Issued at the end of December 2009 by the State Administration of Taxation (SAT), Circular 698 has caused a stir in the Chinese market. The circular states the grounds on which the authorities may tax a foreign company that indirectly transfers an equity ...
[more]
Issued at the end of December 2009 by the State Administration of Taxation (SAT), Circular 698 has caused a stir in the Chinese market. The circular states the grounds on which the authorities may tax a foreign company that indirectly transfers an equity interest in a subsidiary in China. The law applies retroactively, giving the tax authorities the licence to investigate any transaction from January 1 2008.
"Circular 698 is actually the biggest change in the Chinese tax system in the last decade," said Brendan Kelly of Baker & McKenzie. "Circular 698 signalled a trend where the Chinese tax bureau has been more aggressive enforcing anti-avoidance rules."
In May 2011 the SAT confirmed that they are prepared to launch 698 investigations based on unofficial information.
Information was released about a dispute where the local tax office launched an investigation after uncovering publicly available information from the internet describing an offshore transaction involving a Chinese operating company.
An investigation by the Shantou Municipal State Tax Bureau revealed that a British Virgin Islands (BVI) company sold a wholly owned subsidiary, which through a number of other holding companies owned a Shantou company, to another BVI company in November 2010.
The Shantou tax office concluded that the transaction lacked a reasonable commercial purpose and the offshore transfer should be deemed as a direct transfer of the Shantou company. This would mean that the offshore transfer should be subject to Chinese capital gains tax.
The result was that the BVI seller paid the SAT Rmb7.2 million ($1.1 million) in March 2011.
This case shows how the SAT is prepared to launch investigations into offshore transactions involving Chinese subsidiaries based on information collected from other channels, though the non-resident sellers have not voluntarily reported the transaction under Circular 698.
This adds little to the understanding of Circular 698 because the facts of the case were indisputable that all the intermediate holding companies were special purpose vehicles with little reasonable commercial purpose outside of avoiding China tax.
This case also provides little insight into the more difficult questions raised by Circular 698, such as what constitutes a reasonable commercial purpose and what is the relationship between reasonable commercial purpose and economic substance.
Controversy
Tax controversy in China has gained momentum in the last 12 months partly due to greater sophistication from tax officials. Taxpayers have expressed concern about numerous complex tax matters, that not only include the taxation of indirect transfer of investments in China, but also permanent establishment issues, entitlement to treaty benefits, taxation for corporate restructuring, and increasing tax controversy cases.
"Tax is becoming more and more important to the government," said Peter Ni of Zhong Lun Law Firm. "China is trying to cool down the real estate market because government revenue from selling land is decreasing significantly. Therefore, [the tax authorities] have to be more aggressive in order to maintain the revenue status quo."
Professionals in the market agree that the tax authorities in China have become increasingly aggressive. As a result, a heightened number of tax challenges are expected to reach the courts. "Tax disputes will increase," said Kelly. "While it hasn't become much of a reality for multinationals, it will."
There has been recent movement on the treaty front, with numerous firms looking to claim entitlement to treaty benefits. However, claiming these benefits is not a simple process.
"Tax treaty benefits are not automatic," said David Liu, partner at Jun He Law Offices. "Taxpayers need to apply for residency from a tax treaty jurisdiction before they can benefit from the treaty."
Tax professionals have observed increasing activity in all sectors over the last 12 months, in particular the state-owned enterprise (SOE) and domestic sectors. SOEs are paying more attention to tax risk management due to their expansion into both domestic and overseas markets, as well as intensified scrutiny from the tax authorities.
In March 2011, the Chinese government passed the 12th five-year plan, which is to run until 2015. The plan aims to rebalance China's economy, shifting emphasis from investment towards consumption. It also seeks to tackle rising wealth inequality, improve social safety nets and infrastructure, and create an environment for more sustainable growth. New laws are expected to be implemented concerning VAT and green tax, via a tiered approach starting with a few selected industries.
"The 12th five-year plan focuses on VAT reform and individual income tax reform," said Ni. "VAT currently applies only to goods not services. The other tax is business tax, which is similar to sales tax in the US. Under the plan, the intention of the Chinese government is to move some items currently on the business tax regime to the VAT tax regime. Eventually, the government might want to unify the two regimes into one single VAT regime."
Transfer pricing
A transfer pricing dispute from early 2011 emphasised the country's shift from enforcement and administration towards complex transfer pricing issues and alignment with internationally recognised practices.
It is believed the tax authorities did their own valuation work in the dispute, rather than rely on external advisers.
The case related to the conclusion and reporting of a valuation of capital gain in an equity transfer transaction in Dalian, a city in northeast China, where a multinational company agreed to pay corporate tax worth Rmb11 million on the capital gain.
The dispute came only months after the SAT released Circular 84 which explained that the SAT will be paying more attention to equity transfer cases to identify and counteract tax avoidance.
Little information is known about the Dalian case. However, it is known that the company undertook an internal corporate restructuring by transferring shares of a number of Chinese companies between certain foreign companies within the same group at cost.
The local tax office did not agree that cost was the correct price to use. They insisted that the arm's-length principle should apply even for an internal corporate restructuring transaction. The authorities argued that the company use the income approach to arrive at the fair value of the shares and so make the adjustment accordingly.
[hide]