Posted by Shi Zhiqun on April 27, 2010 under Anti-Avoidance, Corporate Tax Planning | 
In 2009 the State Administration of Taxation (SAT) undertook significant steps in relation to clamping down on anti-avoidance practices. Yet, recent indications suggest that the SAT considers that there is a significant way to go. Officials have been repeatedly indicating that in 2010, China will step up efforts to counter tax evasion, with a particular focus on transfer pricing in the pharmaceutical and automotive industries, the use of intangible assets and share transfers, and cross-border related business transactions.
The SAT spent considerable recourses in 2009 developing a sound system for its anti-avoidance investigation practices and it is expected that in 3020 this will continue to be fine-tuned. An official from the SAT’s International Tax Department recently commented that up until “present investigations focused more on anti-avoidance in respect of the purchase and sale of tangible assets, cost sharing by controlled foreign companies and thin capitalization”. However, from this year, the SAT will look beyond these more simplistic anti-avoidance practices and will examine the issues on a more complex level, including exploring rational pricing of intangible assets and equity. In addition, outbound investment will receive special attention, particularly the transfer pricing practices employed by Chinese companies investing abroad and controlled foreign company management.
The SATs efforts to combat anti-avoidance in 2009 garnered significant results – the work of the national anti-avoidance team resulted in adjustments to taxable income totally 16.09 billion yuan and 2.09 billion yuan in back taxes.
Promisingly, the SAT official also indicated that the SAT will seek to encourage bilateral Advance Pricing Agreements (APAs). Bilateral APAs allow multinational companies to achieve greater certainty in terms of their transfer pricing practices. There has been some doubt in the past about the difficulties in obtaining bilateral APAs and accordingly it is encouraging to see commitment to them by the SAT. Since 2005 China has entered into 12 bilateral APAs and it is expected that this number will rise as multinationals become more familiar with China’s approach and the attitude of tax officials to them.
Posted by Jane Peng on under Anti-Avoidance, Tax Controversy |
The new Rules for the Tax Administrative Review (Order of SAT [2010] No. 21) (hereinafter the “New Rules”), issued by the State Administration of Taxation (“SAT”), have superseded the Interim Rules for the Tax Administrative Review (Order of SAT No. 8). One of the aims of the New Rules is, arguably, to increase protection of the legal rights of taxpayers and other interested parties. It is also evidence that one purpose is to ensure supervision of the tax authorities so that they lawfully exercise their authority. The New Rules introduce several major modifications to the tax administrative review system, such as the scope of administrative review, rules on admissible evidence and the method of hearings.
However, probably the most significant change is the introduction of a compromise and conciliation system in accordance with Articles 40 and 50 of the New Rules. Whilst negotiation with the tax authorities in China, both prior to commending litigation and during litigation, is already a common practice there were long standing concerns about the legality of such practices and whether agreements that had been reached were, in fact, enforceable. The New Rules seek to provide a stronger legal basis for such practices.
Compromise Agreements
The New Rules outline the requirements for a binding compromise agreement. It is first noted that the content of a compromise agreement shall not damage the interests of the public and/or individuals. Once a compromise agreement has been approved by the relevant administrative review organ, an applicant is not permitted to apply for review on basis of the same fact and reason. However, apart from this, the New Rules do not specifically detail the legal effect of a compromise agreement. There are still concerns as to the extent to which a compromise agreement can be enforced. It is also not clear whether the applicants can revoke a compromise agreement and reapply for review should new evidence come to light. Finally, the New Rules do not outline that the action that can be taken when one party does not meet their obligations under the compromise agreement.
The new Rules represent a significant attempt by the SAT to bring legitimacy and transparency to the tax administrative review system in China. Whether they achieve such an aim is yet to be seen.
Posted by Matthew on February 1, 2010 under Anti-Avoidance, China Tax, Tax Controversy |
In 2008 China dramatically reformed its taxation system through the introduction of the Enterprise Income Tax Law. There were two substantial changes brought about by the EITL. Firstly, it removed the previous tax distinction for domestic enterprises and foreign invested enterprises (FIEs) under which FIEs had been subject to a highly concessional rate of tax. The second significant change was the introduction and strengthening of China’s international anti-avoidance rules. This included a wider definition of a tax resident company, the introduction of rules relating to thin capitalisation, extensive documentation requirements in respect of transfer pricing, the introduction of a general anti-avoidance rule and controlled foreign company rules.
Throughout 2008 and 2009 various regulations, measures and circulars were promulgated at all levels of the tax administration system for the purpose of implementing the new law. The SAT spent much of 2009 assembling an large enforcement team and hired 500 more officials. One common theme in all of this was the push to target the shifting of profits off-shore. It had been quite a common practice, up until 2008, for foreign invested enterprises to effectively generate no profit in China through an array of related party transactions. As a result of this new environment, nearly all foreign invested enterprises have had to undertake a review of their structures.
It is also important to note that, and in the usual manner of Chinese bureaucratic politics, traditionally local tax bureaus only sporadically, if at all, followed the mandate of the State Administration of Taxation (SAT). This was because the local tax bureaus were also answerable to the provincial and local level governments. Such governments were more interested in encouraging investment in their regions, then ensuring that national level policies were followed to the letter of the law. Accordingly, many legal and non-legal concessional arrangements were entered into at a local level. However, more recently there has been a growing willingness by the local tax officials to follow intructions from the national guys. This has three potential implications. Firstly, we can expect national level policies to enforced more effectively and consistently at a local level. Secondly, many non-legal concessional tax arrangements that were entered into in the past may no longer receive protection by the local officials. Thirdly, it will be less likely that such arrangements will occur in the future.
Yet, we are yet to feel the full brunt of the changes. This is because the tax authorities, whilst having undertaken internal reviews of files, have generally not put taxpayers on notice that they are being subject to an investigation in respect of the 2008 year. The authorities commenced their internal reviews in May/June 2009 and, from what we have been told, will commence sending out notices of tax adjustments in the first quarter of this year. Interesting times ahead – for us anyway.
Posted by Matthew on January 29, 2010 under Anti-Avoidance, Corporate Tax Planning, International tax |
The following scenario is one that we have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).
The scenario:
Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.
This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:
Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.
Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.
Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.
Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.
Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.
Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.
Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.
Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.
Posted by Li Wei on January 27, 2010 under Anti-Avoidance, China Tax, Tax Controversy |
In 2009, 13803 cases of fraudulent use of tax invoices were uncovered by public security departments throughout China. As a result, the Chinese government collected RMB1.226 billion in additional tax and a further RMB233 million in fines.
