China Tax Monthly
Beijing/Hong Kong/Shanghai
In this issue of the China Tax Monthly, we will discuss the following tax
developments in China:
1. Hong Kong Tax Residency Certificate Valid for Three Calendar Years
for Treaty Purposes
2. Jiangsu Case: Transfer Pricing Adjustments on Related-party
Transaction Between Domestic Affiliates
3. Ningxia Case: Share Transfer Price Adjusted Based on Internal
Comparable Transactions
4. Shandong Case: Transfer Pricing Adjustments to Outbound Royalty
Payments
5. Guangdong Case: China’s First Tax Litigation Case on Dual
Employment Arrangements
1. Hong Kong Tax Residency Certificate
Valid for Three Calendar Years for Treaty
Purposes
On 6 June 2016, the State Administration of Taxation (SAT) issued Bulletin
351 to implement the agreement between the SAT and the Inland Revenue
Department (IRD) on the use of tax residency certificates issued by the
IRD. According to Bulletin 35, a person (entity or individual) can use an
IRD-issued tax residency certificate as evidence of Hong Kong residency
status for the calendar year listed on the tax residency certificate and
for the following two calendar years. If the person loses Hong Kong
tax residency status at any point during the three years, then the IRDissued
tax residency certificate can no longer be used as evidence for the
person’s Hong Kong residency status.
Previously, under SAT Bulletin [2015] No. 602, in order to claim tax treaty
benefits, a Hong Kong tax resident was required to submit an IRD-issued
tax residency certificate in the preceding calendar year or in the current
calendar year. In other words, under Bulletin 60, a tax residency certificate
was valid proof of residency status for a maximum of two calendar
1 Announcement of the State Administration of Taxation Concerning the Use of Hong
Kong Tax Residency Certificates in Mainland China, SAT Bulletin [2016] No. 35,
dated 6 June 2016, retroactively effective from 15 April 2016.
2 State Administration of Taxation’s Bulletin on the Administrative Measures for
Non-resident Taxpayers to Claim Tax Treaty Benefits, SAT Bulletin [2015] No. 60,
dated 11 August 2015, effective from 1 November 2015.
May 2016
China Tax Monthly is a monthly
publication of Baker & McKenzie’s
China Tax Group.
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2 China Tax Monthly | May 2016
years. Now, under Bulletin 35, a tax residency certificate is valid proof of
residency status for a maximum of three calendar years. This extended
validity will lower the Hong Kong tax resident’s compliance burden when
claiming tax treaty benefits with the PRC tax authorities. However, also
note that nowadays the IRD is asking more questions when issuing a tax
residency certificate to a Hong Kong company, such as source and nature
of income, place and nature of business activities, place of management
and control and information about Hong Kong employees (if any), etc.
These questions may cause potential difficulties for a Hong Kong company
without sufficient substance to obtain a tax residency certificate from the
IRD.
2. Jiangsu Case: Transfer Pricing
Adjustments on Related-party Transaction
Between Domestic Affiliates
On 31 May 2016, China Taxation News reported that the Changzhou Local
Tax Bureau made a transfer pricing adjustment on a financing transaction
between two domestic affiliates and collected RMB10.44 million in
enterprise income tax (EIT) and interest.3
Facts
A tax official learned from bank information that a real property
development enterprise established in Changzhou (“Subsidiary”),
which was a wholly-owned subsidiary of another Changzhou enterprise
(“Parent”), borrowed RMB720 million as long-term debt in 2013, resulting
in a total outstanding debt of RMB1.82.billion. The tax official doubted the
commercial rationale behind the Subsidiary taking on such a large debt
load because the Subsidiary had not invested in any new projects since
2013.
The tax official then examined the Subsidiary’s financial statements and
annual tax returns and found that the Subsidiary deducted RMB121 million
in financing expenses before tax in 2013. Meanwhile, the Subsidiary had
RMB605 million in account receivables from the Parent in 2013.
The tax official questioned the Subsidiary’s financial officer about why the
Subsidiary would bear the financing expenses on funds that were actually
used by the Parent. The financial officer explained that such arrangement
was common for real property development enterprises and argued
that the arrangement did not reduce the EIT payable because both the
Subsidiary and Parent were subject to EIT at 25%.
Not convinced by this explanation, the tax official extended the
investigation to the Parent. The tax official found that the Parent’s main
source of income was dividends distributed by its subsidiaries. Because
3 See http://www.ctaxnews.net.cn/html/2016-05/31/
nw.D340100zgswb_20160531_2-06.htm?div=-1.
May 2016 | China Tax Monthly 3
these dividends were exempt from EIT, the Parent had negative taxable
income in 2012, 2013 and 2014 after deduction of expenses.
Based on these findings, the tax official concluded that the purpose of the
financing arrangement was to avoid EIT. As an enterprise with negative
taxable income, the Parent would not benefit from interest expense
deductions unless it transferred its subsidiaries and therefore realized
sufficient taxable income to offset the interest expenses within five years.
Whereas, as an enterprise with positive taxable income, the Subsidiary
would receive immediate EIT benefits from the interest expense
deductions.
After further negotiation, the Subsidiary agreed to book interest income
from the Parent based on the average interest rate and pay RMB10.44
million in EIT and interest on the income.
Observations
As a general principle, the PRC tax authorities would not make a
transfer pricing adjustment on a domestic related-party transaction
where the transactional parties are subject to the same effective
tax rate and the transaction does not lead to a decrease of the
country’s overall tax revenue.
4
This case shows the tax authority’s
willingness to scrutinize a domestic related-party transaction
where the overall tax revenue is reduced. Thus, multinationals
should conduct a thorough review of related-party transactions
between their Chinese operations to determine whether those
transactions could trigger a tax audit.
3. Ningxia Case: Share Transfer Price
Adjusted Based on Internal Comparable
Transactions
On 6 May 2016, China Taxation News reported that the Yinchuan State
Tax Bureau adjusted the transfer price of a share transfer based on an
internal comparable share transfer and collected RMB3.5 million in EIT
from the share transfer.5
Facts
In June 2012, a foreign shareholder (“Transferor”) transferred its 25
percent shareholding in a foreign-invested enterprise (FIE) to a Hong
Kong company (“Transferee”), which was an affiliate of the Transferor.
Six months before the 2012 share transfer, the FIE repurchased 3.84
percent of its own shares from a domestic shareholder at the price of
RMB13.8 million. Although the 2012 share transfer was conducted only six
4 Article 30 of Guo Shui Fa [2009] No. 2, dated 8 January 2009, retroactively
effective from 1 January 2008.
5 See http://www.ctaxnews.net.cn/html/2016-05/06/
nw.D340100zgswb_20160506_3-10.htm?div=-1.
4 China Tax Monthly | May 2016
months after the share repurchase transaction, the profit rates of the two
transactions were found to differ significantly. The domestic shareholder
realized a 453 percent profit while the Transferor only realized a
21.percent profit.
Due to the huge difference in the profit rates, the tax bureau suspected
the 2012 share transfer was conducted at an “obviously low price” to avoid
tax. The tax bureau then questioned the FIE’s financial officer about the
two transactions. In response, the FIE’s financial officer argued that the
two transactions were not comparable. Although not entirely clear from
the news report, it appears the FIE’s financial officer argued that the FIE’s
main business purpose in the share repurchase was to buy back enough
shares so that the FIE could be listed in Hong Kong. In order to repurchase
the needed shares, the FIE had to pay an inflated share repurchase price
to the domestic shareholder who had refused to sell the shares for less.
In order to assess the 2012 share transfer price, the tax bureau required
the FIE to provide: (i) the FIE’s board resolution and pricing documentation
for the share repurchase transaction; and (ii) the FIE’s audit report and
appraisal report from the time of the 2012 share transfer. At first the FIE
was reluctant to provide the information.
Without access to this information, the tax bureau said they would adjust
the transfer price using the share repurchase price as the comparable
uncontrolled price unless the FIE could submit information to evidence
the arm’s length price of the 2012 share transfer. Faced with this “threat”,
the FIE submitted its audit report and development plan. However, the
tax bureau concluded that the information submitted was not sufficient to
prove the arm’s length price of the 2012 share transfer.
The tax bureau finally decided to calculate the FIE’s overall value based
on the share repurchase price and adjusted the 2012 share transfer price
accordingly. As a result, the Transferor paid an additional tax of RMB3.5
million on the share transfer.
Observations
In practice, the tax authorities would normally rely on the appraisal report
of the target company to assess the share transfer price when there is no
comparable uncontrolled transaction.
In this case, the FIE argued that the share repurchase was conducted
at an inflated price and therefore should not be used to determine the
arm’s length price of the 2012 share transfer. However, as the FIE was
unable to provide sufficient information (for example, an appraisal report)
to evidence the arm’s length price of 2012 share transfer, the tax bureau
adjusted the 2012 transfer price based on the share repurchase price even
though the resulting adjusted price probably exceeded the arm’s length
price.
The news report does not contain enough factual information about the
2012 share transfer and the share repurchase for us to determine whether
they were actually comparable. Nevertheless, this case shows how
May 2016 | China Tax Monthly 5
poor supporting documentation can lead to an unfavourable tax result.
Therefore, taxpayers should sufficiently document the arm’s length price
for all share transfers to avoid unnecessary tax costs.
4. Shandong Case: Transfer Pricing
Adjustments to Outbound Royalty
Payments
On 28 June 2016, China Taxation News reported that the Qingdao State Tax
Bureau made a transfer pricing adjustment to outbound royalty payments
and collected RMB14.95 million in EIT and interest from an equity joint
venture (EJV)6.
Facts
According to the news report, the EJV was investigated because it had
stable sales revenue but fluctuating profit in the past ten years. In
particular, from 2004 to 2007 when the EJV was entitled to tax incentives,
it had positive profits. Whereas, it incurred loss in those years when the
tax incentives were not available.
During the investigation, the tax bureau identified two abnormal royalty
payments from the EJV. The first payment related to a technology, which
was announced to be outdated by the Ministry of Commerce in 2003.
However, the EJV paid royalties for this technology until 2009. The other
payment related to a long-term license of a patented technology. The
royalty payment was calculated at a fixed rate, which remained the same
for 20 years. However, the tax bureau expected such royalty payment
to reduce by year because the technology would normally become less
advanced as time goes by.
The tax bureau determined that these two royalty payments were not at
arm’s length, and decided to make a transfer pricing adjustment using the
net margin method. As a result, the EJV recognized an additional taxable
income of RMB95 million, and paid RMB14.95 million in EIT and interest.
Observations
The PRC tax authorities have started to focus more on cross-border
intercompany payments such as royalties and service fees. Unreasonable
royalties paid by Chinese subsidiaries to offshore affiliates are subject
to increasing scrutiny. MNCs should conduct a thorough review of its
existing and future TP policy on IP related transactions.
6 See http://www.ctaxnews.net.cn/html/2016-06/28/
nw.D340100zgswb_20160628_3-07.htm?div=-1.
6 China Tax Monthly | May 2016
5. Guangdong Case: China’s First Tax
Litigation Case on Dual Employment
Arrangements
In November 2015, a Chinese appellate court in Guangdong ruled that a
foreign individual who was dually “employed” by a PRC company and a
foreign company was liable to pay individual income tax (IIT) in China on
salary derived from the foreign company.7
This case is China’s first tax
litigation case on the tax treatment of “dual employment” arrangements.
Facts
The taxpayer, a US tax resident, was the legal representative and board
chairman for a PRC company from 2005 to 2007. During that time, the
taxpayer was also employed by a foreign company affiliated with the PRC
company. In 2005, 2006 and 2007, the taxpayer was present in China for
259.5, 289 and 286 days respectively. In addition to an annual commercial
insurance fee of USD7,761, the foreign company paid the taxpayer salary
of USD107,124, USD176,566 and USD120,081 for foreign employment
activities during those same years.
The Guangzhou Local Tax Bureau required the PRC company to withhold
an additional RMB658,556.01 (approximately USD99,507) in tax on the
taxpayer’s salary paid by the foreign company. The taxpayer initiated an
administrative review followed by an appeal in district court. Both the
administrative review panel and the district court ruled in favor of the
Guangzhou Local Tax Bureau.
The taxpayer then appealed the district court’s judgment to the Guangzhou
Intermediate People’s Court (“Appellate Court”).
Issues and holdings
The key issues and holdings in the appellate case were:
• Was the taxpayer’s salary paid by the foreign company subject to
tax under PRC law? The Appellate Court held that the taxpayer’s
salary was subject to PRC tax because the taxpayer was present
in China for more than 183 days in each of 2005, 2006 and 2007.
This presence in China meant that the salary received during that
time was partially derived from employment exercised in China.
Therefore, the salary was partially taxable in China, which was
proportional to the time that spent in China, regardless of whether
the salary was paid by the foreign company.
• Did the PRC company have a withholding obligation if the income was
subject to PRC tax? The Appellate Court held that the PRC company
was obliged to withhold IIT on the salary because the PRC Company
should have paid the salary, which was instead paid by the PRC
7 The full text of the judgment is available (in Chinese) at: http://wenshu.court.
gov.cn/content/content?DocID=a0a8b884-2c29-465c-9797-be259a2105ca.
May 2016 | China Tax Monthly 7
Beijing
Suite 3401, China World Office 2
China World Trade Centre
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Beijing 100004, PRC
T: +86 10 6535 3800
F: +86 10 6505 2309
Hong Kong
14/F Hutchison House
10 Harcourt Road
Central, Hong Kong
T: +852 2846 1888
F: +852 2845 0476
Shanghai
Unit 1601, Jin Mao Tower
88 Century Avenue, Pudong
Shanghai 200121, PRC
T: +86 21 6105 8558
F: +86 21 5047 0020
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company’s affiliated foreign company. The court based its reasoning
on Guo Shui Fa [1999] No. 2418, which states that an FIE must
withhold IIT on employee salary that should have been paid by the
FIE but was instead paid by the FIE’s offshore affiliate.
• Did the China–US tax treaty preclude China from taxing the income?
The Appellate Court held that China was not precluded by the
China–US tax treaty from taxing the foreign-paid but locally-earned
income because Article 14 of the China–US tax treaty entitles China
to tax a US tax resident’s employment income if: (i) the employment
is exercised in China; and (ii) the US tax resident is present in China
for more than 183 days in the relevant calendar year. The taxpayer
was employed in China and was present in China for more than 183
days in each of 2005, 2006 and 2007; therefore, China was entitled
to tax the US tax resident’s employment income paid by the foreign
company.
Observations
China’s domestic law adopts the time apportionment method to tax a non-
PRC-domiciled foreigner’s employment income, i.e., tax is first calculated
on the foreigner’s worldwide employment income and then apportioned
by his / her working time in China.9
The time apportionment method has
been practiced by the PRC tax authorities for years.
The Appellate Court’s holding in this case once again confirmed
this time apportionment method. In the light of this case, every
foreigner working under a dual employment arrangement
should assess his / her IIT liability in accordance with the time
apportionment method, and try to avoid additional cost arising from
tax non-compliance
8 Notice of the State Administration of Taxation on Issues Concerning Withholding
Individual Income Tax on Salaries Paid by Foreign Entities to Employees of Foreign-
Invested Enterprises and Foreign Enterprises’ Establishment or Place, Guo Shui
Fa [1999] No. 241, dated 21 December 1999, effective from 1 January 2000.
9 Notice of the State Administration of Taxation on Issues concerning the Income Tax
Liability on Salaries and Wages Derived by Individuals without Domiciles within the
Territory of China, Guo Shui Fa [1994] No. 148, dated 30 June 1994, effective
from 1 July 1994.
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