Posted by Shi Zhiqun on December 31, 2009 under China Tax | 
Many readers may have come across the many different types of tax regulations and policies in China – such as Caishui, Guoshuifa, Guoshuian etc. This can all be quite confusing at times so we thought that we would attempt to clarify how the laws, regulations etc interact. We will use the Enterprise Income Tax system as an example.
Basic Law
The taxation of enterprises is governed principally by the Enterprise Income Tax Law which was promulgated by the National People’s Congress (China’s governing parliament). The EITL is what is referred to as a Basic Law. This is the fundamental law underpinning a certain legal area (in this case the income taxation of enterprises). The NPC only meets once a year so Basic Laws can be very difficult to change. It can take up to ten years from an initial draft stage to the promulgation stage. Also, as with any political system, the more decision makes involved in a process the more highly politicised an issue will be. As such, Basic Laws are usually very … basic. They tend to be quite short and vaguely drafted in order to accomodate change at the level of regulations and to obtain a broad consensus.
Implementing Regulations
The next document in respect of enterprise income taxation is the Implementing Regulations of Enterprise Income Tax Law which is issued by the State Council. Now we start to get a bit more substantive. The State Council meets on a regular basis and is a relatively small group (in contrast to the NPC). The Implementing Regulations puts the meat on the bone of the EITL. However, once again the Implementing Regulations are not overly detailed and leave a lot to the imagination (or the tax authorities). Implementing Regulations are basically drafted by the SAT and signed off by the State Council.
Circulars and Measures
There are a number of different circulars and measures that are issued at different levels of the tax administration including the following:
- Guofa - these are circulars issued by the State Council. These are usually very short and confined to a single issue or topic area;
- Caishui – these are notices jointly issued by the SAT and the Ministry of Commerce;
- Guoshuifa (or Measures) – these are issued by the State Administration of Taxation and can be quite detailed. In 2009 the SAT issued Guoshuifa (No 2) a very detailed range of measures on anti-avoidance practices.
- Guoshuihan – these are internal circulars issued by the SAT to the various provincial and local level SATs and local taxation bureaus outlining policy practice in respect of a certain area. In early December 2009 the SAT issued Guoshuihan [698] 2009 which outlined a new practice in respect of the taxation of off-shore equity transactions.
From a theoretical legal perpsective, the regulations higher up the end of the chain will have more force. For example, if a Guoshuihan circular contradicts a Caishui circular, the latter will prevail. However, in practice they are all fairly equal in terms of the need to be obeyed. Whilst Guoshuihan circulars are only internal policies, they effectively reflect the terms of the superior Laws and Regulations themselves, or at least the SAT’s interpretation of those Laws and Regulations.
To make things more confusing, these are just the regulations issued at a national level. Each provincial level SAT and, in fact, each provincial taxation bureau have their own set of regulations and policies.
Posted by Matthew on December 29, 2009 under Corporate Tax Planning |
The State Administration of Taxation (“SAT”) has, in a circular issued on 11 December 2009, indicated its intention to target off-shore transactions involving the indirect transfer of Chinese enterprises (Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-resident Enterprises Guoshuihan [2009] 698) (“Circular 698”). Circular 698 represents the latest challenge to off-shore holding company or special purpose vehicle structures in China.
Common Off-shore Holding Company Structure
The attached is a very common off-shore holding structure in China (often referred to as a vanilla off-shore structure). Refer to the attached for an understanding of the abbreviations used throughout the article.
There are a number of reasons, including non-tax reasons, why inbound investments in China are structured in this fashion. One of the principal tax reasons, and relevant in terms of Circular 698, is the ability to effectively sell China Co, through transferring the equity interests in H Co, without incurring any tax liability in respect of that sale. The transfer of equity in a Chinese resident companies gives rise to tax liability. However, strictly speaking, no tax liability will arise in respect of the sale of an off-shore company by a non-resident shareholder.
The qualification to this is Article 47 of China’s Enterprise Income Tax Law which is a general anti-avoidance rule (“GAAR”). Article 47 relevantly empowers the SAT to make an adjustment where an arrangement has been entered into that has no reasonable business purpose and results in a reduction in taxable income.
Circular 698
Circular 698, effectively, operates in two scenarios; the direct sale of a Chinese resident enterprise and the indirect sale of such an enterprise. It first should be noted that there is an exception to Circular 698 with respect to listed shares. However, it is doubtful that this exception would apply to shares that subsequent to acquisition are listed on the stock exchange.
Direct Sale of Chinese Resident Enterprise
A direct sale of a Chinese Resident Enterprise refers to where the Chinese enterprise is sold as opposed to the holding company (H Co in the structure outlined above).This aspect of the Circular is relatively uncontroversial. It simply requires a non-resident to declare and pay any enterprise income tax with respect to the transfer of equity in a Chinese resident enterprise where such payment is not made, or is unable to be made, by the relevant withholding agent. Payment of such tax must be made within 7 days of the agreed equity transfer date.
Indirect Sale of Chinese Resident Enterprises
In Circular 698, relying upon the GAAR in Article 47, the SAT indicates that in certain circumstances the sale of H Co will give rise to a tax liability in China for A Co – the authorities effectively deem the transaction to be a sale of China Co. The circumstance that may give rise to such tax liability is where the SAT has formed the view that the arrangement (i.e. interposing the off-shore holding company as the shareholder of China Co) has no reasonable business purpose.
Circular 698 also contains a mechanism that aims to assist the SAT with enforcing these new rules – documentation disclosure requirements. In accordance with paragraph 5 of the Circular, where the tax rate of the jurisdiction in which H Co is a resident is less than 12.5% or the jurisdiction does not tax foreign sourced income, upon transferring the equity in H Co, A Co is required to provide the following documents to the local tax authority (within 30 days of the contracts being signed):
- The equity transfer contract or agreement;
- The relationships between the A Co and H Co on funds, management, procurement and marketing;
- H Co’s production, management, personnel, finance and property conditions etc;
- The relationship between H Co and China Co on funds, management, procurement and marketing;
- The proof of a reasonable business purpose on setting up H Co by A Co;
- Other relevant information required by the taxation authority.
Circular 698 is stated to apply from 1 January 2008 (the date that the Enterprise Income Tax Law became operable). This is a relatively draconian measure although it could be argued, as I am sure the SAT would contend, that the Circular is consistent with the spirit of Article 47 of the Enterprise Income Tax Law and therefore taxpayers have been put on notice that such arrangements are no longer acceptable. Further, the SAT has provided strong indications throughout 2009 that it intends to aggressively target such arrangements. In light of such circumstances, it is arguable, that the retroactive aspect of the Circular should not be considered harsh. Regardless of whether it is fair, the Circular permits the tax authorities to review any off-shore transactions that occurred from 1 January 2008 to date.
Paragraph 7 of the Circular empowers the tax authorities to make a tax adjustment where a transfer of equity in a Chinese resident enterprise is made to a related party and the consideration for the transfer is less than the arms-length price for the equity.
Implications of the Circular
The Circular challenges the traditional structures for investing into China and as such requires all companies to review their current structures. Our discussions with the SAT in relation to the Circular have indicated that they do not intend to utilize it arbitrarily or aggressively.
Importantly, taxpayers will not be subject to tax under Circular 698 where they can establish a reasonable business purpose for the existence of H Co. Accordingly, a critical issue is what will be a “reasonable business purpose”. No definition or clarification of the meaning of “reasonable business purpose” has been provided by the SAT up until present and, accordingly, there is a question mark over the breadth of the term. In particular does “business” have wide or narrow meaning – it is our understanding that the SAT favours the view that “business” requires the purpose to be reasonable in the context of the business operations of the Chinese resident enterprise. A wider interpretation may suggest that a transaction that is entered into to further a commercial objective for the company or its shareholders may have a reasonable business purpose. For example, could interposing H Co for the purpose of enabling an easy transfer of the Chinese resident enterprise (i.e. without the regulatory red tape of an on-shore transaction) be a “reasonable business purpose”. Although such an interpretation is open on the language of Article 47 of the EITL, it is likely that the SAT will resist, for obvious reasons, any attempts to base a “reasonable business purpose” on such motivations.
Finally, it should also be noted that Circular 698 should be read in conjunction with Circular 601 – a notice by the SAT in respect of the term “beneficial owner” contained in China’s tax treaties. These circular together establish the SAT’s approach to the use of special purpose vehicles.
Remaining questions
Enforcement
The SAT will face a number of challenges in enforcing Circular 698. Over the past year there are been an increased willingness by taxation authorities worldwide (including some low-tax off-shore jurisdictions) to cooperate with respect to information exchange in taxation affairs. Despite this, it will still be extremely difficult for the SAT to police all off-shore transactions. One has to assume that Circular 698 will be targeted at big-ticket transactions rather than the average sale of a Chinese enterprise. Consistent with this, early indications have been that Circular 698 will be used fairly conservatively by the tax authorities and ordinary transactions will not be targeted. However, it would not be safe to rely upon these matters in the absence of taking appropriate action to ensure that your holding company structure is compliant with the Circular.
Interaction with Double Tax Agreements
Article 58 of the EITL provides that the provisions of any income tax treaties between China and a foreign government will prevail inthe case of any inconsistency with the EITL. Accordingly, it must be presumed that Circular 698 is subject to the terms of any relevant income tax treaty. Importantly, there would seem to be a few income tax treaties that would assist arrangements to fall outside the terms of the Circular. For example, Article 13 of the China-Mauritius tax treaty generally prevents China, in respect of a company resident in Mauritius, from taxing capital gains from shares where the holding is less than 25% (except where such income represents gains from the alienation of a permanent establishment.) Unless it can be established that China Co is a permanent establishment of H Co, for holdings of less than 25% in China Co, no taxable event would seem to arise on a direct transfer of shares in China Co by H Co.
Importantly, Article 5(7) of the China-Mauritius income tax treaty would generally prevent China Co from being considered a permanent establishment of H Co. A direct transfer of a less than 25% interest in China Co by a H Co based in Mauritius would appear to not give rise to taxation in China and in which case Circular 698 would have no application. The Chinese tax authorities could invoke the GAAR generally to such an arrangement, although as yet there has been no indication that the SAT intends target such arrangements. The important point is that the transaction would be outside the terms of Circular 698 and back in the more vague territory of the GAAR.
Extra-Territoriality
One of the common criticisms of the Circular since it was issued has been the perceived extra-territorial nature. Apart from the documentation disclosure requirements, such criticisms would seem to be misguided. Whether we like it or not, it is a generally accepted principle of taxation that tax may be imposed by a country on non-residents in respect of income sourced from that country. The terms of the OECD Model Tax Treaty accept and generally endorse this principle. It is also a generally accepted principle of international taxation, once again whether we like it or not, that tax authorities are entitled to look beyond the form of a transaction where the particular form has been chosen for the purpose of avoiding or minimising tax liability (that is, where the domestic legislation permits them to do so). Once we accept both these principles, it is difficult to contend that the SAT is not entitled to take the steps (that is, disregarding H Co for tax purposes where there is no reasonable business purpose for its existence) outlined in Circular 698.
Attempts have been made to compare the Circular with the ongoing dispute between Vodafone and the Indian tax authorities, presently before the Indian High Court, in respect of Vodafone’s off-shore acquisition of Hutchinson Essar. In truth, such a comparison is poor one because India did not have a GAAR in its tax code at the relevant time. The ability of tax authorities to tax off-shore transactions in the absence of a GAAR will usually be questionable and hence why reference was made to the United States’ “doctrine of effects” – the principle that US competition law can apply to acts outside of the US where those acts have an “effect” inside the US – before the High Court in India.
Conclusion
Whilst Circular 698 represents a fundamental shift in the tax treatment of off-shore equity transactions in China, it should come as no surprise given the developments in China’s international tax regime over the past 24 months. Neither is the Circular inconsistent with general international legal principles as some have claimed. It is, however, imperative for all foreign investors that have utilised an off-shore company for investing into China to undertake a review of their current structure and implement any necessary changes.
Posted by Li Wei on December 28, 2009 under China Law |
A foreign investor has several options that it can use to establish a business presence in China. The option selected will vary, depending on the type of business activity, and the business plan formulated by the investor. The following are the common legal structures that can be used for foreign investment in the China:
- Representative Office
- Joint Venture (Cooperative or Equity)
- Wholly foreign owned enterprise
- Partnerships (see here http://www.chinataxblog.com/?p=86)
Representative Offices (ROs)
ROs are not separate legal entities but rather are extensions of the parent company. They are limited in the activities that they can undertake. Permitted activities include the general promotion of the parent company, market research and arranging contracts with customers of parent company. Importantly, they are not permitted to engage in direct sales activities nor sign any contracts. Employees of ROs are employed through special employment agencies. ROs are generally being phased out with the growing liberalization of China’s foreign investment laws – at one time ROs represented one of only ways that some foreign companies could enter China. One of the problems with ROs today is that they are generally taxed on a revenue basis as opposed to a profits basis. Previously, it was not difficult to obtain tax free status for ROs to avoid such a method of taxation. However, the tax authorities no longer generally provide such status for ROs.
Wholly foreign owned enterprises (WFOEs)
As the name implies, WFOEs are entities that are wholly foreign owned. There are restrictions on WFOE establishment in China and, as a result, the WFOE structure can only be used in certain business sectors. The amount of business sectors permitted to use a WFOE has grown over the past 5 years as China has implemented its WTO commitments. As WFOEs have minimum registered capital requirements. Under the Company Law of China this requirement is a mere RMB30,000. However, in practice the authorities in China have demanded significantly more capital depending upon the nature of the industry. A unique feature of China’s corporate laws is that all companies must have a prescribed business scope and are strictly only permitted to operated their business within that scope. The required registered capital is tied to the nature of the business scope. Registered capital is required to paid in within 2 years of the company first being established.
Joint Venture (JV)
The JV is the most traditional form of operating structure for foreign investment in China and, previously, was the only vehicle available to foreign investors for many years. There are two types of JV structures: Equity Joint Ventures (“EJVs”) and Cooperative Joint Ventures (“CJVs”). The major difference between the two structures is that partners in an EJV must pay in registered capital and derive profits directly in proportion to the equity invested, with the assets owned in proportion to equity holdings. As the industries in which WFOEs have been permitted to operate have widened, the use of JVs have decreased. There are a number of horror stories of failed JV experiences in China. However, there have also been some very successful cases. With the greater liberalization of China’s foreign investment restrictions, the relevance and need to use the JV model has lessened. Although, in the right circumstances JVs still remain an important business model for operating in China, particularly where the relevant industry is restricted by China’s legal guidelines.
Posted by Matthew on December 25, 2009 under China Tax, Corporate Tax Planning |
State Administration of Taxation notification on strengthening corporate income tax management on non-resident enterprises equity transfer income No. 698 (2009)
To State Administration of Taxation & local Taxation Bureau of each province, autonomous region, municipality and city specifically designated in the state plan:
In order to regulate and strengthen the corporate income tax management on equity transfer income, based on the “Enterprise Income Tax Law of The People’s Republic of China” and its implementing regulations, “Tax Collection and Administration Law of The People’s Republic of China” and its implementing regulations, “State Administration of Taxation Notification on issuing ‘Non-resident Corporate Income Tax Source Withholding Interim Measures’’ (No. 3 (2009)), and “Ministry of Finance State Administration of Taxation Notification on Issues Dealing With Corporate Income Tax on Enterprise Restructuring Business (No. 59 (2009)), there are a number of notices as follows:
- The equity transfer income mentioned in this notification refers to equity transfer income of Chinese resident enterprise shares from a non-resident enterprise. (Buying and selling Chinese resident enterprise shares listed on a stock exchange are not included).
- If withholding agent is unable to perform withholding obligations or doesn’t pay according to the Law, the non-resident enterprise shall declare and pay corporate income tax with the relevant tax administration authority where the Chinese resident enterprise registered at (the authority who is in charge of the corporate income tax collection and management of the Chinese resident enterprise) within 7 days after the agreed share transfer date according to the equity transfer contract or agreement (if the transferor obtains income from the transfer in advance, then the date should be the actual date when the equity transfer income occurs). Non-resident enterprise that does not declare truthfully or /and pay their tax on time will be dealt with according to the relevant tax collection and management laws and regulations.
- Equity transfer income refers to the difference between equity transfer price and the actual share cost. Equity transfer price refers to the income the share transferor received which may be in the forms of cash, non-monetary assets or equity. If the invested enterprise has undistributed profit or holds various after-tax funds, the amount from stockholders retained earnings right that is transferred together with the equity from the transferor will not be deducted from the equity transfer price. Actual share cost refers to the actual investment amount paid by the transferor to the Chinese resident enterprise at the time it invested in the shares, or the actual equity transfer price paid to the original transferor at the time buying those transferred shares.
- When calculating the equity transfer income, the currency used when the non-resident enterprise invested in the Chinese resident enterprise or purchasing the equity from the original investor will be used to calculate the equity transfer price and equity transfer cost price. If the same non-resident enterprise has invested in multiple times, the currency used in the first calculation will be used to calculate equity transfer price and equity cost price, weighted average method will be used to calculate equity cost price; if the currencies of each investment are not the same, the amount should be calculated in the currency used in the first time with the exchange rate on the day of each investment occurred.
- When a foreign investor (the actual controlling party) transfers a Chinese resident enterprise equity indirectly, if the actual tax rate margin is lower than 12.5% in the country (region) where the transferred offshore holding company is located or the country (region) doesn’t levy income tax to its resident on overseas income, then the enterprise needs to provide the following information to the tax administration authority where the Chinese resident enterprise registered with within 30 days after the signing of the equity transfer contract:
a. The equity transfer contract or agreement;
b. The relationships between the foreign investor and the offshore holding company on funds, management, procurement and marketing;
c. The offshore holding company’s conditions on production, management, personnel, finance and property etc;
d. The relationships between the offshore holding company and Chinese resident enterprise on funds, management, procurement and marketing;
e. The proof of a reasonable business purpose on setting up the offshore holding company by the foreign investor;
f. Other relevant information required by the taxation authority.
6. If a foreign investor (actual controlling party) transfers the equity in a Chinese resident enterprise equity indirectly via arrangements such as through the misuse of the corporate form without a reasonable business purpose to avoid corporate income tax liability, the relevant tax authority, after report for investigation from the State Administration of Taxation, holds the right to re-characterise the equity transfer deal according to the economic substance and ignore the existence of the offshore holding company used for the tax arrangement.
7. If a non-resident enterprise transfers the equity in a Chinese resident enterprise to a related party and the transfer price is not in line with the arms length principle for the purpose of reducing taxable income, the relevant tax authority holds the right to make adjustment according to general practice.
8. If a foreign investor (the actual controlling party) transfers the equity in several native or offshore holding companies’ simultaneously, the Chinese resident enterprise whose equity is transferred should provide the whole transfer contract and supplementary contract to the relevant taxation authority. If there is no supplementary contract, the Chinese enterprise should provide detailed information on each transferred holding company to the relevant taxation authority, the transfer price for each native enterprise need to be clarified. If the price cannot be separated, the taxation authority holds the right to choose a reasonable approach to make adjustment to the transfer price.
9. If a non-resident enterprise who has obtained equity transfer income is eligible for special tax treatment according to the special organization restructuring requirement (Tax No. 59 (2009)), the enterprise should submit information in writing that provide proof of meeting the whole requirement for record-keeping purpose to the relevant taxation authority and get approval from provincial taxation authority.
10. Implementation of this notification starts on January 1, 2008. If you encounter any problem regarding implementation, please report to the State Administration of Taxation (International Taxation Division). Issued on December 10, 2009
Posted by Matthew on December 23, 2009 under Corporate Tax Planning |
Circular 698 is a Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-resident Enterprises. The critical aspect of Circular 698 is that it requires foreign entities to disclose the indirect sale of Chinese enterprises – that is when a holding company that owns a Chinese enterprise is sold. The reason for this is that transfers of Chinese enterprises are subject to tax (in the case of foreign entities this is a 10% withholding tax). Notice of such a transfer (and stipulated documentation in respect of the transder) must be given to the Chinese tax authorities within 30 days of the agreement being signed.
Tax authorities in China had recently used China’s general anti-avoidance rule to the same effect (see the Chongqing and Xinjiang cases). However, this Notice is a far more direct approach and indicates the SAT’s aggressive position in respect of these types of transactions.
A translation of the Circular will be posted shortly. For now more information on Circular 698 can be found here.
