Comments (2)

By Matthew, December 31, 2009 7:18 pm

Sorry I just have a problem with some of the supposed “legal” analysis going on out there about 698. Deloitte made the following comment in their summary of the Circular.

Circular 698 creates some legal questions as to whether the Chinese government has the right to tax foreign companies

Now perhaps I have misinterpreted this but this is just plain wrong. China has a right to tax foreign companies in respect of income sourced from China. Every single one of China’s double tax treaties recognises such a right, subject to some limitations. Standard theories of international taxation support such a right. China’s Enterprise Income Tax Law supports such a right. Perhaps this is just a loose statement by Deloitte but I expect better.

The difficult issue in respect of Circular 698 is that income from the sale of an off-shore entity is not strictly China sourced income (in the usual sense that the term is understood). Accordingly, the more pertinent question is whether the SAT can use Article 47 (the general anti avoidance rule) of the EITL to reconstruct the arrangement to deem the income to be Chinese sourced (that is, a sale of the Chinese resident enterprise). Personally I cant see why not. Perhaps this is because I am accustomed to the Australian Taxation Office’s use of Part IVA of the Income Tax Assessment Act (which contains Australia’s general anti-avoidance rule). However, Article 47 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.

Interposing an off-shore company and the sale of it would seem to be a transaction that results in a reduction of taxable income. The real question will be whether there is a reasonable business purpose and that will be subject to the particular circumstances.

Those people over at PWC provide a  more  reasoned argument when they raise the issue of the interaction between Chinese taxation and taxation in the home jurisdiction (not the off-shore jurisdiction). For example, if an Australian company transfers an off-shore company, the income would be taxable under Australia’s capital gains regime. However, if tax has been paid to China (under Circular 698) then the Australian company would be entitled to a tax off-set in Australia and the ATO would be worse off. However, it does seem that the ATO wants to do the same thing as the SAT so there may be the prospect of agreement on this issue.

Comments (2)

By Matthew, December 29, 2009 3:06 pm

The below is an article I have prepared on Circular 698. The article looks at both the practical issues and policy considerations.

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SAT targets off-shore equity transactions

The State Administration of Taxation (“SAT”) has, in a circular issued on 11 December 2009, indicated its intention to target off-shore transactions involving the indirect transfer of Chinese enterprises (Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-resident Enterprises Guoshuihan [2009] 698) (“Circular 698”). Circular 698 represents the latest challenge to off-shore holding company or special purpose vehicle structures in China.

Common Off-shore Holding Company Structure

The attached is a very common off-shore holding structure in China (often referred to as a vanilla off-shore structure). Refer to the attached for an understanding of the abbreviations used throughout the article.

There are a number of reasons, including non-tax reasons, why inbound investments in China are structured in this fashion. One of the principal tax reasons, and relevant in terms of Circular 698, is the ability to effectively sell China Co, through transferring the equity interests in H Co, without incurring any tax liability in respect of that sale. The transfer of equity in a Chinese resident companies gives rise to tax liability. However, strictly speaking, no tax liability will arise in respect of the sale of an off-shore company by a non-resident shareholder.

The qualification to this is Article 47 of China’s Enterprise Income Tax Law which is a general anti-avoidance rule (“GAAR”). Article 47 relevantly empowers the SAT to make an adjustment where an arrangement has been entered into that has no reasonable business purpose and results in a reduction in taxable income.

Circular 698

Circular 698, effectively, operates in two scenarios; the direct sale of a Chinese resident enterprise and the indirect sale of such an enterprise. It first should be noted that there is an exception to Circular 698 with respect to listed shares. However, it is doubtful that this exception would apply to shares that subsequent to acquisition are listed on the stock exchange.

Direct Sale of Chinese Resident Enterprise

A direct sale of a Chinese Resident Enterprise refers to where the Chinese enterprise is sold as opposed to the holding company (H Co in the structure outlined above).This aspect of the Circular is relatively uncontroversial. It simply requires a non-resident to declare and pay any enterprise income tax with respect to the transfer of equity in a Chinese resident enterprise where such payment is not made, or is unable to be made, by the relevant withholding agent. Payment of such tax must be made within 7 days of the agreed equity transfer date.

Indirect Sale of Chinese Resident Enterprises

In Circular 698, relying upon the GAAR in Article 47, the SAT indicates that in certain circumstances the sale of H Co will give rise to a tax liability in China for A Co – the authorities effectively deem the transaction to be a sale of China Co. The circumstance that may give rise to such tax liability is where the SAT has formed the view that the arrangement (i.e. interposing the off-shore holding company as the shareholder of China Co) has no reasonable business purpose.

Circular 698 also contains a mechanism that aims to assist the SAT with enforcing these new rules – documentation disclosure requirements. In accordance with paragraph 5 of the Circular, where the tax rate of the jurisdiction in which H Co is a resident is less than 12.5% or the jurisdiction does not tax foreign sourced income, upon transferring the equity in H Co, A Co is required to provide the following documents to the local tax authority (within 30 days of the contracts being signed):

1. The equity transfer contract or agreement;
2. The relationships between the A Co and H Co on funds, management, procurement and marketing;
3. H Co’s production, management, personnel, finance and property conditions etc;
4. The relationship between H Co and China Co on funds, management, procurement and marketing;
5. The proof of a reasonable business purpose on setting up H Co by A Co;
6. Other relevant information required by the taxation authority.

Circular 698 is stated to apply from 1 January 2008 (the date that the Enterprise Income Tax Law became operable). This is a relatively draconian measure although it could be argued, as I am sure the SAT would contend, that the Circular is consistent with the spirit of Article 47 of the Enterprise Income Tax Law and therefore taxpayers have been put on notice that such arrangements are no longer acceptable. Further, the SAT has provided strong indications throughout 2009 that it intends to aggressively target such arrangements. In light of such circumstances, it is arguable, that the retroactive aspect of the Circular should not be considered harsh. Regardless of whether it is fair, the Circular permits the tax authorities to review any off-shore transactions that occurred from 1 January 2008 to date.

Paragraph 7 of the Circular empowers the tax authorities to make a tax adjustment where a transfer of equity in a Chinese resident enterprise is made to a related party and the consideration for the transfer is less than the arms-length price for the equity.

Implications of the Circular

The Circular challenges the traditional structures for investing into China and as such requires all companies to review their current structures. Our discussions with the SAT in relation to the Circular have indicated that they do not intend to utilize it arbitrarily or aggressively.

Importantly, taxpayers will not be subject to tax under Circular 698 where they can establish a reasonable business purpose for the existence of H Co. Accordingly, a critical issue is what will be a “reasonable business purpose”.  Article 120 of the Implementing Regulations if the Enterprise Income Tax Law define reasonable business purpose as:

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

No clarification of the meaning of “reasonable business purpose” has been provided by the SAT up until present and, accordingly, there is a question mark over the breadth of the term as understood by the SAT. In particular does “business” have wide or narrow meaning – it is our understanding that the SAT favours the view that “business” requires the purpose to be reasonable in the context of the business operations of the Chinese resident enterprise. A wider interpretation may suggest that a transaction that is entered into to further a commercial objective for the company or its shareholders may have a reasonable business purpose. For example, could interposing H Co for the purpose of enabling an easy transfer of the Chinese resident enterprise (i.e. without the regulatory red tape of an on-shore transaction) be a “reasonable business purpose”. Although such an interpretation is open on the language of Article 47 of the EITL and Article 120 of the Implementing Regulations, it is likely that the SAT will resist, for obvious reasons, any attempts to base a “reasonable business purpose” on such motivations. That such an approach may be wrong at law (given the terms of the EITL and Implementing Regulations) may be irrelevant.

Finally, it should also be noted that Circular 698 should be read in conjunction with Circular 601 – a notice by the SAT in respect of the term “beneficial owner” contained in China’s tax treaties. These circular together establish the SAT’s approach to the use of special purpose vehicles.

Remaining questions

Enforcement

The SAT will face a number of challenges in enforcing Circular 698. Over the past year there are been an increased willingness by taxation authorities worldwide (including some low-tax off-shore jurisdictions) to cooperate with respect to information exchange in taxation affairs. Despite this, it will still be extremely difficult for the SAT to police all off-shore transactions. One has to assume that Circular 698 will be targeted at big-ticket transactions rather than the average sale of a Chinese enterprise. Consistent with this, early indications have been that Circular 698 will be used fairly conservatively by the tax authorities and ordinary transactions will not be targeted. However, it would not be safe to rely upon these matters in the absence of taking appropriate action to ensure that your holding company structure is compliant with the Circular.

Interaction with Double Tax Agreements

Article 58 of the EITL provides that the provisions of any income tax treaties between China and a foreign government will prevail inthe  case of any inconsistency with the EITL. Accordingly, it must be presumed that Circular 698 is subject to the terms of any relevant income tax treaty. Importantly, there would seem to be a few income tax treaties that would assist arrangements to fall outside the terms of the Circular. For example, Article 13 of the China-Mauritius tax treaty generally prevents China, in respect of a company resident in Mauritius, from taxing capital gains from shares  where the holding is less than 25% (except where such income represents gains from the alienation of a permanent establishment.) Unless it can be established that China Co is a permanent establishment of H Co, for holdings of less than 25% in China Co, no taxable event would seem to arise on a direct transfer of shares in China Co by H Co.

Importantly, Article 5(7) of the China-Mauritius income tax treaty would generally prevent China Co from being considered a permanent establishment of H Co. A direct transfer of a less than 25% interest in China Co by a  H Co based in Mauritius would appear to not give rise to taxation in China and in which case Circular 698 would have no application. The Chinese tax authorities could invoke the GAAR generally to such an arrangement, although as yet there has been no indication that the SAT intends target such arrangements. The important point is that the transaction would be outside the terms of Circular 698 and back in the more vague territory of the GAAR.

Extra-Territoriality

One of the common criticisms of the Circular since it was issued has been the perceived extra-territorial nature. Apart from the documentation disclosure requirements, such criticisms would seem to be misguided. Whether we like it or not, it is a generally accepted principle of taxation that tax may be imposed by a country on non-residents in respect of income sourced from that country. The terms of the OECD Model Tax Treaty accept and generally endorse this principle. It is also a generally accepted principle of international taxation, once again whether we like it or not, that tax authorities are entitled to look beyond the form of a transaction where the particular form has been chosen for the purpose of avoiding or minimising tax liability (that is, where the domestic legislation permits them to do so). Once we accept both these principles, it is difficult to contend that the SAT is not entitled to take the steps (that is, disregarding H Co for tax purposes where there is no reasonable business purpose for its existence) outlined in Circular 698.

Attempts have been made to compare the Circular with the ongoing dispute between Vodafone and the Indian tax authorities, presently before the Indian High Court, in respect of Vodafone’s off-shore acquisition of Hutchinson Essar. In truth, such a comparison is a poor one because India did not have a GAAR in its tax code at the relevant time. The ability of tax authorities to tax off-shore transactions in the absence of a GAAR will usually be questionable and hence why reference was made to the United States’ “doctrine of effects” – the principle that US competition law can apply to acts outside of the US where those acts have an “effect” inside the US – before the High Court in India.

Conclusion

Whilst Circular 698 represents a fundamental shift in the tax treatment of off-shore equity transactions in China, it should come as no surprise given the developments in China’s international tax regime over the past 24 months. Neither is the Circular inconsistent with general international legal principles as some have claimed. It is, however, imperative for all foreign investors that have utilised an off-shore company for investing into China to undertake a review of their current structure and implement any necessary changes.

Comments (0)

By Matthew, December 25, 2009 6:28 pm

State Administration of Taxation Notification on Strengthening Corporate Income Tax Management on Non-resident Enterprises Equity Transfer Income No. 698 (2009)

To State Administration of Taxation & local Taxation Bureau of each province, autonomous region, municipality and city specifically designated in the state plan:

In order to regulate and strengthen the corporate income tax management on equity transfer income, based on the “Enterprise Income Tax Law of The People’s Republic of China” and its implementing regulations, “Tax Collection and Administration Law of The People’s Republic of China” and its implementing regulations, “State Administration of Taxation Notification on issuing ‘Non-resident Corporate Income Tax Source Withholding Interim Measures’’ (No. 3 (2009)), and “Ministry of Finance State Administration of Taxation Notification on Issues Dealing With Corporate Income Tax on Enterprise Restructuring Business (No. 59 (2009)), there are a number of notices as follows:

1. The equity transfer income mentioned in this notification refers to equity transfer income of Chinese resident enterprise shares from a non-resident enterprise. (Buying and selling Chinese resident enterprise shares listed on a stock exchange are not included).
2. If a withholding agent is unable to perform withholding obligations or does not pay according to the Law, the non-resident enterprise shall declare and pay corporate income tax with the relevant tax administration authority where the Chinese resident enterprise registered at (the authority who is in charge of the corporate income tax collection and management of the Chinese resident enterprise) within 7 days after the agreed share transfer date according to the equity transfer contract or agreement (if the transferor obtains income from the transfer in advance, then the date should be the actual date when the equity transfer income occurs). Non-resident enterprise that does not declare truthfully or /and pay their tax on time will be dealt with according to the relevant tax collection and management laws and regulations.
3. Equity transfer income refers to the difference between the equity transfer price and the actual share cost. The equity transfer price refers to the income the share transferor received which may be in the form of cash, non-monetary assets or equity. If the invested enterprise has undistributed profit or holds various after-tax funds, the amount from stockholders retained earnings that is transferred together with the equity from the transferor will not be deducted from the equity transfer price. The actual share cost refers to the actual investment amount paid by the transferor to the Chinese resident enterprise at the time it invested in the shares, or the actual equity transfer price paid to the original transferor at the time buying those transferred shares.
4. When calculating the equity transfer income, the currency used when the non-resident enterprise invested in the Chinese resident enterprise or purchasing the equity from the original investor will be used to calculate the equity transfer price and the equity transfer cost price. If the same non-resident enterprise invested capital multiple times, the currency used in the first calculation will be used to calculate the equity transfer price and the equity cost price. The weighted average method will be used to calculate the equity cost price; if the currencies of each investment are not the same, the amount should be calculated in the currency used the first time with the exchange rate on the day that each investment occurred.
5. When a foreign investor (the actual controlling party) transfers a Chinese resident enterprise equity indirectly, if the actual tax rate is lower than 12.5% in the country (region) where the transferred offshore holding company is located or the country (region) does not levy income tax to its resident on overseas income, then the enterprise needs to provide the following information to the tax administration authority where the Chinese resident enterprise is registered within 30 days after the signing of the equity transfer contract:

a. The equity transfer contract or agreement;

b. The relationships between the foreign investor and the offshore holding company on funds, management, procurement and marketing;

c. The offshore holding company’s conditions on production, management, personnel, finance and property etc;

d. The relationships between the offshore holding company and Chinese resident enterprise on funds, management, procurement and marketing;

e. The proof of a reasonable business purpose on setting up the offshore holding company by the foreign investor;

f. Other relevant information required by the taxation authority.

6. If a foreign investor (actual controlling party) transfers the equity in a Chinese resident enterprise equity indirectly via arrangements such as through the misuse of the corporate form without a reasonable business purpose to avoid corporate income tax liability, the relevant tax authority, after report for investigation from the State Administration of Taxation, holds the right to re-characterise the equity transfer deal according to the economic substance and ignore the existence of the offshore holding company used for the tax arrangement.

7. If a non-resident enterprise transfers the equity in a Chinese resident enterprise to a related party and the transfer price is not in line with the arms length principle for the purpose of reducing taxable income, the relevant tax authority holds the right to make adjustment according to general practice.

8. If a foreign investor (the actual controlling party) transfers the equity in several native or offshore holding companies’ simultaneously, the Chinese resident enterprise whose equity is transferred should provide the whole transfer contract and supplementary contract to the relevant taxation authority. If there is no supplementary contract, the Chinese enterprise should provide detailed information on each transferred holding company to the relevant taxation authority, the transfer price for each native enterprise need to be clarified. If the price cannot be separated, the taxation authority holds the right to choose a reasonable approach to make adjustment to the transfer price.

9. If a non-resident enterprise who has obtained equity transfer income is eligible for special tax treatment according to the special organization restructuring requirement (Tax No. 59 (2009)), the enterprise should submit information in writing that provide proof of meeting the whole requirement for record-keeping purpose to the relevant taxation authority and get approval from provincial taxation authority.

10. Implementation of this notification starts on January 1, 2008. If you encounter any problem regarding implementation, please report to the State Administration of Taxation (International Taxation Division).

Issued on December 10, 2009