General Anti-Avoidance Rule

Article 47 of the EITL provides Chinese tax authorities with the power to make adjustments ‘through a reasonable method’ where an enterprise enters into an arrangement ‘not for any reasonable business purpose’. Article 120 of the EIT Regulations clarifies the meaning of ‘not for any reasonable business purpose’, stating that it refers to an arrangement where the ‘main purpose is to reduce, exempt or defer the payment of taxes’. The tax authorities have ten years statute of limitations in which to make an adjustment for non-arm’s length principle transactions or any arrangement that does not have any reasonable business purpose.

Controlled Foreign Companies

Prior to the EITL, the concept of a controlled foreign company was not found in China’s income tax law. Article 45 of the EITL now provides for the attribution of income to a resident enterprise where profits are held by a non-resident enterprise that is controlled by the resident enterprise. Attribution of income to a resident company will occur where:

1. The resident enterprise “controls” a foreign enterprise.
2. The tax rate in the foreign enterprise’s country is “obviously lower” than the tax rate provided for in Article 4(1) of the EITL.
3. The non-resident enterprise has not distributed its profits; and
4. The non-resident enterprise does not have reasonable business operational needs for not distributing the profits.

 There two important things to note in respect of this. Firstly, “control” occurs where:

1. The resident enterprise or Chinese resident solely holds, directly or indirectly, 10% or more of the voting common stock of a foreign enterprise, or jointly holds, directly or indirectly, 50% or more of the stock of the foreign enterprise; or
2. the taxpayer has substantial control over the foreign enterprise with respect to equity, capital, business management, sale or purchase, etc.

 Secondly, Article 118 of the EIT Regulations clarifies what is meant by “obviously lower”, which is 50 per cent of the tax rate stipulated in Article 4(1) of the EITL.

Transfer Pricing Rules

China’s transfer pricing provisions (Article 41 of the EITL) require related party transactions to be conducted on an arm’s length basis. The EIT Regulations clarify what is meant by the term “related party” which, under Article 109, refers to enterprises, other organizations and individuals that have any of the following relations with an enterprise:

1. direct or indirect relationship with respect to capital, management, sale or purchase, etc;
2. directly or indirectly controlled by a common third party; and
3. any other relationship of interest.

The arms length principle provides, under Article 110 of the EIT Regulations, that related party transactions shall conform to a fair market price that would have applied if the transaction had taken place between two independent parties. Chinese tax authorities can make adjustments through “reasonable methods” where there has been a non-arms length dealing (Article 41 of the EITL), and can impose interest and a 5 per cent penalty on such adjustments (Article 48 of the EITL). As is noted above, a ten year statute of limitations is imposed on the making of such adjustments. In order to avoid potential transfer pricing disputes, under Article 42 of the EITL, a resident enterprise may enter into an “Advance Pricing Agreement” (APA) with the tax authorities, which sets out in advance the method for determining the transfer pricing for any related party transactions.

The most substantial change in China’s transfer pricing rules under the EITL has been the inclusion of what has been termed the “documentation requirements”. To ensure greater transparency in relation to transfer pricing, the EITL, pursuant to Article 43, requires enterprises to provide an annual declaration in respect of related-party transactions. Further, the tax authorities can request a taxpayer to provide “relevant materials” to any transaction between affiliated enterprises. The original draft of the EITL Regulations stated that such information had to be provided to the tax authorities within 30 days of request. However, no such stipulation appears in the final version which merely requires the documentation to be provided ‘within the time limit as set down by the tax authorities’ (Article 114). Where the taxpayer fails to provide such documentation, under Article 44 of the EITL the tax authorities may determine the taxable income after an investigation, and the onus then shifts to the taxpayer to establish that such a determination is not accurate (Article 115 of the EIT Regulations).

Thin Capitalisation Rules

Article 46 of the EITL prohibits the deduction of interest payments to a related party where the debt-to-equity ratio exceeds the “prescribed standards. The prescribed standards”, in accordance with Article 119 of the EIT Regulations, were issued by the Ministry of Finance and the State Administration in the Notice on the Tax Deductibility of Interest Expense Paid to Related Parties (Caishui [2008] No. 121), which provides two prescribed debt to equity ratios; for financial entities the acceptable limit is 5:1 and for non-financial enterprises the acceptable limit is 2:1.

Pursuant to Article 85 of the Measures the related party debt to equity ratio is defined as the ‘portion of the debt investment received [by the entity] from all its related parties (“related party debt investment”) to the equity investment (“equity investment”)’, and importantly related party debt investment includes ‘debt investment guaranteed by related parties in any form.’ The amount of the related party debt investment and the equity investment are determined by the monthly average in a given year. Interestingly, Article 89 of the Measures appears to make provision for the allowance of a deduction if the debt to equity ratio is exceeded, where the taxpayer can demonstrate that the transaction is otherwise consistent with arms length principles.