China’s strengthening cross-border tax enforcement

January 14, 2013

When investing into Asia-Pacific, as is the case in any market, all tax aspects should be considered as part of the decision making process.

This article was first published in the Ernst & Young Global Tax Policy and Controversy Briefing, Issue 11, December 2012 (pdf, 4.26 MB)

These include:

  • Local country withholding taxe
  • Access to double tax treaties
  • Capital gains tax
  • Transfer taxes
  • Thin capitalization rules and deductibility of interest expense
  • The availability of incentives, including tax holidays or reduced tax rates
  • Potential tax exposures, including permanent establishment and/or tax residency
  • Transfer pricing considerations.

More recently, however, general anti-avoidance rules (GAARs) and other anti-treaty shopping measures have been becoming an increasingly important consideration. This is certainly no exception in China, as this detailed analysis of recent and upcoming policy sets out.

Asia’s shifting anti-abuse landscape

Jurisdictions in this region — Australia, the People’s Republic of China, India, Indonesia, Japan and South Korea, for example — are intensifying their review and adjustments on tax arrangements they view as artificial or consider abusive tax avoidance.

Clear and consistent documentation of the business purpose and operational alignment of the tax strategy are increasingly important as tax benefits are often contingent on the satisfaction of varying business purposes and substance requirements being imposed that in many cases extend beyond internationally accepted tax practices.

Multinational corporations (MNCs) operating in the region and investors in the Asia-Pacific should be aware that the tax authorities are focused on tax-motivated structures and transactions that are considered to lack business purpose and commercial substance. They may deny the intended tax benefits, including the benefits of a relevant tax treaty in many cases despite having satisfied the conditions of the treaty.

An important and growing element of the authorities’ increased enforcement efforts is the enactment of GAARs and specific anti-avoidance rules (SAARs) to counteract perceived abuse or the improper use of a double taxation agreement (DTA). These anti-avoidance rules are part of an effort to preserve and expand their taxing rights to prevent what they view as tax avoidance and protect their tax base.

Alarmingly, there are instances where the use of either a general or specific anti-avoidance rule has been used to tax transactions that are not artificial or should not be viewed as abusive tax avoidance. A statutory GAAR is in effect in Australia, Hong Kong, New Zealand and Singapore. Although India, Japan and South Korea do not currently have a GAAR, they are focused on tax-motivated transactions and the abuse of DTAs and will attack certain transactions or tax arrangements using a substance-over-form approach.

Tax authorities in the region are increasingly using GAARs and substance-over-form principles to combat what they view as tax avoidance transactions, and there is an increasing concern that their approach has extended beyond internationally accepted standards, creating much uncertainty for taxpayers and deterring cross-border investment and deployment of capital as a result of the lack of certainty about the tax treatment of transactions.

China has a GAAR provision, and the substance-over-form principle was introduced into the tax regime in January 2009 when the State Administration of Taxation (SAT) issued Guoshuifa (2009) No. 2 (Circular 2), the trial version of the Implementation Measures for Special Tax Adjustments. This article discusses the trend of GAAR enforcement and legislations in China and, importantly, what guidance may be forthcoming given the developing and very often uncertain tax landscape. It also provides our perspective on the Government’s and the SAT’s approach.

China’s GAAR

China introduced its first set of GAAR legislation in its 2008 corporate income tax reform. Since then, rules and enforcement efforts, aimed particularly at non-residents, have been introduced to combat tax avoidance and treaty shopping. The SAT’s increased enforcement efforts are strengthened by the GAAR provision of the new Unified Corporate Income Tax Law (CITL), which became effective 1 January 2008.

As part of the CITL, China adopted certain provisions that have broadened its tax net and tax enforcement abilities (including abusive tax situations). Of particular importance are the rules set forth within Chapter 6, the special tax adjustment section of the law, including the anti-avoidance rules under Article 47.

The article gives the tax authorities the ability to adjust taxable income when enterprises make business arrangements that give rise to a reduction of taxable income and are not supported by a rational business purpose. Like previous legislation in China, the CITL only set forth the overall guiding principles of the law — further definition, guidance and clarification are needed to provide much more certainty about the tax treatment of transactions and for taxpayers to better understand how these anti-avoidance rules will be enforced in practice.

The CITL was followed by the release of the Corporate Income Tax Law Implementation Regulations (CITLIR), issued by the State Council on 6 December 2007. The CITLIR provide that business arrangements without bona fide business purposes as cited in Article 47 are considered arrangements whose primary purpose is to reduce, avoid or defer tax payments.

Since the issuance of the CITL and the CITLIR, the SAT has issued important guidance to taxpayers regarding compliance with GAAR, including guidance published on 8 January 2009 with the release of Circular 2, the trial version of the Implementation Measures for Special Tax Adjustments. Circular 2 provides guidance on how taxpayers shall comply with and tax administrators shall enforce and administer the provisions contained in Chapter 6 of the CITL.

More specifically, Chapter 10, Article 92 of Circular 2 instructs tax bureaus to apply this provision to enterprises that are abusing incentive tax policy, tax treaty provisions, legal vehicle form or structure, tax havens and other arrangements without bona fide business purposes. It also instructs tax bureaus to apply a substance-over-form principle in reviewing a particular arrangement’s legal formality, timing, duration, potentially connected steps, and financial and tax implications for the relevant parties.

With a focus on substance-over-form, China tax authorities are increasingly willing to disregard or recast perceived tax-motivated structures, entities or transactions. This guidance appears to be very broad and provide authority to tax bureaus to make adjustments to transactions or the tax benefits enjoyed. Additionally, subject to limited safeguards, it allows tax bureaus to disregard legal entities deemed to lack substance while at the same time there is a lack of guidance as to what type of substance may be necessary to preclude a challenge under GAAR.

Circulars 601 and 698 introduced

On 27 October 2009, the SAT issued Guoshuihan (2009) No. 601 (Circular 601), setting out guidelines on the interpretation and determination of the term “beneficial owner” under tax treaties. The SAT’s interpretation of beneficial ownership determines whether a non-resident recipient is entitled to a reduced rate of withholding tax and applies to the dividend, interest and royalty articles of the tax treaties that China has entered into with other tax jurisdictions, including the Hong Kong and Macau Special Administrative Regions of China.

Circular 601 provides guidance for the tax authorities to follow when processing applications from nonresident taxpayers for the benefits under a relevant DTA for such passive income (e.g., reduced withholding taxes). In line with taking a substance-over-form approach, Circular 601 prescribes a list of seven factors that are considered disadvantageous to the nonresident recipient in recognition of its beneficial ownership for tax treaty purposes:

  • The recipient is under an obligation to distribute all or the majority (i.e., 60% or above) of the China-sourced income to a resident of a third jurisdiction within a specified period (i.e., 12 months).
  • Other than holding the properties or rights that generate the income received, the recipient conducts little or no business activities in China.
  • The recipient is a corporation or another type of business entity, and the assets, size of operations and human resources of the recipient are disproportionately small relative to the income received from China.
  • The recipient does not, or almost does not, have rights to control or dispose of the income or the properties or rights giving rise to the income, and bears little or no risks.
  • The recipient is exempt from tax or is not subject to tax in the residence country with respect to the income received from China, or the recipient pays tax in the residence country but at an extremely low effective tax rate.
  • With respect to interest income from a loan agreement, the recipient has a loan or deposit agreement with another party with terms (e.g., amount, interest rate, execution date) resembling those in the primary loan agreement.
  • With respect to royalty income arising from a copyright, patent or technical know-how (collectively intellectual property or IP) transfer agreement, the recipient has an agreement with another party regarding the same IP.

Despite this list, in practice we have found that this is a controversial area where the application of the factors is unclear. In the absence of business substance, China tax authorities will likely question the application for treaty benefits, and the determination as to the availability of a reduced withholding tax may be called into question based on the facts and circumstances.

Because this area has been largely within the control of the local in-charge tax authorities, we often see beneficial ownership denied by the in-charge tax authorities when only one or two unfavorable factors exist. Unfortunately, certain factors should be irrelevant to the determination of beneficial ownership, e.g., factor five above, which is most often unmet?

This denial is particularly likely when the recipient lacks employees and substantive business activities or operations, despite that taxpayer’s view that the recipient is the beneficial owner applying the term as defined by the Organization for Economic Co-operation and Development (OECD). However, the beneficial ownership matter is complex, and the determination or assessment is often a difficult issue as Circular 601 invokes a new anti-abuse dimension to the term “beneficial owner,” broadening the scope of the term outside the meaning as defined by the OECD.

Given the uncertainty this situation has created regarding whether a reduced treaty rate of withholding tax would apply, as provided in the dividend, interest and royalty articles of certain DTAs entered into by China, additional guidance has long been overdue. On 29 June 2012, after a series of consultations, the SAT released a supplementary notice to Circular 601, Notice (2012) No. 30 (Notice 30), which provides some guidance on how to assess beneficial ownership status in respect to passive income (i.e., dividends, interest and royalties).

Notice 30 provides an important clarification stressing that all relevant factors should be considered “collectively” when assessing beneficial ownership status; status should not be denied simply because one of the seven factors exists, which is always the case. However, Notice 30 also clarified that beneficial owner status should not be granted purely because relevant arrangements were not put in place to evade or reduce tax or to transfer or accumulate profits.

In other words, lack of a tax avoidance motive in itself is not sufficient to meet the requirements of beneficial ownership which is based on an analysis of the relevant factors.While this clarification can be viewed as a favorable development, taxpayers should be aware that Notice 30 does not provide the local in-charge tax authorities or taxpayers with guidance as to what weight will be given to each of the factors, and it does not note which factors might be the most important.

In practice, even though it should not be relevant, China tax authorities have placed a strong importance on substance, which appears to be among the most important factors. Further, it is uncertain as to what China tax authorities may require in any particular case.

From our experience, no one factor will be viewed as conclusively important; instead, the totality of facts approach is adopted in each case. This is also in line with Article 1 of Notice 30 wherein it provides that “all factors specified under Circular 601 should be analyzed and determined in its totality.” It is for the taxpayer to articulate its facts and make the case officer understand, as much as possible, the circumstances upon which business decisions are made and other relevant facts.

Article 3 of Notice 30 introduced a new narrow safe harbor: the “same country publicly listed company” exception. In case the immediate holding company of a China tax resident company is in a DTA jurisdiction, and its parent company is a publicly listed company (Listco) resident in the same jurisdiction, it would be deemed that the Listco or the immediate holding company will satisfy the beneficial ownership test and that beneficial ownership status be granted.

One additional condition is that the intervening companies along the ownership chain between the Listco and the immediate holding company be 100% held by Listco, and that the intervening companies can only be of the same jurisdiction of the beneficial ownership applicant, or be a China tax resident.

Under Article 2, the notice lists certain documents and evidence that will be examined when assessing beneficial ownership status. The list of documents suggests what is required to enable the tax official to assess whether the applicant can have the discretionary power to direct the money flow of the passive income recipient, which is very much in line with the OECD Discussion Draft, “Clarification of the Meaning of ‘Beneficial Owner’ in the OECD Model Tax Convention” (Sections 12.4, 12.5), as reinforced in the recent two Canadian tax cases Prevost Car paragraph 13 and Velcro paragraph 34. In addition, strong elements of anti-abuse language are embedded in Notice 30, beyond the tests for “discretionary use, enjoyment and control” as cited in Prevost Car or Velcro.

Additional difficulties could result from the fact that the provincial bureau is the in-charge determining bureau for beneficial ownership cases, and location variation could happen even though Article 8 of Notice 30 provides that the different tax bureaus should communicate with each other when determining a beneficial ownership for the same applicant covering different locations.

It is worth noting that even though a beneficial ownership case does not require the SAT’s approval (Article 7, Notice 30), it does not, however, disturb the normal Administrative Review procedures as laid down under the Tax Collection and Administration Law and Tax Administrative Review Rules in cases of disagreement by a taxpayer to the determination of the provincial tax bureau.

In China’s case, in practice, to pass the beneficial ownership test, an enterprise needs to pass the tax residence test, the beneficial ownership test itself and the GAAR test before beneficial ownership status can be granted. In reviewing the previously listed seven factors set forth in Circular 601, factors 2 and 3 focus on the business activities and operations of the recipient and appear to look at these not only in absolute terms but also in relative terms, creating uncertainty as to what might be sufficient substance in any particular case.

Despite the recent release of Notice 30, additional guidance and further clarification are still needed regarding the application of the seven factors in totality and determination of beneficial ownership. This is particularly true for the required substance and the nature of the substance, as they have in practice been among the most important factors.

For example, what constitutes “substantive business operations”? Would management or holding functions be sufficient, or is commercial operational substance or both necessary?

This determination is particularly important as the OECD commentary does not indicate substance is a requirement or view it as a distinguishing fact in determining beneficial ownership (even under the expanded definition set forth in the OECD Discussion Draft). In fact, outside of China domestic law definition of beneficial ownership, substance is not a relevant factor in the determination. The key and decisive factor, as set forth in the OECD Discussion Draft, is simply whether the recipient of, for example, a dividend “has the full right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass the payment received to another person.”

What has been clear since 2009, when Circular 601 was issued, is that China tax authorities intend to curtail what they believe to be tax avoidance or abuse of tax treaties. They are proceeding cautiously in regard to further clarifying how to assess beneficial ownership, and they should consider a totality of facts. At the same time, as set forth in Notice 30, the SAT wants to have safeguards in place and has stipulated that only the provincial level tax authorities will have the authority to deny beneficial ownership status.

698 follows fast on the heels of 601

Subsequent to the issuance of Circular 601, on 10 December 2009 the SAT issued the now-famous Guoshuihan (2009) No. 698 (Circular 698). Circular 698 addresses gains from equity sales (i.e., capital gains) and is aimed at increasing the administration and taxation of direct and indirect capital gains derived by non-residents.

Circular 698 stipulates the non-residents’ obligation to report such gains and China tax authorities’ jurisdiction over them. It also imposes an obligation on non-residents to supply information and documentation regarding indirect sales with a focus on potentially abusive transactions. Circular 698 had retroactive effect from 1 January 2008, the date China’s GAAR came into effect.

With the issuance of Circular 698, China tax authorities are clearly continuing to intensify their tax collection and administration efforts with respect to non-residents intending to combat tax avoidance. Circular 698 makes it clear that China tax authorities believe a substance-over-form approach should extend to capital gains derived indirectly by non-residents on equity transactions in abusive situations, and it highlights the SAT’s willingness to disregard certain entities under GAAR if they were established for tax avoidance purposes and lack business purpose and commercial activities.

Circular 698 asserts China tax authorities’ right to invoke the GAAR to disregard one or more intermediate holding companies if their existence serves no commercial purpose except the avoidance of tax liabilities. This right effectively re-characterizes the indirect sale as a direct disposition of China company or investment. The release of Circular 698 follows a number of high profile audit cases.

A common transaction may involve a multi-tier structure, as depicted in Figure 2.

The Chongqing case

In a well-publicized audit case, the Chongqing Municipal Tax Bureau denied the intended tax benefits of an indirect sale by disregarding the existence of (or looking through) a Singapore Special Purpose Vehicle (SPV) that was established to hold the investment in a China company. In this case, the tax authority in Chongqing challenged the avoidance of China tax upon an indirect disposal of an investment in a China tax resident entity and looked through the most immediate holding company, taxing the Singapore parent as if there had been a direct disposal of China target.

The tax authorities used a substance-over-form approach to reclassify the transaction as a direct transfer of the shares by disregarding the existence of the Singapore SPV. Further, the case was reviewed and approved by the SAT centrally and may have had an influence on the SAT’s issuance of Circular 698.

As illustrated by this case, and now supported by Circular 698 and subsequent audit cases, if the foreign investor disposes the equity interest in China company by indirectly transferring the shares of an intermediate holding company that holds the shares in China company, such indirect disposition will likely be scrutinized. If the SPV’s jurisdiction imposes no tax or a low effective tax rate with respect to offshore income, the seller must make significant disclosures to the local China in-charge tax bureau — in other words, the filing “safe harbor” is not met.

Potential look-through in cases of indirect equity sales

Circular 698 requires the seller to submit the following information and documents to the in-charge tax authorities of a China resident company within 30 days of signing the equity transfer agreement:

  • The equity transfer agreement/contract
  • A statement describing the relationship between the seller and the intermediate holding company in the areas of finance, business and buy-sell transactions
  • A statement describing the intermediate holding company’s business operations, human resources, finance and assets
  • A statement describing the relationship between the intermediate holding company and China resident company in the areas of finance, business and buy-sell transactions
  • An explanation of the reasonable commercial purpose for the seller in establishing the intermediate holding company
  • Other information as required by the in-charge tax authorities

Upon examination of the above information and documents, if the in-charge China tax authorities believe the establishment of an intermediate holding company by the foreign investor (i.e., the foreign entity that has actual control over China company) does not meet the business purpose and substance requirements and was created to avoid China corporate income tax, the in-charge tax authorities in China have, after obtaining approval from the SAT, re-characterized the share transfer transaction according to the substance-over-form doctrine and disregarded the existence of the intermediate holding company to impose China withholding tax on the capital gains realized. A summary of Circular 698 cases published through August 2012 is shown in Figure 3.

Practical considerations

With this in mind, taxpayers should pay special attention to having defendable commercial substance in the relevant tax treaty country or intermediary holding company location, and they should document the business purpose or commercial rationale of the holding company to reduce their exposure to China taxation on an indirect share transfer. They also should, due to the retroactive nature of Circular 698, consider the potential impact of having a lack of substance in the intermediary holding company on the taxation of any indirect sale transaction or transfer (including group reorganizations) occurring on or after 1 January 2008.

The substance-over-form principle stressed in Circulars 2, 601 and 698 has emerged as a major trend regarding the taxation of non-residents. While the guidance provided to date is helpful, many uncertainties still exist, particularly in how these rules will be developed and implemented in practice. The SAT has made it known that additional guidance on the implementation of GAAR should be forthcoming including supplemental guidance to Circular 698.

Beyond the determination of beneficial ownership and the many related open issues, further guidance is required regarding what level of substance is required or necessary in the intermediary holding company that is transferred to preclude a recast of an indirect equity transfer as a direct transfer of shares under GAAR in what would otherwise be a transaction not subject to taxation in China, given no China-source income arises.

Would non-tax business purposes and operational substance in a lowertier holding company below the transferred entity preclude a recast under GAAR? Further, would related-party transactions or reorganizations be viewed differently? Absent such guidance, it is not possible to know with any certainty what equity transfer transactions may be subject to attack under GAAR.

The interaction between China’s anti-avoidance provisions and tax treaties

As of July 2012, China had signed 99 DTAs. Of these, a number include an anti-abuse provision within an article of the treaty. As an example, the protocol (2010) amending the 2000 China-Barbados DTA has an anti-abuse provision allowing China tax authorities to exercise a GAAR to override the DTA in certain cases. Under Article 4 of the protocol, the DTA provides:

“The provisions of this Agreement shall in no case prevent a contracting state from the application of the provisions of its domestic laws aiming at the prevention of fiscal evasion and avoidance, provided that the taxation in that State on the income concerned is not contrary to this Agreement.”

Importantly, it is worth noting that subsequent to amending the China-Barbados DTA, many (but not all) DTAs signed by the PRC after 1 January 2009 have included an article to apply a domestic GAAR treaty override. Therefore, we believe this will be a continuing trend in future DTA negotiations. Of the 11 DTAs entered into after 1 January 2009, more than 50% contain such a GAAR clause, as shown in Table 1 below.

*DTAs renegotiated and signed after 1 January 2009

Given that this is a developing area, it is not clear when and how the SAT will exercise China’s rights under the DTA and override the intended treaty benefit. Further, it is possible the SAT would apply GAAR or a substance-over-form approach if the specific DTA doesn’t contain an anti-abuse clause. It may be worth noting that China may be inclined to invoke exchange of information (EOI) privileges to assist the tax bureau in obtaining information on cases under review, and as noted under Article 5 of Notice 30, the tax bureau may revoke beneficial ownership status previously granted in cases where additional information obtained through EOI suggests justification to do so.

This is not inconsistent with China tax authorities’ use of the EOI in other cases. In the Xinjiang case, a published case involving the disposition of a China resident enterprise by a Barbados holding company (SPV), the Xinjiang State Tax Bureau denied in June 2008 tax treaty benefits on a capital gains tax exemption of a Barbados company based on the failure to substantiate tax residency in Barbados. In this regard, SAT employed the EOI provision of the treaty and ultimately concluded that the SPV was not a Barbados tax resident based on the limited information provided by the Barbados government.

Where next for China’s GAAR?

A circular issued in April 2012 indicated that the SAT intends to increasingly incorporate accepted international practices into GAAR’s legislative considerations and aim to improve the balance between domestic and international laws. At the same time, the SAT also set out that a panel review scheme for GAAR cases might be created in the near future to fairly and consistently implement GAAR across the nation.

This panel review feature is also included in recent GAAR proposals from India and the UK, and it has long been a part of Australia’s GAAR administration. The SAT plans to issue its updated GAAR implementation rules by the end of 2012.

In designing its rules, GAARs of other jurisdictions with GAAR experience will no doubt be considered, as will the recommendations of ongoing consultations and refinements in Australia, India, the UK and other jurisdictions. Ultimately, the goal of the SAT is to design a rule that could create more taxpayer certainty and more concrete guidelines to tax officials at field level.

The impact of anti-avoidance measures on investment models in China

MNCs and investors investing in China have many tax and nontax considerations to manage when developing an efficient legal entity, tax and operational structure — and not just because of China’s changing tax treatment of foreign-owned enterprises. Going forward, structuring into China must take into account the existence, enforcement and development of China’s GAAR and the ongoing enforcement of Circulars 601 and 698, which has created much uncertainty.

In practice, this will have a significant impact on common structures that lack substance or commercial activities. MNCs and investors are urged to review their group holding structures to make sure there is a sufficient degree of appropriate substance in the relevant holding company jurisdictions and document the non-China tax purposes for having established the holding company in the relevant jurisdiction (i.e., the business purposes of establishing an entity and operations in such as jurisdiction).

This is not only important for determining beneficial ownership, but also for assessing whether an indirect sale or transfer may be re-characterized as a direct transfer under GAAR. Prior to the Chongqing case and the release of Circular 698, it was believed that, unlike a limited number of jurisdictions that will look up the chain and tax an indirect disposition, China would only tax capital gains resulting from a direct disposition.

Following the release of Circular 698, it is clear that this is no longer the situation. GAAR may be asserted on transactions required to be reported, and such indirect transfers may be taxed. Unless the taxpayer can demonstrate and document that it has adequate business purpose, substance and/or commercial activities in the relevant jurisdiction, it is likely GAAR will be asserted and China non-resident capital gains tax levied.

Conclusion

With an increasing amount of investment in the region and the continued use of multi-tiered investment structures to minimize local country taxes, tax authorities in China — and many other Asia-Pacific jurisdictions — are closely scrutinizing tax arrangements that they feel may have been used for tax avoidance. Whether a GAAR is designed to tackle anti-avoidance or anti-abuse, the growing number of similar measures arising globally creates a considerable amount of uncertainty for MNCs and investors.

Past transactions require careful scrutiny, as do future transactions. Each case must be taken on its own merits, and the characteristics of local GAARs and SAARs — not to mention the known cultural approach of the local taxing authority — must be applied to specific fact patterns. MNCs and investors investing in China should carefully review their investment structures and investment strategies.

With the increasing focus on treaty shopping, indirect share transfers and abusive tax arrangements, taxpayers should assess the potential tax risks that exist and consider steps that can be taken to mitigate such risks, including legal or operational restructuring. Further, taxpayers should consider establishing protocols to monitor similar developments in key markets, as well as examine how any future guidance may affect their tax risk profile and exposure to China and other countries’ withholding or capital gains tax on prior or future transactions.

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