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By Matthew, January 29, 2010 5:25 pm

This is the first post in a series on some of the more common tax problems that I have seen in my time in working in China. A lot of these problems were, at one stage, not problems. But the changing tax environment has meant that many such arrangements are now outdated. Others were always problems, but persisted because of an environment of non-enforcement.

The following scenario is one that I have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).

The scenario:

Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.

This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:

Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.

Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.

Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.

Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.

Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.

Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.

Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.

Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.

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By Matthew, December 16, 2009 11:54 am

A five-year case involving China’s first use of information exchange to confirm related-party transactions and succeed in tax adjustments has recently been finalised in Xiamen. The anti-avoidance investigation adjusted the taxpayer’s taxable income by 28.07 million yuan, and back taxes 2.93 million yuan. http://www.chinataxblog.com/?p=28

This is a very significant tax case that has just recently been concluded. It is first case where the State Administration of Taxation has used information exchange (in this case with the US) in respect of related party transactions. The case took over 5 years to conclude and demonstrates the patience of the SAT to get their man. Given the importance I have decided to give a little case summary (I feel like Im back in Law school).

Xiamen Case

The name of the company has not been revealed by the tax authorities. However, the structure was a very common one. A foreign invested enterprise (“China Co”) was set up in Xiamen almost 20 years ago for the purpose producing leather and polyurethane (a rubber like material) shoes. The enterprise was basically established as an original equipment manufacturer (OEM) and did not retail the shoes it produced. Overtime the business developed a stable level of production and profitability. However, China Co’s reported profits remained low. This was despite the fact that the scale of the operations expanded from an initial 4 production lines to 14 production lines, that annual production capacity increased from 4 million pairs of shoes to 10 million pairs and that the capital of the company was increased from $400,000 to $9,000,000.

The tax authorities looked cynically on such low profits and in 2004 began investigations into the company’s affairs. Through these investigations it became clear that China Co had one principal client, an American company (“US Co”). There was also some other dodgy stuff going on. China Co had a poor tax record generally, having previously been subject to tax adjustments. At some stage, the ownership of the equity was transferred to a nominated individual (the SAT formed the view that this was done to avoid an appearance of a related party transaction).

However, it was incumbent upon the SAT (in order to invoke the transfer pricing rules) to establish that China Co and US Co were related parties. In response to the tax authorities enquiries, China Co argued that there was neither an investment relationship (US Co was not a shareholder in China Co) nor any common senior management between the two companies. Accordingly, China Co argued that this was an ordinary commercial relationship (note that this case was determined pursuant to the old transfer pricing rules). Despite the obvious concerns arising out of the inherent nature that the business was run, the authorities had difficulties in acquiring sufficient evidence to establish a related party nexus.

In around 2007-2008, the authorities determined to proceed with an information exchange with their US counterparts in relation to the companies. This information exchange included information in relation to the two companies bank accounts. The information provided established a critical clue – that the controller of US Co’s bank account was the individual shareholder of China Co. This therefore established a requisite related party nexus.

It should be noted that the current transfer pricing rules provide that parties will be related where one party largely controls the purchase and sales activities of the other party. Its likely that proving that US Co controlled China Co would no longer be necessary. The fact that China Co’s whole business was, in essence, for the purpose of supply China Co would likely be sufficient.

This is a good little case for several reasons. Firstly, it provides a good example of how tax authorities use information exchange to investigate avoidance practices. Secondly, it provides a good example of a structure that was once quite common in China (and is still not uncommon) that will be particularly targeted by the SAT over the coming years. Finally, it provides a good example of the crude use of transfer pricing to reallocate profits.

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By Matthew, November 22, 2009 10:58 pm

I wanted to give an example of how an appropriate transfer pricing strategy can deliver tax savings to a company. Here I will use the example of an Australian company (Aus Co) that establishes a wholly foreign owned entity (WFOE) in China. Aus Co is the direct shareholder. This is a very simple scenario and most multinational groups will adopt far more detailed and complex arrangements.

No Transfer Pricing

We will assume that the WFOE had $1000 of taxable income in the current financial year. That generates a tax liability in China of $250 (25% x 1000) . Accordingly, $750 is able to be paid as a dividend. The dividend payment will be subject to 10% withholding tax and accordingly a $75 tax liability arises for AusCo. WFOE, as a withholding agent, is required to pay that amount. As such, the after-tax amount received by Aus Co is $675. It should be noted that non-portfoilo dividends (dividends in respect of shareholdings in a company above 10%) are exempt from tax in Australia.

Transfer Pricing

Now we assume that the China intellectual property  for the WFOE is held by Aus Co which licenses the rights to use the IP to the WFOE for $20 per month ($240 per year).  Aus Co has also lent funds for the WFOE to use for operational purposes with interest of $10 per month ($120 per year).

We will need to assume that the interest rate and royalty fee amount are consistent with China’s transfer pricing rules. We will also assume that the loan does not infringe China’s thin capitalisation rules. In China, after deducting the royalty fee and the interest, the WFOE’s taxable income is $640. As a result, the WFOE is liable to $160 in tax (25% x $640).  Accordingly, the WFOE is able to pay a dividend of $480 to Aus Co. Withholding tax of 10% ($48) is payable for the dividend. Aus Co will receive a $436 after tax dividend which is not taxable in Australia.

The royalty fee and interest (in total $360) will be subject to withholding tax of 10% = $36. This means that Aus Co will receive $324. This will be subject to tax in Australia at the corporate rate of 30%. However, Aus Co is entitled to an offset for tax paid in China. The Australian tax is determined by grossing up the income to the pre-foreign tax amount and then providing a credit for the foreign tax paid. Accordingly, this will be calculated as follows: $360 x .3 – $36 = $72 tax. After tax, Aus Co will receive $252.

In total, including the dividend, Aus Co will receive $688. This is $13 more than what Aus Co would have received without transfer pricing. This may seem like a small amount but if the taxable income of the company had been sufficiently more (lets say 1 million) the tax savings each year can be significant.

WORD OF CAUTION: It should be noted that the royalty and interest will also likely be subject to business tax of 5% in accordance with the Interim Regulations on Business Tax. No off-set for the payment of such tax is provided in accordance with Australian law. Accordingly, the savings may be less in such circumstances.