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By Matthew Wong, Jane Wang, and April Ma, PwC China
Foreign banks are experiencing a rapidly changing environment in China with revenue authorities engaging in intense tax audits in which they challenge financial transactions that take aggressive positions that in many cases generally are inconsistent with established international tax norms. This environment more recently has been fueled by Chinese tax authorities seeking revenue to address government plans to stimulate and stabilize the economy.
Tax bureaus all over China are engaging in intense tax audits and pressure has been exerted on the tax enforcement and collection process. As a result, Chinese tax officers have become more aggressive in the corporate tax arena, leading to significant assessments in virtually all areas of direct income tax and indirect tax. In particular, the volume of tax audits is rising for the banking industry in China, creating an uncertain environment for foreign bankers.
This article seeks to highlight the current tax audit landscape for foreign banks in China.
The Chinese tax authorities have been shifting to pursue more modern approaches with respect to tax audits. Specifically, they have focused on large business enterprises (“LBEs”) as these taxpayers are a key source of tax revenue.
China's tailored approach to the tax administration of Large Business Enterprises (LBEs) is still in an early stage of development. Three years ago, the PRC State Administration of Taxation (SAT) established a Large Business Tax Department and short-listed 45 large business enterprises (including domestic enterprises and MNCs) at a national level to be directly managed by SAT. These enterprises are subject to customized tax administration which is considered to be more appropriate given the scale and complexity of the operations of these taxpayers.
Among the national LBEs short-listed by SAT are a number of large banks and financial services groups. Meanwhile, local tax authorities in different cities and provinces have echoed SAT's LBE tax administration initiatives. As a result, they have started to identify LBEs with operations within their geographic purview for customized tax administration.
Foreign banks in China generally manage a large asset portfolio with complicated operations covering multiple locations. These banks generally have more sophisticated financial transactions, cross-border funding and forex dealings as well as trading of complex financial products such as derivatives. They are vulnerable to be selected as LBEs by local tax authorities, which could then mean more scrutiny and a more stringent approach to tax administration.
If a foreign bank in China were to be selected as an LBE, the tax authorities will generally perform robust tax risk management assessments on the bank and its operations. If the tax authorities conclude that the bank has failed to establish effective internal tax risk control systems, they may classify the bank as having a high tax management risk. Thereafter, more stringent tax administration is likely to be enforced, including more frequent tax audits on the bank to ensure the bank's proper tax compliance.
Foreign banks anticipating that they may be selected as an LBE may need to strengthen their internal tax risk control systems, in particular, on the following aspects:
In addition, foreign banks should also observe the following SAT Guidelines as the benchmark in assessing their existing tax risk management function effectiveness and take actions to improve it if necessary.
China's current situation is quite unique in that revenues from indirect taxes (>60 percent) have been far greater than those from direct tax (<40 percent) for quite some time. This is particularly relevant to the banking industry as banks in China have a heavy indirect tax burden, i.e. the 5 percent business tax on financial service income. China's business tax regime continued to be one of the biggest tax challenges to foreign banks.
The existing business tax regime set out four separate buckets of financial service income, each designated for a distinct category of transactions: foreign exchange, stocks (equity), bonds and others. The existing regulations, which have been developed for almost two decades, restrict the assessment of taxable gains and losses among different buckets of transactions and over periods of time. As a result, losses in one bucket cannot be used to offset profits in another buckets, even if they occur within the same period.
This regime does not consider the commercial realities that exist in modern financial markets, in which best market practices require that overall transactions actually consist of multiple transactions. Further, the current rules appear to ignore the volatility of transactions during business cycles that often play out well beyond the boundaries of one year. Consequently, the existing business tax system may lead to imbalanced and unfavorable tax consequences over the long term due to the fact that the tax structure was not designed to consider the realities of the business cycle on a series of financial transactions rolled out over an extended period of time. Meanwhile, controversies and disputes may arise during tax audits where the bank is found to execute transactions to try to avoid these imbalanced and unfavorable business tax results.
Recently, foreign banks' transfer pricing practices are subject to closer scrutiny by the PRC tax authorities during tax audits.
Interbank funding transactions with overseas affiliates or head offices are one of the key challenges during the tax audits on foreign banks in China. In a typical tax investigation, the bank has to prove to the satisfaction of the tax inspector that not only the interest rate charged on the interbank funding with overseas affiliates is reasonable but also the bank has strictly complied with the PRC thin capitalization rules. Such rules require that banks in China cannot have a related party debt-to-equity ratio exceeding 5:1 unless the banks can provide robust transfer pricing documentation to support that the interbank funding arrangements comply with the arm's length principle.
Another common transfer pricing challenge on foreign banks in China is the outsourcing charges paid to overseas head office or affiliates. Typically, foreign banks in China may outsource back-office functions and processing support services to their overseas parent or a regional hub outside of China. Services that are outsourced often include the processing of contracts, information technology support, product development, product specific accounting and finance support. Meanwhile, the size of support service fees charged to foreign banks in China has increased significantly in recent years because of their rapid expansion in China.
Accordingly, this subject has become an area of focus during tax audit. Most foreign banks have global policies determining their pricing of support services and head office support and in many cases that there is also global transfer pricing documentation describing the pricing mechanism. Careful explanation of such policies and documentation to the PRC tax inspectors are required in order to defend that these service fees are charged on an arm's length basis.
An Advance Pricing Arrangement (“APA”) is an arrangement between a taxpayer and the tax authority setting out, in advance of inter-company transactions, the method for determining the transfer pricing for those transactions. APA programs are designed to resolve actual or potential transfer pricing disputes in a principled, cooperative manner, as an alternative to the traditional dispute resolution process, e.g. transfer pricing audit and defense.
APAs can be unilateral, bilateral and multilateral. A unilateral APA is an arrangement between a taxpayer and the competent Chinese tax authority while a bilateral or multilateral APA involves one or more competent authorities of China's tax treaty countries. APAs may cover a wide variety of transactions such as intercompany, provision of services, loan transaction, etc.
In China, APAs are increasingly used by multinational corporations to reduce tax audit risks. Foreign banks anticipating tougher transfer pricing audit by the PRC tax authorities may seek to negotiate for an APA.
Meanwhile the PRC tax authorities are also engaging in a strategic approach with respect to APAs. Although widely encouraged and promoted by the SAT, they only plan to focus on “important” cases by prioritizing APAs involving high risk, large amounts, or complex functions.
The Chinese tax authorities are gradually shifting from a collection-administration approach to a risk-assessment approach with respect to tax audits and administration with the aim of increasing both time and resource efficiencies. The authorities are now focused on certain areas such as transactions and offshore structures involving low or no tax countries. In addition to detecting on specific “suspicious” transactions, the Chinese tax authorities are also concentrating their efforts on key industries and groups.
In the past, some banks may have tried to explore the opportunities to carry out structured finance transactions in China with a view to generating tax benefits for themselves or for their clients.
It is crystal clear that the concepts of general anti-avoidance, beneficial ownership and anti-treaty-shopping are under the radar scheme of the PRC tax authorities. Structured finance schemes without real business substance are vulnerable to attack by the PRC tax authorities.
The use of fake invoices to create falsified expense records have become a widespread problem to tax authorities in China. It has become a standard procedure in most tax audit cases that tax inspectors would conduct a robust review of the supporting invoices on the taxpayer's disbursement records.
Given that bankers normally claim significant entertainment and travelling expenses during their normal course of business which may be vulnerable to abuses, tax inspectors in China would develop specific tasks in their bank audit program to try to uncover any weakness of the target's invoice administration practice. In the last two years, the Chinese tax authorities have made significant tax adjustments in a number of bank tax audit cases whereby a large volume of the banks' normal business expenditures, including hotel charges, travel agency fees, entertainment expenses and staff housing expenses claimed by their employees, were found to be unsupported by valid invoices.
In response, foreign banks in China should strengthen their expense reimbursement administration system to ensure that their accounting and administrative staff are equipped with the right tax knowledge to identify fake invoices on expense claims. A more tax-focused internal audit program should be introduced to the banks for controlling the expense disbursement cycle and to ensure that all major expense claims are supported by proper invoices for tax deductions.
Due to the increasing need for mobility of global financial service talent, international secondment arrangements have been widely adopted around the world in the banking industry. There are no exceptions for China given the shortage of local talent at this stage. Under a typical secondment arrangement, a foreign bank seconds its employees (“secondees”) from its overseas head office or parent to work for its Chinese branches or affiliate whereas the latter reimburses the former for the costs of salaries, allowances and other fringe benefits that the former agrees to pay on its behalf during the course of the secondment with no profit mark-up.
In the past, the Chinese tax authorities have in general accepted that the foreign bank overseas head office assigning secondees to the Chinese branches is a mere salary paying agent. They tended to agree that the overseas head office was not providing services to the Chinese branches by virtue of the secondees assigned to China, and hence the overseas head office does not constitute a permanent Establishment (“PE”) in China.
However, where the secondee is considered to be representing the overseas head office by providing services in China to the Chinese branches, then the overseas head office may be deemed as constituting a PE in China. The overseas head office, even a foreign corporation, could be exposed to China corporate income tax (“CIT”). By the same token, Business Tax (“BT”), which is a kind of gross sales tax imposed on provision of services, would also be imposed on the reimbursement, which is otherwise seen as service fee.
In the recent tax audit of foreign banks, the China tax authorities have tightened up their review of secondment arrangements. Some tax inspectors have started to suspect that some foreign banks are using secondment arrangements to avoid Chinese taxes for those service projects undertaken by the overseas head office, to its branches and subsidiaries in China. Accordingly, they construe the reimbursement of the secondees payroll costs from China to overseas are a services fee income received by the foreign bank's overseas head office, thus imposing CIT and BT thereon.
Although the PRC SAT has previously shed some light on its technical views on how to assess the service PE exposure under secondment arrangements in a tax Circular No. 75 issued in July 2010, however, the general guidance set out in this tax circular did not ease the challenges on the secondment arrangements by local-level tax bureaus. In the tax audit of banking sector, controversies and disputes continue to arise in relation the PE exposure, associated tax implications and tax clearance of the reimbursement cost to be remitted overseas under secondment arrangements.
Foreign banks are experiencing rapid change with respect to tax audits in China. A close review of the broad trends crossing the future tax audit and controversy environment in China has become a business imperative. Meanwhile, foreign banks in China should consider a proactive and coordinated approach with respect to tax audits and disputes by engaging in various pre-audit prevention techniques, such as obtaining pre-clearance rulings, building enhanced relationships with revenue authorities, conducting documentation and course of conduct reviews, and pursuing best practice policies.
About the Authors
Matthew Wong is a Tax Partner of PwC China in Shanghai leading the China Financial Services Tax Practice Group. Jane Wang is a Tax Partner of PwC China in Shanghai leading the Tax Controversial Services for Central China region. April Ma is a Tax Manager PwC China in Shanghai and a key member of the China Financial Services Tax Practice Group. This article has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this article without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC Consultants (Shenzhen) Ltd. its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this article or for any decision based on it.
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This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.
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