What Is China Doing on Anti-Tax Avoidance?

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Nicolas  Zhu Gilbert Shen

Nicolas Zhu and Gilbert Shen, CMS China

Nicolas Zhu is a Partner and Gilbert Shen is a Senior Associate with CMS China

The legal environment for transfer pricing and anti-tax avoidance in China has changed significantly over the past few years. Chinese tax authorities are making continuous efforts to create a fairer and more transparent tax environment for international trade and cross-border transactions.

On June 7, 2017, Wang Jun, Commissioner of the China State Administration of Taxation (“SAT”), signed the BEPS Action 15 Multilateral Instrument on Tax Treaty Measures to Tackle BEPS (“MLI”) on behalf of the People's Republic of China (“PRC”), which marked one of the milestones in China's efforts towards anti-tax avoidance.

Measures Introduced

Looking back over the past few years, the China SAT has been devoted to improving the domestic legal environment for anti-tax avoidance. Guoshuifa [2009] No. 2 Special Tax Adjustment Implementation Measures (“Announcement 2”), issued in 2009, used to be the key guideline for anti-tax avoidance and transfer pricing in China. From 2015, however, in the context of the OECD Action Plan on Base Erosion and Profit Shifting (“BEPS”), the SAT started to issue a series of new rules and regulations, which has led to significant changes in the transfer pricing and anti-tax avoidance environment in China:

  •  on September 17, 2015, release of the Discussion Draft of Special Tax Adjustment Implementation Measures for public discussion, aiming at comprehensively revising the existing Announcement 2;
  •  on July 29, 2016, release of Announcement [2016] No. 42 Announcement on Reporting of Related Party Transactions and Contemporaneous Documentations (“Announcement 42”), partially replacing relevant chapters of Announcement 2;
  •  on October 11, 2016, release of Announcement [2016] No. 64 Announcement on Improvement on Administration of Advance Pricing Arrangements (“Announcement 64”), partially replacing relevant chapters of Announcement 2;
  •  on March 17, 2017, release of Announcement [2017] No. 6 Announcement on Administration of Special Tax Investigation and Adjustment and Mutual Agreement Procedures (“Announcement 6”), partially replacing relevant chapters of Announcement 2.

General Anti-avoidance Rule

The SAT has introduced a general anti-avoidance rule (“GAAR”) which serves as a broad general rule to crack down on tax avoidance arrangements.

From a historical perspective, the GAAR in China was originally introduced by Article 47 of the PRC Corporate Income Tax (“CIT”) Law in 2008. In 2009, with the release of Announcement 2, general principles on the implementation of GAAR were further provided. In 2014, the China SAT issued Administrative Regulations for the General Anti-Avoidance Rule (Trial) (“SAT Announcement [2014] No.23”). In conjunction with the PRC CIT Law and Announcement 2, SAT Announcement [2014] No.23 provides a more comprehensive and transparent legal environment for GAAR implementation in China.

According to the GAAR in China, license fees or service fees paid to related parties should match the economic benefit that the license/service brings to the licensee/service recipient. Tax authorities shall redefine the nature of a tax avoidance arrangement based on business substance, and revoke an enterprise's tax benefit obtained from the tax avoidance arrangements. Tax authorities may, from a tax perspective, deny the existence of enterprises without economic substance, particularly those which are established in tax havens and result in the tax avoidance of their associated or unassociated parties.

The GAAR is usually adopted in testing the reasonableness of related party transactions: one example could be the outbound payment of service fees, where the SAT has increasingly focused in recent years.

The following paragraphs provide a detailed introduction to the GAAR in China.

Scope of GAAR

When tax authorities conduct a special tax adjustment based on Article 47 of the PRC CIT Law to address a deliberate “tax avoidance arrangement”, the GAAR shall apply. Generally, business arrangements with the two characteristics described below are likely to be deemed “tax avoidance arrangements”:

  •  the sole purpose or main purpose of the arrangement is to obtain tax benefits; and
  •  although the business arrangement appears to qualify for a tax beneficial treatment from a legal perspective, its business nature is not in line with its legal format.

The above-mentioned term “tax benefits” refers to tax consequences such as CIT reduction, exemption or deferral.

However, according to Article 2 of Announcement [2014] No.23, the GAAR does not apply to the following situations:

  •  arrangements irrelevant to cross-border transactions or payments;
  •  illegal behavior, including tax avoidance, fraud for tax refund, other tax fraud, etc.

Further, according to Article 6, where a business arrangement falls within the scope of a typical special anti-tax avoidance arrangement, including transfer pricing, cost sharing arrangement, controlled foreign corporations, thin capitalization, etc., tax authorities shall first apply corresponding special anti-tax avoidance rules (which will be addressed later in this article). Similarly, if tax treaty provisions or a domestic rule on the application of a treaty is applicable (such as rules on beneficial ownership or limitation of benefits), such treaty provisions or domestic rules shall prevail over the GAAR.

General Methods of Adjustment

According to the GAAR, tax authorities may adopt one of the following methods to deny the tax benefits obtained through a tax avoidance arrangement:

  •  entirely or partially recharacterizing an arrangement;
  •  denying the existence of a certain transaction party, or deeming certain transaction parties as the same one single entity, from the perspective of business nature and substance;
  •  recharacterizing of income, deductible cost, tax beneficial treatment, foreign tax credit, or reallocation of the said items among relevant parties involved in the transaction; or
  •  other methods which they consider as reasonable.

Standard Procedures of GAAR Application
Case Registration

Local tax authorities are generally responsible for identification of cases subject to a tax special adjustment. However, considering that anti-tax avoidance cases are usually quite complicated, application for case registration shall be reviewed and approved by upper level tax authorities—the provincial tax authorities and the SAT.

Investigation

Local tax authorities are generally responsible for carrying out the detailed process of investigation.

Tax authorities have the right to require taxpayers to provide sufficient information, including background information on the business arrangement, documents explaining the commercial purpose of such arrangement, internal documents related to the arrangement, etc. Upon receiving the Notice of Tax Assessment from the tax authorities, taxpayers are obliged to submit the required documents within 60 days. In special circumstances, a 30-day extension may be granted. If a taxpayer fails to provide the documents required, the tax authorities may deem an amount of tax payable based on the relevant regulations and standard procedures.

The tax authorities have the right to obtain information connected to overseas entities via information exchange systems, or other applicable methods. The tax authorities also have the right to require a party or individual that is involved in tax planning for the entity under investigation to provide relevant information and documents.

Issuing Notice of Special Tax Adjustment

Upon receiving the SAT's approval for the case registration, the tax authority in charge shall proceed with the investigation within the following nine months. Final assessment shall be made based on the review and approval from provincial tax authorities and the SAT.

Upon receiving approval from the SAT, the local tax authorities in charge shall issue an Initial Notice of Special Tax Adjustment to the taxpayer. The taxpayer is allowed to appeal with the upper level tax authorities within seven days of receiving that Notice. The taxpayer's appeal will be reported to, and eventually assessed by, provincial tax authorities and the SAT. If the taxpayer accepts the tax assessment, or if the taxpayer's appeal is rejected, a final version of Notice of Special Tax Adjustment will be issued by the tax authority in charge.

Dispute Resolution

If a taxpayer does not agree with the result of the tax adjustment, the taxpayer is allowed to seek legal assistance in accordance with applicable PRC law. Any domestic double taxation resulting from the tax adjustment shall be settled by the SAT. If the tax adjustment leads to cross-border double taxation, the taxpayer may apply to enter a mutual agreement procedure.

Attitude of the SAT towards Anti-tax avoidance and Special Tax Adjustment

The SAT is making continuous efforts on anti-tax avoidance and special tax adjustment. In recent years, the following trends in the SAT's approach can be identified.

Monitoring of Profit Level

Over the past few years, only enterprises under a tax audit have been subject to monitoring by the tax authorities on an ongoing basis, over a five-year follow-up supervision period. With the release of Announcement 6, however, all enterprises in China will be monitored on their profit level over a period of time, through annual reporting of related party transactions. This means that enterprises with an unstable profit level are more likely to be identified and targeted for tax audit. This trend indicates that Chinese tax authorities are making efforts to work out a more comprehensive method for special tax investigation and adjustments. In this context, it is now more important than ever that enterprises in China should efficiently manage their transfer pricing risks through their daily operation.

Types of Enterprises Likely be Targeted for Tax Audits

Announcement 6 makes it clear that enterprises with the following typical characteristics will be more likely to be targeted for tax audit or special tax adjustment:

  •  enterprises with a large amount of related party transactions, or which are engaged in various types of related party transactions;
  •  enterprises making a loss, low profits or unstable profits, over a period of time;
  •  enterprises whose profit level is lower than the average level of the relevant industry;
  •  enterprises whose profit earned does not match the functions and risks undertaken, or whose profit allocated does not match the costs borne;
  •  enterprises that are engaged in transactions with related parties located in countries or regions with low tax rates;
  •  enterprises that do not meet the compliance requirements including contemporaneous documentation and annual report of related party transactions;
  •  enterprises whose related party debt-to-equity ratio has exceeded the upper limit;
  •  foreign enterprises which are controlled by PRC resident enterprises and/or individuals, and established in a country or region where the effective tax rate is lower than 12.5 percent, and which do not distribute profits or reduce profit distribution without reasonable business needs;
  •  enterprises that are engaged in other transactions without proper commercial reasons.

It is noteworthy that items seven to nine above are newly included in Announcement 6 compared to the previous regulations; we can see the trend that with more Chinese entities expanding their business overseas, Chinese tax authorities are increasingly paying attention to such so-called “go-global companies.”

Hidden Transactions

Announcement 6 brings up the concept of “hidden related party transactions,” indicating that any hidden related party transactions which directly or indirectly result in the reduction of the SAT's overall tax income shall be restored for special tax adjustment purposes. For example, if a PRC enterprise provides services or licenses to an overseas related party free of charge, such transaction will be “hidden” as there is no cash flow of remuneration for the transaction. However, such “hidden transaction” can be restored, if evidence is found which can prove the existence of such transaction. Such “hidden transactions” are likely to increase with more Chinese enterprises expanding their business overseas.

Intangibles

Announcement 6 stipulates that an entity cannot share returns derived from intangibles if it only legally owns the intangibles without actually making contribution to the value creation of the intangibles. To assess the degree of contribution, various aspects have to be considered, including overall business model and operational status of the group, each group entity's activities in relation to development, enhancement, maintenance, protection, exploitation and promotion of the intangibles, etc.

It is worth noting that Announcement 6 provides for the principles of transfer pricing administration not only for “payment of license fees,” but also for “receipt of license fees.” This may also be seen as evidence that Chinese tax authorities are increasingly focusing on the go-global companies, which are gradually taking on the role of royalty licensors.

Related Party Services

According to Announcement 6, related party services in line with the arm's length principle should be beneficial services and priced based on fair value under normal business circumstances. “Beneficial services” refers to the services which can bring direct or indirect economic interest to the service recipient, and where a non-related party is also willing to purchase or voluntarily carry out the service activities by itself in the same or similar situations. If an enterprise pays service fees to related parties for non-beneficial services, tax authorities can initiate special tax adjustment by disallowing the enterprise from deducting the full costs arising from the service charges from its taxable income for PRC CIT purposes.

Non-beneficial services mainly include the following:

  •  the services provided by related parties overlap with the activities already conducted by the service recipient itself or purchased by the service recipient from other parties;
  •  the fees charged are for investment-related activities that benefit the direct or indirect shareholders (e.g., activities of controlling, managing and supervision of the invested companies) of the service recipient;
  •  the benefits obtained by the service recipient come from extra interest of just being a member of a certain company group, but no concrete services are specifically provided;
  •  the relevant activities of related parties have already been compensated for in other transactions;
  •  the related party services are not related to the functions and risks undertaken by the service recipient or are not in line with the business needs of the service recipient;
  •  other service activities of related parties that do not bring direct or indirect economic interest to the service recipient or the services that a non-related party is not willing to purchase or voluntarily carry out by itself.

Location-specific Factors

It is noteworthy that, differently from developed countries which consider intangibles as one of the most important profit-making factors, Chinese tax authorities are emphasizing the contribution of location-specific factors, such as location savings, market premiums, etc., to an entity's profit-making capability. In other words, the Chinese tax authorities may hold the view that additional return should be returned to China, if extra profit has derived from such special location factors closely related to the Chinese market. The Chinese tax authorities' attitude towards location-specific factors is also reflected in another tax document—Announcement 64, which provides for new rules of administration on advanced pricing arrangements (“APAs”). According to Announcement 64, an APA application is more likely to be accepted by the tax authority if an applicant takes into consideration location-specific factors.

Special Anti-tax Avoidance Rule (“SAAR”)

Cost Sharing Arrangements

Announcement 2 (Articles 69 and 74 being annulled) and Announcement 42 supply provisions on administrative guidance on cost sharing arrangements (“CSA”), according to which participants of a CSA are entitled to the beneficial right of the joint development or assignment of intangible property or participation in services, and therefore should bear the corresponding costs of such activities. The costs borne by the associated parties should be consistent with the costs which would be spent by unrelated parties seeking the beneficial right under comparable conditions. An enterprise's beneficial right associated with a CSA involving intangible assets or services should be based on reasonable and measurable expected returns and based on reasonable business assumptions and operational conversations. CSA participants are not required to pay a royalty for the use of intangible assets developed or received by the CSAs.

During the implementation of a CSA, if the actual costs which the participants share do not match the actual benefits received, compensating adjustments should be made based on the actual situation. The costs allocated to an enterprise under a CSA signed with its associated parties will not be tax deductible where:

  •  the CSA does not have a solid commercial purpose or economic substance;
  •  the CSA does not comply with the arm's length principle;
  •  the allocation of costs and benefits does not comply with the principle that cost should match with income;
  •  the enterprise has not completed a record process for the CSA, or has not prepared, maintained and submitted contemporaneous documents with respect to the CSAs as required; or
  •  the enterprise's future operational period will be less than 20 years from the date when the CSA is signed.

Currently, in China, a CSA related to services is generally applicable to group purchase and group marketing planning activities. However, current CSA regulations in China have not provided clarifications on tax implementation and treatment: there is, therefore, still much to be done on a practical level with regard to CSAs in China.

Controlled Foreign Corporations

Announcement 2 includes rules on controlled foreign corporations (“CFCs”).

CFCs refer to foreign enterprises which are controlled by resident enterprises and/or individual residents of the PRC (“Chinese resident shareholders,” including Chinese resident enterprise shareholders and Chinese resident individual shareholders) and established in a country or region where the effective tax rate is 50 percent lower than the tax rate of 25 percent stipulated by the PRC CIT Law and which do not distribute profits or reduce profit distribution without reasonable business needs.

Announcement 2 provides a definition of “control”, which refers to situations where substantial control is formed in respect of shareholding, financing, business, purchase and sales, etc. “Control in respect of shareholding” refers to the situation where any single one of the Chinese resident shareholders directly (through a single layer) or indirectly (through multiple layers) holds more than 10 percent of total voting shares of a foreign enterprise in any day of the taxable year, and all of such Chinese resident shareholders jointly hold more than 50 percent of total shares of the foreign enterprise.

Moreover, Announcement 2 introduces a calculation method for percentage of shareholding when indirect multiple layer shareholding is involved, as well as a calculation method for deemed dividend income from a CFC that is to be included in the Chinese resident enterprise shareholder's taxable income of the current period.

The deemed dividend income may be exempt from being included in a Chinese resident enterprise shareholder's taxable income of the current period, if any one of the following conditions is met:

  •  the CFC is located in a non-low-tax-rate country/region, which is designated by the SAT;
  •  the CFC mainly derives income through active business activities; or
  •  the annual profits of the CFC are less than 5 million renminbi (approximately 625,000 euros).

However, there are regulations to avoid double taxation—if the deemed dividend is already taxed overseas, the overseas income tax may be credited in accordance with relevant provisions of the PRC CIT Law or double tax treaties. In addition, if the profits actually distributed by a CFC have already been taxed in accordance with the PRC CIT Law, such profits can be excluded from the Chinese resident shareholder's taxable income of the current period.

Thin Capitalization

According to the PRC tax regulations, for enterprises in China, any interest expense arising from the related party debt exceeding twice (for non-financial institutions) or five times (for financial institutions) the equity investment in the company cannot be deducted from the taxable income for CIT purposes unless sufficient evidence can be provided to prove that such loan arrangement is made on the arm's length principle. Announcement 2 (Article 89 annulled) and Announcement 42 provide for detailed rules on thin capitalization in China, including calculation methods, compliance requirements, etc.

Non-deductible interest expenses cannot be carried forward to the following tax years, and should be allocated among associated parties according to the proportion of interest actually paid to each associated party against total interest expenses. Such interest allocated to domestic parties which have a higher effective tax rate will be allowed to be deducted for CIT purposes, while interest paid to overseas parties directly or indirectly shall be deemed as dividend distribution, and any gap for tax liability between interest expense and dividend should be made up. Any tax overpayment which resulted from the above treatment will not be refunded.

Going Forward

The legal environment for transfer pricing and anti-tax avoidance in China has changed significantly during the past few years. Chinese tax authorities are continuously making efforts to create a fairer and more transparent tax environment for international trade and cross-border transactions. Foreign companies will need to pay increasing attention to transfer pricing and anti-tax avoidance regulations in China.

Nicolas Zhu is a Partner and Gilbert Shen is a Senior Associate with CMS China. They may be contacted by email at: nicolas.zhu@cmslegal.cn; gilbert.shen@cmslegal.cn

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