China’s new 2007 Enterprise Income Tax Law, for the first time in Chinese tax history, introduced a set of anti-avoidance rules in its Special Tax Adjustments chapter, which include not only transfer pricing and advanced pricing agreement rules but also rules on cost sharing agreements, thin-capitalization, controlled foreign corporations, and general anti-avoidance.
On January 8, 2009, the SAT released long-awaited Circular Guoshuifa  No 2, Implementation Measures of Special Tax Adjustments (Trial) that details rules on administrating all the aspects of those anti-avoidance rules. If the Special Tax Adjustments chapter represents the first anti-voidance legislation in China, Guoshuifa  No 2 can be viewed as the first comprehensive operating manual of anti-avoidance administrations in China. All the provisions in Guoshuifa  No 2 take retrospective effect from January 1, 2008. The most significant provisions of Guoshuifa  No 2 are summarized and analyzed as follows.
Annual filing of related party disclosure forms
As the starting point of the anti-avoidance administration, Guoshuifa  No 2 restates that all enterprises shall file the following nine forms annually to report related party transactions:
- Form 1 – Related party relationships
- Form 2 – Summary of related party transactions
- Form 3 – Purchases and sales
- Form 4 – Labor services
- Form 5 – Intangible assets
- Form 6 – Fixed assets
- Form 7 – Financing
- Form 8 – Outbound investments
- Form 9 – Outbound payments
Those forms require enterprises to indicate whether they have contemporaneous transfer pricing documentation in place. The forms need to be filed together with the annual enterprise income tax return. For the tax year of 2008, the filing deadline is May 31, 2009.
Transfer pricing documentation
A significant new requirement in Guoshuifa  No 2 is the annual contemporaneous documentation requirement that is in addition to the filing of the above nine forms. Enterprises are not required to submit the documentation to the tax authorities until receiving a formal notice. However, once receiving a notice, an enterprise must submit the documentation within 20 days. Failure to submit the documentation will result in a fine in the range of RMB 2,000 to 50,000. Also, if there is a TP adjustment, failure to submit the documentation will result in an additional interest levy of 5 percent.
Enterprise can be exempt from the annual documentation requirement if they meet the following criteria:
- The annual amount of related party purchases and sales of tangible goods is below RMB 200 million and the annual amount of all other related party transactions (services, royalties, interest, etc.) is below RMB 40 million;
- The related party transactions are covered under an advanced pricing agreement; or
- The foreign shareholding of the enterprise is below 50 percent and that enterprise only has related party transactions within China (i.e. with other Chinese enterprises).
The documentation shall cover 5 broad categories and 26 sub-categories of information and should be in Chinese. The 5 categories are:
- Organization structure
- Description of business operations
- Description of related party transactions
- Comparability analysis
- Transfer pricing method
The deadline for completing contemporaneous documentation is five months after the end of a tax year, i.e. May 31. For the year 2008, the deadline is extended to December 31, 2009. Contemporaneous documentation shall be kept for at least 10 years.
Transfer pricing methods
Under Guoshuifa  No 2, enterprises can use one of the following six acceptable methods that are the same methods as under the OECD transfer pricing guidelines, to determine their transfer pricing:
- Comparable uncontrolled price method
- Resale price method
- Cost plus markup method
- Transactional net margin method
- Profit split method
- Other methods that are in accordance with the arm’s length principle
Guoshuifa  No 2 describes in details each of the methods but doesn’t indicate any clear hierarchy for selecting transfer pricing methods, except saying that an enterprise or tax authorities shall choose a transfer pricing method that is most suitable in light of the following five comparability factors:
- Characteristics of the assets or labor services involved
- Functions and risks of each party involved
- Contract terms
- Economic circumstances
- Business strategies
Guoshuifa  No 2 lists seven types of targets that may attract a transfer pricing audit. They are:
- Enterprises with significant amounts or numerous types of related party transactions
- Enterprises with long term losses, very low profits or fluctuating profits
- Enterprises with profitability lower than those in the same industry
- Enterprises with profitability that doesn’t match their functions and risks
- Enterprises dealing with related parties in tax havens
- Enterprises failing to file annual related party disclose forms or prepare contemporaneous documentation
- Enterprises that obviously violate the arm’s length principle
Based on the recent speech of a SAT official, the three major flags are long term low profitability or losses, noncompliance with the disclosure and documentation requirements and transacting with tax havens.
Advanced pricing agreement ("APA")
The APA rules in Guoshuifa  No 2 are basically a restatement of the 2004 APA rules with certain modifications and amendments. Guoshuifa  No 2 sets forth detailed requirements and procedures regarding applying for, negotiating, implementing and renewing APAs. To apply for an APA, an enterprise must have at least RMB 40 million of related party transactions. The term of an APA will cover transactions for 3 to 5 years.
Cost sharing agreement ("CSA")
The implementation rules on CSA are pretty much based on the OECD transfer pricing guidelines. However, in the service context, CSAs are limited to group procurement or group marketing strategies. A CSA, once entered into, shall be filed with the SAT within 30 days. Furthermore, by June 20 of every year, an enterprise shall submit a set of contemporaneous documentation to the tax authorities that includes key information on the implementation of the CSA and any changes to the CSA, participating parties and forecasts.
Controlled foreign corporation ("CFC")
Due to lack of experience and knowledge in this brand new area, the draft team of Guoshuifa  No 2 managed to define only a few key items but failed to set forth detailed guidance on the implementation of CFC rules.
Guoshuifa  No 2 provides that when determining a resident’s shareholding percentage of an indirectly owned foreign subsidiary, the general rule is to multiply its shareholding percentage of the intermediate holding company by the holding company’s shareholding percentage of that foreign subsidiary. However, if the intermediate holding company owns more than 50 percent of that foreign subsidiary, the intermediate holding company is treated as owning that foreign subsidiary 100 percent for the computation purposes.
The deemed dividends from a CFC attributable to its Chinese resident enterprise shareholder are calculated using the following formula:
Reportable income=Deemed dividend distributions × Number of holding days/Number of days in the CFC’s tax year × Shareholding percentage
The foreign corporate income tax coming with deemed dividends can be credited against Chinese enterprise income tax.
Future cash distributions made by a CFC the income of which has been previously taxed as deemed dividends in China shall be exempt from Chinese enterprise income tax.
Guoshuifa  No 2 provides for three exceptions where CFC rules will not apply, which are:
- The CFC is established in a country or jurisdiction that doesn’t have a low tax rate and is designated by the SAT;
- Its income is derived from active business operations; or
- It has annual profits of less than RMB 5 million.
In our Nov China tax update, we reported that Circular 121 sets out the prescribed debt-to-equity ratios – 2:1 for non-financial enterprises and 5:1 for financial enterprises. Guoshuifa  No 2 provides for the mechanics for how to calculate the debt to equity ratio (on a monthly weighted average basis) and further provides that if an enterprise would like to claim deduction of excessive interest expenses, it should prepare and file contemporaneous documentation to the tax authorities.
Guoshuifa  No 2 also clarifies that the non-deductible interest expenses, if paid to overseas related parties, shall be deemed as dividends and thus subject to dividend withholding tax if the dividend withholding tax rate is higher than the interest withholding tax rate.
General anti-avoidance rules
Guoshuifa  No 2 provides that local tax authorities can, upon the approval of the SAT, launch a general anti-avoidance investigation on an enterprise if the enterprise is found to be engaged in any of the following activities:
- Abusing tax incentives
- Abusing tax treaties
- Abusing corporation forms and structures
- Avoiding taxes using tax havens
- Other tax arrangements that don’t have a reasonable business purpose
In determining if an enterprise is engaged in a tax-avoidance arrangement, the tax authorities shall adopt the principle of substance over form. Furthermore, the tax authorities shall consider the following factors:
- Form and substance of the arrangement
- Conclusion time and duration of the arrangement
- How the arrangement is executed
- Connection between each step or part of the arrangement
- Changes of financial status of each party involved in the arrangement
- Tax consequences of the arrangement
The tax authorities can also require the tax planner to submit the materials relevant to the tax avoidance arrangement under investigation.
The tax authorities are empowered to re-characterize transactions based on the true economic substance and disregard the intended tax benefits under a tax-avoidance arrangement. In particular, enterprises without any economic substance including those established in tax havens for the purpose of tax-avoidance, can be disregarded.
Corresponding adjustments and international negotiations
Guoshuifa  No 2 provides that corresponding adjustments shall be allowed in the case of a transfer pricing adjustment in order to avoid taxable taxation. If this involves an overseas related party resident in a treaty country, the SAT will, upon the application of the enterprise, launch negotiations with the competent authorities of that treaty country based on the mutual agreement procedures in the treaty. The application of corresponding adjustments shall be made within 3 years after receiving the transfer pricing adjustment notice.
It should be noted that the corresponding adjustment rule shall not apply where the transfer pricing adjustment involves payments of interest, rental or royalty to overseas related parties. In other words, the excessive withholding tax in such a case is not refundable.
First Anti-Treaty-Abuse Case Publicized in China
Right before Guoshuifa  No 2 was issued, the SAT issued Guoshuihan  No 1076, endorsing an anti treaty-abuse case decided by the Xinjiang Uygur Autonomous Region tax authorities.
The issue was if the Barbados-incorporated company in question that derived capital gains from the sale of its equity interest in a Chinese joint venture company could qualify for the capital gains tax exemption under the China-Barbados treaty. The Xinjiang tax authorities denied the treaty based exemption in the end because they concluded the Barbados company didn’t meet the residency requirement under the treaty and thus would not be considered a resident of Barbados.
The case initially caught the attention of the tax authorities because of the unusual arrangement entered into by the parties involved. Basically, the Barbados company purchased the equity interest in the Chinese JV only one month after the Barbados company was formed and sold the interest about one year after. The return on such an investment was 36 percent, which was pre agreed by the parties. As such, in substance, the return could be arguably considered interest.
The case above clearly indicates that the tax authorities in China intend to seriously implement anti-avoidance rules and will scrutinize similar transactions closely going forward.
An interesting question is what if the Barbados company in question was indeed a Barbados resident even if it was just a holding company. Could the Chinese tax authorities still deny the treaty benefits based on Chinese domestic anti-avoidance rules? Our quick research shows that the answer should probably be NO because the China-Barbados treaty doesn’t permit that. However, if the Barbados company in this case is a HK company, in theory, China should have the right to use domestic anti-avoidance rules to attack the arrangement because Article 25 of the China-HK treaty specifically permits that.
The take-way for companies that have similar offshore holding company structures is that they need to review their structures to determine if they are vulnerable to scrutiny and, if so, what will be the best remedy.