Joint Venture Becomes the Main Object of General Anti-Tax Avoidance Investigation
By Liu Tianyong，Beijing Hwuason Lawyers
Due to long term loss and scale expanding to the contrary, foreign invested enterprises have become one of SAT’S most important focuses recently. Known from general anti-tax avoidance in 2010, Join Venture has become the investigation core; taking Dalian anti-tax avoidance case, Kangshifu indirectly share transferring case in 2011 for examples.
The general feature of Join Venture is always like that: setting up in China according to PRC’law, part of the investment coming from overseas and certain control power held by foreigninvestors. Its ownership structure is much more complicated than WFOE and China domesticenterprise. And Chinese and foreign parties’ pooling the interests and sharing the risk makeJoin Venture a tool for both parties. Meanwhile, it is also qualified as a Chinese legal person innature, while intimately related with foreign investment, which makes its business modevaried.
Part one: The Reason Why Joint Venture Becoming the Main Investigating Target of General anti-tax avoidance
1. The development of legal system of revenue impacts tax status of Join Venture.
Joint Venture is one of the main forms for foreign investment. Thanks to loose economic policy and investment orientation over the years, foreign owned enterprises enjoy super-national treatment and other preferential policy, and there is not too much limitation concerning legality in business act out of legal sense. In the wake of building up Chinese national strength, market maturity and competitive situation between enterprises, it is necessary to create a more purified marketing environment. Chinese government revised a set of law and regulation, basically unified the parallel system, and adjusted all enterprise in various natures without discrimination. Till now, wholly foreign owned enterprises and Join Ventures have to relocate their marketing roles and restrain themselves with stricter new laws and regulations. In thissituation, if they are not able to adapt to the new business environment, it is possible for them to face tax risks
2. Both strengthening internal cooperation between government departments and developing bilateral anti-tax avoidance assist anti-tax avoidance investigation
Due to Join Venture’s complicated operating structure, outbound affiliated parties and mature trading mode, it is not easy for tax authority which is not experienced in transfer pricing to recognize during anti-tax avoidance period. While recently, a law-based and effective government has been built and the internal cooperation between departments and hierarchy has been strengthened, it is convenient for department to query valid information needed. The operating procedure is more and more transparent, and it is also hard to do some illegal operation. In this event, tax authority reasonably turns its main point to them.
Furthermore, international anti-tax avoidance cooperation is becoming global wide gradually but not regional. As far, China has signed bilateral tax treaty with over 100 countries and districts, which clearly regulated the measures in information exchange and mutual assistance in tax collection. More than that, many countries are using other legal system of revenue and OECD general standards for reference, following the development of international tax, in the purpose of unifying tax laws. In such a background, the scope for transnational enterprises to obtain tax interest grows more and more narrow.
3. It is sensitive for Join Venture to transfer equity
SAT issued GUOSHUIHAN  No. 698, which explicitly put certain limitation on nonresident enterprises direct and indirect equity transferring. Out of operation strategy and other arrangement, in recent years it is more and more frequent for Join Venture to transfer its equity.
At the same time, foreign investment vehicle often choose to be set in low tax rate area or even tax heaven. Through arranging transfer pricing, they hardly pay tax in China. This situation make it fits with general anti-tax avoidance regulated in No.698. And it is comparatively easy to obtain internal information; therefore tax authority puts Join Venture as main objects in anti-tax avoidance recently.
Part two: EnterprisesCoping Mechanism in Current Situation
1. Join Venture should make a clear judgment for current situation, enhance self-checking, and take precautionary step SAT issued a series of normalizative documents of law such as GuoshuihanNo.698, No.601, which cancelled Join Venture’s tax advantages, and focused its tax behavior. At present, enterprises should adjust its behavior on time according to those policies, strive for drawing close to the requirements of those normalizative documents of law and finish internal adjustment before possible investigation risk. Meanwhile, during the period of restructure and operation, enterprises should pay attention to its regulatory compliance, and take care of keeping files, records and accounting vouchers, so as to prepare for document submitting in the future.
2. Enterprise which wishes a long-term development should overweight internal communication and distribute profit reasonable.
Known from general anti-tax avoidance cases, the reason leading to Join Venture’s anti-tax avoidance often lies in their unmerited internal communication coordination. In the profit distribution, apart from certain investment profit both Chinese and foreign parties obtain from yearly profit distribution, Join Venture also takes advantages of related transaction with outbound parent company, such as disclosure fee, raw material purchasing and selling product to get some part of profits. This unequal status between two parties in the profit sharing mechanism leads to contradiction. Stimulating by other factors, it usually becomes the main conflict between the two investing parties. And the outcome of such conflict is to expose Join Venture’s drawback under public sight, and to provide clue and basis for tax authority to intervene.
3. There should be reasonable profit during enterprise management, and also a fair price between related parties’ transaction regardingassets, commodity and stock.
Joint Venture is easy to be doubted that they transfer profit out of China via its relationship. In this consideration, SAT targets those enterprises with long-term loss, meager profit and fluctuating profit but extended their operation range as main investigated object in Special Taxation Adjustment Implementation Regulation(Trial) . At the same time, local taxation authorities gave concrete figures on each industry’s average rate of profit and lowest profit index regarding to industrial characteristics. Enterprise may choose to maintain its profit rate within given amplitude range, so as to reduce doubtable point in tax avoidance and to prevent risk from investigation. Besides, trading behaviors between related party in asset, equity and commodity may refer to customs price, industry index, and marketing value to fix a price, and make it fit to the rules.
All rights reserved by the original copyright holder. The contents of this article are intended to provide a general guide to the subject matter and should not be treated as a substitute for specific advice concerning individual situations. Readers should seek legal advice before taking any action with respect to the matters discussed herein.
ABOUT THE AUTHOR
Beijing Hwuason Lawyers – Senior Partner
Mr. Liu Tianyong is one of China’s most prominent tax lawyers, founding the first specialized tax law firm inChina. He is a Senior Partner at Hwuason and regularly advises both international and domestic clients on all aspects of Chinese tax law.
Mr. Liu Tianyong is also regularly interviewed by the media on China taxation and business issues. In the past he has undertaken interviews with organizations such as CCTV, Legal Daily, People’s Daily, China Taxation News, China Business, Economic Daily, Xinhua News Agency, and China Business News.
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1.Tax authorities focus on the thin capitalization in anti-avoidance
Anti-avoidance, a major means to achieve fair taxation rights and interests and avoid profit transferring by enterprises, has been conducted frequently by developed countries and highly valued by developing countries. Currently, tax authorities in China has set up a well-established system for anti-avoidance which encompassing transfer pricing, APA, thin capitalization and controlled foreign enterprises.
SAT indicates that competent tax authorities would expand the areas of anti-avoidance from transfer pricing and APA to cost allocation agreements, controlled foreign enterprises, thin capitalization and GAAR. By the end of 2011, the first case of anti-avoidance of thin capitalization was closed, which reflects the new focus of anti-avoidance of competent tax authorities.
In early 2011, national taxation bureau in Shaanxi analyzed the accounting books of related enterprises and discovered that a Japanese company was involved in a lot of questionable points concerning taxation. Firstly, the debt-to-assets ratio of the enterprise was high and there existed a lot of related parties borrowing; secondly, the enterprise was in the situation of long-term loss while increasing capital constantly; thirdly, offshore banks offered substantial bank loan to the long-term loss enterprise under the joint and several guarantee of the parent company. Based on the abovementioned questionable doubt, preliminary judgment was made by national taxation bureau of Shaanxi that the enterprise was suspect of tax avoiding through thin capitalization. Further investigation to the enterprise indicated that the enterprise was also involved in other tax avoiding activities such as overseas related purchase, equity transfer and general anti-avoidance. The first anti-avoidance case of thin capitalization was launched upon the opening of investigation by SAT. After discussion, analysis and negotiation, the case was concluded with the finding that the enterprise paid the tax for RMB11million after special tax adjustment.
2. Relevant laws and regulations regarding anti-avoidance of thin capitalization
In recent years, thin capitalization, as a prominent means to avoid tax, results from the different treatment towards interests of debt and dividends of equity in accounting and taxation. The use of thin capitalization as a means to avoid tax is increasingly spread around the world along with the prospering of international capital market, which attracts great concern of tax authorities and gives rise to the legislation regarding anti-avoidance of thin capitalization.
With a view to preventing tax avoidance of enterprise through increasing debt investment and pre-tax deduction, provisions concerning thin capitalization are specified in relevant laws and regulations.
According to article 46 and 47 of Law of the People’s Republic of China on Enterprise Income Tax, the expenses incurred by an enterprise for payment of interest, due to the fact that the ratio of the bond or equity investment it receives from its affiliates is in excess of the prescribed norm, may not be deducted when it calculates the amount of its income taxable and Where an enterprise earns less taxable income or amount of income because it implements plans other than the ones designed to achieve reasonable business objectives, the taxation authority shall have the right to make adjustment in a reasonable way.
According to article 119 of Regulations on the Implementation of Enterprise Income Tax Law of the People’s Republic of China, “Debt investment”, as referred to in Article 46 of the Enterprise Income Tax Law, shall mean the financing that an enterprise directly or indirectly obtains from the related party but has to repay the principal and pay the interest or has to make compensation by other means in the nature of interest payment;
The debt investment an enterprise indirectly obtains from the related party shall include:
(1) the debt investment that a related party provides through an unrelated third party;
(2) the debt investment provided by an unrelated third and guaranteed by a related party that assumes joint and several liabilities; and
(3) other debt investment indirectly obtained through any related party in the nature of obligation assumption.
“Equity investment”, as referred to in Article 46 of the Enterprise Income Tax Law, shall mean the investment an enterprise accepts for which it does not have to repay the principal and pay the interest and of which the investor holds ownership over the net assets of the enterprise in question.
“Standards”, as referred to in Article 46 of the Enterprise Income Tax Law, shall be separately formulated by finance and taxation authorities of the State Council.
According to provisions of Notice of the Ministry of Finance and State Administration of Taxation on Taxation Policies Relating to the Standard for Pre-Tax Deduction of Interest Expense of Related Parties of the Enterprises, when calculating the taxable income, the interest expenses actually paid by the enterprise to the related party not exceeding the threshold specified below and in conformity with the relevant provisions of the Tax Law, and its Implementation Regulations shall be deductable. The excess portion shall not be deductible during the current period of occurrence and subsequent years.
Except when meeting the provisions of Clause 2 below, the interest expenses actually paid by the enterprise to the related party shall conform to the debt-to-equity ratio specified below:
(1) 5:1 for financial enterprises; and
(2) 2:1 for other enterprises.
If the enterprise can provide relevant materials in accordance with appropriate requirements of the “Tax Law” and its “Implementation Regulations” and prove that related trading activities conform to the principle of independent trading or that the actual tax burden of the enterprise is not greater than that of domestic related parties, the interest expenses actually paid by the enterprise to the domestic related parties shall be deductible when calculating the taxable income.
According to article 89 of Implementing Measures for Special Tax Adjustment (Trial),
to apply for the deduction of interest expenses when the associated party debt to equity ratio of the enterprise exceeds the standard ratio to be deducted from the taxable income, the enterprise shall, in addition to what is required pursuant to the relevant provisions in Chapter 3 hereof, prepare, reserve, and submit current materials based on the requirements of taxation authorities. It shall demonstrate that the debt investment amount, interest rate, term, financing conditions and debt to equity ratio are in line with the arm’s length principle by including the following contents:
(1) Analysis of the borrower’s solvency and borrowing capacity;
(2) Statement on the borrowing capacity and the financing structure of the group;
(3) Statement on any changes in equity investment, such as the enterprise’s registered capital;
(4) The nature, purpose, and market situation of the associated party debt investment;
(5) The currency, amount, interest rate, terms, and financing conditions of the associated party debt investment;
(6) The conditions and terms of the collateral provided by the enterprise;
(7) The conditions of guarantor and terms of the guarantee;
(8) The interest rate and financing conditions of loans of similar nature and terms;
(9) The conversion condition of the convertible bonds; and
(10) Other supporting documents that can prove the compliance with the arm’s length principle.
3. Interpretation on the measures regarding anti-avoidance of thin capitalization
Heads-up from international tax department of Hwuason:
1.How to define debt investment and equity investment?
Although article 119 of Regulations on the Implementation of Enterprise Income Tax Law of the People’s Republic of China has stipulated the definition of debt investment, with the invention of increasingly numerous financial instruments it is hard to define debt investment specifically and enterprises shall focus on the nature of the investment.
2. The treatment of an enterprise engaging in tow kinds of business
In accordance with relevant regulation, the interest expenses actually paid by the enterprise to the related party shall conform to the debt-to-equity ratio specified below: (1) 5:1 for financial enterprises; and (2) 2:1 for other enterprises. n case that the enterprise is engaged in both financial business and non-financial business, the interest expenses actually paid by the enterprise to the related party shall be calculated separately using a reasonable method; in case of failure to calculate separately using a reasonable method, the deductible pre-tax interest expenses shall be calculated in accordance with the proportion applicable to other enterprises specified in Clause 1 of Notice.of the Ministry of Finance and State Administration of Taxation on Taxation Policies Relating to the Standard for Pre-Tax Deduction of Interest Expense of Related Parties of the Enterprises.
3. Enterprises are facing an increased risk of anti-avoidance for thin capitalization
China taxation authorities have expanded the area of anti-avoidance inspection to related equity, intangible assets transfer and financing. Compared with complicated related transaction, such as intangible assets transfer and equity transfer, relevant laws and regulations have specified the ratio between related debt investment and related equity investment and enterprise involving in related financing shall disclose related information during the annual settlement. Therefore, competent taxation authorities could easily find the thin capitalization problem of enterprises in the taxation collection and management system and conduct further investigation. Hwuason lawyers advice enterprises with huge amount of related financing shall review the reasonableness of related transaction arrangements in order to decrease the risk of transfer pricing. Additionally, where enterprises intend to deduct the interests exceeding specified ratio, they shall prepare and keep CPT documentation upon the request of competent taxation authorities, proving related financing arrangement comply with arm’s length principle.
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I. Enterprise income tax law (EIT Law for short hereafter) and its implement rules.
Article 2 of EIT Law: For the purposes of this Law, the term “resident enterprises” shall refer to enterprises that are set up in China in accordance with the China law, or that are set up in accordance with the foreign laws but with “Place of effective management” in China. Article 4 of enterprise income tax law implements rule “Place of effective management” as stated in Article 2 of the EIT Law shall refer to an establishment of an enterprise that exercises substantially overall management and control over the production and business, personnel, accounting, properties, etc.
II. Circular No. 82
For enterprises registered outside China in accordance with foreign laws with enterprises or enterprise groups as main controlling investors, if enterprises’ place of effective management is within China, it could be recognized as resident enterprises of China.
III. Circular No. 45
To an overseas enterprise with dual resident status after recognized as a resident enterprise of China, the tax treaties or agreements signed between China and relevant countries or regions will be applied.
In general, article 4 of tax treaties or agreements “resident” clause will confirm the application scope of parties and double taxation due to dual resident status.
The main content of article 4 item 1 is resident recognition in accordance with domestic laws and regulations. For example, article 4 item 1 of tax agreement between mainland and Hong Kong is about resident recognition according to mainland law and Hong Kong law, resident here includes enterprises and individuals.
Double taxation solution is always in article 4 item 2 and 3. Item 2 is about individuals while item 3 is about enterprises.
According to tax treaties, if an enterprise is recognized as resident by both two countries, the taxation power belongs to the country where the place of effective management is located in.
For example, tax treaty between China and Canada stipulates that, to dual resident, contracting parties shall solve it through negotiation and communication. While the tax agreement between mainland and Hong Kong stipulates to dual resident enterprises, the place of effective management prevails. However, tax treaty between China and Japan stipulates that to dual resident enterprises, head or main office prevails.
Suppose Enterprise B is set up in Hong Kong under Hong Kong laws, the place of effective management of B is in China mainland. Under Hong Kong law, B is resident for registering in Hong Kong, and according to Chinese mainland law, B is resident as well due to the place of effective management. Hence, B gains dual resident status. According to tax agreement between China mainland and Hong Kong, the place of effective management prevails. Therefore, B will be deemed as resident enterprise of China mainland.
IV. OECD model
Article 4 of OECD is also about resident recognition, which is reference for enterprises. But if there is explicit rules in tax treaties, tax treaties prevail. OECD stipulates: For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature. Where by reason of the provisions of paragraph 1, if an individual is a resident of both Contracting States, then his status shall be determined as follows:
i. he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);
ii. If the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode;
iii. If he has a habitual abode in both States or in neither of them, he shall be deemed to be a resident only of the State of which he is a national;
iv. If he is a national of both States or of neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement. Also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein. Where by reason of the provisions of paragraph 1, a person other than an individual is a resident of both Contracting States, and then it shall be deemed to be a resident only of the State in which its place of effective management is situated.
SAT issued “Circular on income tax management measures of resident enterprises registered inside China (Trial)” on July 27th 2011, and made detailed rules on tax management of resident enterprises registered outside China. There are two forms to “resident enterprises registered outside China” recognition, one is enterprise application and the other is tax authorities’ investigation. According to the previous rules, enterprise could submit application of “resident enterprise registered outside China” to tax authorities of location where the actual management is or the main Chinese investors are. The resident enterprise registered outside China will be deemed as resident enterprise in tax management.
The main difference between resident enterprise and non-resident enterprise is tax treatment of dividend and such equity investment. The dividend income of “resident enterprises registered outside China” gained from other resident enterprises inside China will be exempted from income tax. However, to non-resident enterprises, it should pay income tax at 10% tax rate.
The recognition conditions to the “resident enterprises registered outside China” are:
i. High management and department location in charge of daily operation and management are in China;
ii. The financial decision and personnel decision are decided or approved by persons or institutions in China;
iii. The main assets, accounting books, seals, and vital documents, such as board decisions, are in China;
iv. The director or higher management with half voting right or above, should often live in China.