This is a post that will attempt to tie a few (possibly completely unrelated although I think not) thoughts I have been having over the past few weeks (possibly years). It became apparent to me today that these thoughts, well at least I think, are somewhat interrelated … so here we go.

In the past few days, I have been having an interesting exchange with a fellow reader, TwoFish, of the ChinaLawBlog in respect of a post published on that blog on Circular 698. Since our exchange, I have had the opportunity to review her/his blog (which I think I was previously unable to access on the mainland as with all [blogname].wordpress.com sites) and I must say that both her/his writing and the cogency of her/his views are of a very high quality. I am sure to become a regular reader of her/his blog and cannot recommend it enough.

I previously promised, implicity, no more postings on 698 and I will try honouring that pledge whilst discussing an issue that will be relevant to 698 but that is of a more general application – the meaning and potential operation of “reasonable business purpose” under China’s general anti-avoidance rule. Over at ChinaLawBlog, TwoFish, who from what I have been able to discern is not a lawyer (I could be wrong on this point) but seems very knowledgeable on legal issues, made the following comment in relation to reasonable business purpose:

What happens in these situations is that the legislature passes extremely broad and vague legislation, and then the courts and the administrative agencies then issue very detailed rulings that add certainty and consistency to the legislation. Much of what constitutes a “legitimate business purpose” in both the US and China tends up being decided by the administrative agencies. The legislature rarely get involved, and you can theoretically appeal to the courts, but that tends to happen under only the most extraordinary conditions (simply because the cost of appealing to the courts are often much, much higher than the matter under dispute).

I agree with Twofish about the general application and operation of vague, broad laws as mentioned. However, I have a few points to make. I will mention all points and then expand upon a few particular issues below. Firstly, included in such a statement, when talking about the reasonable business purpose test and General Anti-Aovidance Rule (GAAR) in the Enterprise Income Law, is an implicit assumption that the meaning of reasonable business purpose and the requirements of the GAAR have been drafted vaguely. Is this the case? I am not so sure. I will outline the position below and let you be the judge. I am not criticising Twofish here. However, there has been a general suggestion by a number of commentators that China’s GAAR is overly vague. I wish to the test these assertions.

Secondly, I similarly think there is a danger, from a  legislative drafting perspective, that such provisions can be so vague and broad, although I should note such a danger does not really exist in China, that the courts will effectively read them down to ensure that they operate reasonably. In more developed legal jurisdictions the courts can play a critical role in delineating the boundaries of such broadly drafted laws. I have never cared too much about the alleged corruption and local favouritism in Chinese courts as it is my view, based on my experience, that such conduct is very much in the minority. However, I do believe that the ability to hold administrative agencies to account is a critical requirement to ensure a stable, mature business environment, particulary with respect to taxation – all companies need to engage with the tax authorities on at least an annual basis. This leads me to make a confession - I am a tax lawyer not because I am comfortable with the ethics of tax avoidance but because, or at least it is one of my reasons, I believe that permitting tax officials to rule unchecked is akin to letting kids have control of the cookie jar. It is on this issue that China can rightly be subject to some criticism although there is some hope for changes in the near future.

Thirdly, part of the problem, as Twofish rightly points out, is that spiralling legal costs can soon outweigh the disputed tax amount. Yet, there are solutions, and qualifications, to this problem. My firm is just one firm, I assume of many (although there are not too many laws firms in China that have sufficient tax experience), that is prepared to enter into alternative fee arrangements in respect of tax litigation, subject to our satisfaction that the taxpayer has a reasonable chance of success. This can include fixed cost and other similar arrangements. Further, tax litigation (not so much in China) has often been funded by syndicates of companies or organisations, such as taxpayer’s associations and similar bodies, who have an interest in seeing the relevant authority’s application of the law overturned. Also, often the value in a tax case is not so much about the value of the disputed tax itself, but, assuming that there is a favourable decision, the value of the “product” (the term is used loosely) that can be developed for the future and marketed by the law firm/accountants to their clients/potential clients. In this sense, the costs v disputed tax amount question is very commonly not relevant. It is amazing how many tax cases – at least in Australia where the greater part of my experience (apart from China) lies – involve very small amounts of disputed tax.

Warning the following sections are quite self-indulgent and basically expand upon some points I identified above.

The General Anti Avoidance Rule

Contrary to some claims, China’s GAAR is not “one sentence in a quasi-civil law statute“. The GAAR is actually conained in three legal documents - the EITL (promulgated by the NPC), the EITL Implementing Regulations (promulgated by the State Council) and the Notice of the State Administration of Taxation on Issuing the Measures for the Implementation of Special Tax Adjustments (for Trial Implementation) (“Measures No 2“) (promulgated by the SAT but authorised by the Implementing Regulations).

As mentioned in an earlier post on 698, Article 47 of the EITL basically empowers the SAT to make a tax adjustment where a transaction has been entered into:

1. that results in a reduction in taxable income; and
2. has no reasonable business purpose.

Article 120 of the Implementing Regulations of the Enterprise Income Tax Law then defines “reasonable business purpose” as:

The expression “not have a reasonable business purpose” as used in Article 47 of the EIT Law means that the main purpose is to reduce, exempt or defer the payment of taxes.

Article 92 of Measures No. 2 then provides that anti-avoidance investigations should target the following arrangements:

1. Abusing tax preferences;
2. Abusing a tax agreement;
3. Abusing the corporate organizational form;
4. Avoiding tax through a tax haven; and
5. Any other arrangement without a reasonable business purpose.

Article 93 of Measures No 2 indicates  the principle of “substance prevails over form” should be followed and that the following matters should be considered:

1. The form and substance of an arrangement;
2. The time of conclusion and the period of execution of an arrangement;
3. The manners for realizing an arrangement;
4. The connections between different steps or components of an arrangement;
5. The changes of financial status of each party involved in an arrangement; and
6. The tax results of an arrangement.

Articles 94, 95, 96 and 97 then provide further detail on how investigations should be conducted, matters to be considered, the method of canceling tax benefits and what can be expected from the taxpayers (and its professional advisers).

That seems fairly detailed and rather precise to me. Compare this with Australia’s first GAAR (that has now been repealed and replaced). The former section 260 of the Income Tax Assessment Act 1936 held any contract

1. altering the incidence of any income tax;
2. relieving any person from liability to pay any income tax or make any return;
3. defeating, evading, or avoiding any duty or liability imposed on any person by this Act; or
4. preventing the operation of this Act in any respect;

to be void as against the Commissioner.

That was it  – pure and simple.

Do vague tax laws always favour the tax officials?

This leads me to a point I made above. In developed tax jurisdictions vague, broad laws can be counter-productive – section 260 is a case in point. From 1936 to 1981 (apart from some early positive cases) this section was over time gradually read down by the courts so that it was effectively neutered. Initially this was done on the basis that the section:

“The section, if construed literally, would extend to every transaction whether voluntary or for value which had the effect of reducing the income of any taxpayer” (Deputy Federal Commissioner of Taxation v Purcell (1921) per Knox CJ) (this was with respect to earlier legislation drafted in similar terms)

The courts in the 1950’s provided that section 260 had no application where the taxpayer made a choice between two alternatives explicitly permitted by Act. This may seem a common sense approach. However, in the 1970’s, this “choice principle” was subsequently used to allow taxpayers to flagrantly construct circumstances permitted by the Act to avoid the operation of section 260.

This could not occur in China. All decisions in cases that I have seen which involve disputed interpretations of vague tax provisions have been interpreted to provide the widest possible meaning. I am also not aware of any case where a SAT Circular (or other Regulation) has been invalidated by the courts because of an inconsistency with a Basic Law. A colleague has mentioned (Im not sure if this was a tax case) that there was a case where the judge held a regulation to be inconsistent and refused to enforce it. However, this judge was, apparently, subsequently suspended. Caution should be used in relying on this story as may be the legal equivalent of an urban myth.