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By Matthew, March 11, 2010 2:42 pm

The following post is not motivated by revenge or anger for Sheppard Mullin’s misuse of my material, although the infringing material is still up (I must say that the arrogance in not taking it down is rather astounding). Rather, one of my missions on this site is to point out shoddy tax analysis as I feel there are too many commercial lawyers (both domestic and foreign lawyers) in China that promote expertise in tax yet clearly dont have a sufficient understanding of this area of the law. I believe this is a function of the fact that, until very recently, basically a monkey could navigate China’s tax regime.

I have pointed out mistakes on several occasions. See the following for examples:

1. One Last Post on 698;
2. Branching Out of China;

I dont claim to be perfect – law is too difficult of a game to suggest that you will always be right. If I make mistakes here please point them out to me.

I make the above proviso because I dont want this to be seen as petty retaliation, although I would imagine that from an objective perspective there is a certainly some pettiness. I am not sure if I would have written this post if a quick response had been received – actually I still would have. Tax is too complex to do it part time.

This morning I had the opportunity to properly review the Sheppard series mentioned in yesterdays post. This review confirmed my initial suspiscions that it was basically all my work (not that I had any real doubts).

What was the convincing evidence? The fact that the small part which wasnt taken from me was blatantly wrong.  Worse it is not just wrong, but it displays a complete lack of understanding of China’s tax laws and the source of taxing obligations in this country. Instalment 1 of the Sheppard series makes the following statement (this is only original material in the series):

The new thin capitalization rules have three immediate effects. First, they reduce the tax efficiency of debt push-downs. Second, they are likely to encourage a shift to local funding sought by foreign enterprises intending to establish an entity in China or to expand operations in China. Third, compliance to these rules will be thwarted by their lack of consistency with the Company Law of the PRC. Specifically regarding the third effect, for foreign corporations with an operating entity in China, the Company Law of the PRC stipulates debt-to-equity ratio requirements as set forth below:

Total Investment	Ratio of Registered Capital to Total Investment	Registered Capital as a % of Total Investment
<= US$3 million	At least 7 : 10	70%
US$3M to < $10M	At least 1 : 2	Higher of 50% or US$2.1m
US$10M to < $30M	At least 2 : 5	Higher of 40% or US$5m
>US$30M	At least 1 : 3	Higher of 33.33% or US$12m

Under these rules, interest payments related to inter-company loans would be tax-deductible. Under Circular 121, however, if the debt-to-equity ratio is not below 2:1 (or 5:1 for financial enterprises) the tax deductions may be violating the thin capitalization rule. Thus, foreign companies with operations in China must seek clarification of these inconsistencies.

Pardon my language but what crap. How could the Company Law, a law that does not regulate taxation, provide that certain debt amounts are deductible for tax purposes. Rather, the Company Law regulates the extent to which companies in China are allowed to fund their operations with debt (related party or otherwise) as opposed to equity – this has no relationship to deductibility for tax purposes and there is no inconsistency with the thin capitalisation rules.

How these laws interact is that whilst the Company Law may permit a company to fund their operations  with a specified level of debt, if the debt is over the debt-to-equity ratio of 2:1 in the thin capitalisation rules, then the amount over the allowed ratio is not deductible (although the level of debt is still permitted for Company Law purposes). The argument of Sheppard Mullin is like saying that because Australia does not restrict (in the Corporations Act) the amount by which investments can be funded by debt, then Australia’s thin capitalisation rules in the Income Tax Assessment Act are inconsistent with the Corporations Act . Rubbish. Given how incorrect this paragraph is, there is no way the author could have written the remainder of the publication. This not only shows a fundamental musunderstanding of tax law but also the role of the Company Law.

Also, given that China’s thin capitalisation rules only apply to related party debt, why would they result in the use of local financing as opposed to overseas financing? Do they understand what they have written earlier in the post?

Until this morning, I included the following sentence at end of my original post  - “It is obviously very hard to detect such things as I know from overseeing such writings from young associates at my previous firm.” In light of the above, I have now deleted that sentence.

Have I been too harsh? Perhaps but given I havent received an email or phone call I dont feel too charitable today.

Comments (0)

By Matthew,

I have just added english translations of two new measures issued by the SAT to the Measures and Circulars page. These measures are the new rules relating to the taxation of representative offices and non-resident enterprises:

1. Guoshuifa [2010] 18 – Notice of the State Administration of Taxation on Issuing ‘Interim Implementing Measures Regarding Tax Management on the Permanent Representative Office of Foreign Enterprises’.
2. Guoshuifa [2010] 19 – Notice of the State Administration of Taxation on Issuing ‘Implementation Measures on Collection of Income Tax of Non-resident Enterprises.

All translations on this site are provided courtesy of Hwuason Lawyers.

Comments (4)

By Matthew, March 5, 2010 11:45 am

Okay as I mentioned, here is my analysis of Guoshuifa [2010] 18. This actually represents my second nostradamus moment during the existence of China Tax Insights. Once again, for those who had paid attention to the tax landscape in China it was not completely surprising. For the last few months I have, on several occasions, indicated that the taxation of ROs was about to change and that people should expect a change for the worse. In fact one of these posts was part of series I did on predicting big tax events for 2010 (a series I havent finished yet and probably wont before 2011 by the way Im going). Its great to already see one of my predictions – well for the ego anywhere – and in fact one of my more adventurous predictions, has come to fruition. The previous posts on this issue can be found here:

1. The Beginning of the End for Representative Offices
2. Are we there yet – Part 1

I should note that another circular issued by the SAT in February (Guoshuifa [2010] 19 is also relevant to my predictions in Are We There Yet – Part 1 and should be read in conjunction with the Circular. I will post about that other circular over the next few days.

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On 20 February 2010 the State Administration of Taxation (SAT) issued Guoshuifa [2010] 18 (the “Circular”), a circular outlining a new tax treatment for representative offices (ROs) of foreign enterprises in China. The Circular replaces several older circulars related the taxation of ROs and the changes are quite significant.

End of Tax Exemption for ROs

In the past, a large number of ROs were exempt from tax in China. The Circular now indicates that the exemption for ROs is to end – both for ROs established in the future and currently existing ROs that are tax exempt. This means a radical shift in profitability for foreign enterprises that had operated in China with such an exemption.

The Taxable Income of the RO

The Circular provides three bases on which the taxable income of a RO is determined; the actual method and two deemed methods. The actual method will apply where the RO can adequately prove gross income and expenses. A similar actual method applied in the past, but in practice it was only used with respect to professional services firms. It is not clear whether the actual method under the Circular will be similarly limited.

The two deemed methods apply where the income of the RO or the expenditure of the RO cannot be adequately established. In such, circumstances the Circular deems the taxable income of the RO to be a minimum of 15% of expenditure or gross income (whichever applies). Under the previous system, the deemed taxable income was 10% so the new Circular will lead to a higher level of taxable income for ROs using the deemed method. The fact that the deemed profit rate is a minimum amount means that local tax officials will have the discretion to impose a higher rate. Once the deemed taxable income is determined, it will then be taxed at the applicable EITL tax rate, which as indicated above will likely be 25%. As a result of all this, where minimal profit is being made by the RO, the Circular provides a strong impetus to keep accurate and sound accounting records so that the actual method can be applied.

Repeal of Guoshuifa (1996) 165

One of the more significant aspects of the Circular is that it repeals Guoshuifa (1996) 165 (“Circular 165”) without addressing matters covered in that circular. Circular 165 indicated what activities of a RO would be taxable and what activities would not be taxable. Non-taxable activities included work carried in relation to the production, manufacturing and sale of the head office’s products, market research, and liaison work. As Circular 165 has been repealed and no mention of non-taxable activities has been made in the Circular, we must assume, unless and until a further circular is issued, that all activities of ROs will be taxable in the future. We understand that tax officials have had long-held concerns about the practice ROs falsely characterising activities to fall within the exception and this may explain why these non-taxable activities are not continued in the Circular.

The Circular possibly represents a fundamental shift in tax liability for ROs in China and, as such, all ROs need to determine how it affects them and impacts upon their profitability.