or indirect economic benefits.
  • Article 5 – Royalty payments, not in compliance with the "arms-length" principle, paid to overseas related parties that only hold legal ownership rights with no contribution to the value creation of the underlying intangible asset.
  • Article 6 – Royalty payments to overseas related parties in compensation for incidental benefits arising from financial or listing activities, where a holding or financing company is established offshore for the main purpose of financing or listing.

Customs' Concerns about Related Party Fees

An additional complication relating to the use of various types of fee structures, such as royalty and franchise fees, has arisen in the indirect tax arena. In recent years audits by China Customs have focused on whether imported goods encompass such factors, and whether the declared value of parts and components imported for production include such fees. China Customs can, and does, conduct import value verification audits and post-entry audits to determine if the prices of goods imported by MNCs are actual and reasonable.

Decree No. 392 of the State Council of the People's Republic of China dated November 23, 2003 stipulates the key conditions that must be met before royalty or franchise fees can be added to the Customs value:

  • The payment must be related to the goods being imported; and
  • The payment must be made as a condition for the sale of such goods to the Customs territory of the People's Republic of China.

These are similar conditions to those established under the WTO Agreement on Customs Valuation.

China Customs will assess the related-party fee payment based on the above-mentioned conditions to determine if it should be added to the value of the imported goods for customs purposes. Notably, when implementing a fee structure under China Customs' valuation rules, any fee that is paid as a condition of sale for export to the People's Republic of China is always included into the customs value.

If an offence is discovered, China Customs has the right to recover the import duty and VAT short-paid for the preceding three years, as well as to impose a penalty of 30-200 percent of the short-paid amount. If there is evidence of fraud by the consignee, consignor or the enterprise, the matter will be transferred to China's Anti-Smuggling Bureau for action.

From Tax Documentation to Customs Actions

With BEPS implementation, the SAT will require Chinese enterprises to hold greater transfer pricing documentation. This means that the Chinese entity will have in its possession key information on the global enterprise, its transfer pricing policy and fee structure. This also means that such information will be accessible to China Customs during an audit. The transfer pricing documentation will reveal all payments made to related entities and it is very likely that China Customs will ask the enterprise to justify such payments. We note that SAT's substantive requirements on related party fees (i.e., based on "arms length" principle) will also apply in case of a China Customs query.

China Customs and the tax authority are two separate enforcement agencies. Thus, if the related-party fees are not clearly spelt out in the contracts or in the transfer price, the enterprise may end up having to make duty/tax reparations to both agencies.

Suggestions on Compliance

Based on past experience, we understand that many existing royalty agreements, technology transfer agreements and trademark agreements were drafted more than 10 years ago and continue to be in use today. Enterprises should, therefore, review their existing royalty agreements, technology transfer agreements and trademark agreements, as well as their tax strategies, to ensure compliance with the new rules. This type of review is also likely to facilitate a better understanding of a firm's Chinese subsidiaries and the entire group's transfer pricing policy.

Several critical factors to highlight:

  • When drafting fee agreements, it is very important to consider both a direct and indirect tax perspective, as well as any other factors.
  • Besides ensuring that the related party fee is set on a true "arms-length" basis, it is also important that such fee agreements are kept separate from sales agreements or contracts, and that there is substantive justification for the fee arrangement.
  • When drafting a royalty agreement relating to domestically manufactured goods, the agreement must clearly state that the royalty is for goods manufactured in China. In other words, the agreement must clearly state what the fee payment is for and provisions within the agreement, including the annexes, should not contradict the subject of the fee payment.
  • Enterprises should establish an effective operational framework and mechanism to manage fee payments, and to respond to and correct mistakes in a timely manner. Such work will involve the overseas parent company, other related enterprises and the Chinese subsidiaries. Enterprises should be prepared to respond effectively and quickly to transfer pricing investigations initiated by China Customs and/or the tax authority, including appropriate documentation and clear and concise explanation of intra-group payments.

Visit us at www.mayerbrownjsm.com

Mayer Brown is a global legal services organization comprising legal practices that are separate entities (the Mayer Brown Practices). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2015. The Mayer Brown Practices. All rights reserved.

This article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein. Please also read the JSM legal publications Disclaimer.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions