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. Business Tax to Be Completely Replaced by VAT from 1 May 2016 2. New HNTE Recognition Rules Take Effect from 1 January 2016 3. Anshan Case: Transfer Pricing Adjustment on Service Fees 4. Beijing Case: Withholding Tax Levied on Disguised Guarantee Fees 5. China Issues Reform Plan on Tax Collection and Administration System 1. Business Tax to Be Completely Replaced by VAT from 1 May 2016 On 5 March 2016, Premier Li Keqiang announced that China will expand the value-added tax (VAT) pilot program to cover the last four major industries still outside the program: financial services, real estate services, construction services and consumer services. These four industries will join the VAT pilot program starting 1 May 2016. With this expansion, the VAT pilot program transforms into a comprehensive nationwide VAT program and completely replaces business tax (BT) in China. Given the small amount of time between the announcement and the expansion date, detailed implementing rules are expected soon. Unlike BT, which is included in the transactional price and not creditable, VAT is excluded from the transactional price and is generally creditable. This difference will significantly alter a taxpayer’s tax liability and compliance burden. Taxpayers engaged in the four industries being brought into the scope of the VAT pilot program should prepare for this shift from BT to VAT. 2. New HNTE Recognition Rules Take Effect from 1 January 2016 On 29 January 2016, the Ministry of Science and Technology, the Ministry of Finance and the State Administration of Taxation (SAT) jointly issued the revised Administrative Measures for the Recognition of High and New Technology Enterprises (HNTE) (“Notice 32”).1 Notice 32 retroactively takes effect from 1 January 2016 and replaces the previous HNTE recognition 1 The Revised Administrative Measures on the Recognition of High and New Technology Enterprises, Guo Ke Fa Huo  No. 32, dated 29 January 2016, retroactively effective from 1 January 2016. February 2016 China Tax Monthly is a monthly publication of Baker & McKenzie’s China Tax Group. Beijing Suite 3401, China World Office 2 China World Trade Centre 1 Jianguomenwai Dajie 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 2 China Tax Monthly | February 2016 rules in Notice 172.2 An HNTE is subject to enterprise income tax (EIT) at the preferential rate of 15 percent rather than the standard 25 percent. Changes to HNTE qualifications Notice 32 makes some notable changes to the previous HNTE recognition qualifications: • Ownership of intellectual property (IP) is required. Previously, to qualify as an HNTE, an enterprise needed to obtain core IP rights of the main products / services within the last three years by way of self-development, transfer, donation, merger & acquisition, or a global exclusive license for a period of more than five years. Notice 32 removes the three-year requirement and provides that the enterprise must own the relevant IP for the enterprise to qualify as an HNTE. • Personnel requirements are lowered. Previously, science and technology (“S&T”) related employees with an associate degree (three-year program or above) had to account for at least 30 percent of the total work force, and at least 10 percent of the total work force had to be engaged in R&D activities (“R&D Personnel”). Notice 32 repeals both the educational requirement for S&T related employees and the R&D Personnel minimum percentage requirement. Under Notice 32, S&T related employees engaged in R&D or technology-innovation activities should account for at least 10 percent of the total workforce. • R&D expense requirement is lowered. Notice 32 leaves unchanged the rules that R&D expenses in the past three accounting years should not be lower than 4 percent of sales revenue for an enterprise with sales revenue ranging from RMB50 million (excluded) to RMB200 million (included) in the last year, and 3 percent for an enterprise with sales revenue over RMB200 million in the last year. However, Notice 32 lowers the floor for R&D expenses from 6 percent to 5 percent for an enterprise with sales revenue of no more than RMB50 million in the last year. In addition, Notice 32 now requires the enterprise to have no serious safety or quality accidents and no serious illegal environmental acts within one year prior to its application. Observations The IP ownership requirement under Notice 32 is likely to affect many Chinese subsidiaries of multinational companies (MNCs). Due to IP protection concerns in China, many MNCs are reluctant to allocate IP ownership to Chinese subsidiaries. Therefore, in practice, many Chinese 2 The Administrative Measures on the Recognition of High and New Technology Enterprises, Guo Ke Fa Huo  No. 172, dated 14 April 2008, retroactively effective from 1 January 2008. February 2016 | China Tax Monthly 3 subsidiaries obtain IP via a license from a foreign affiliate. Under Notice 32, these Chinese subsidiaries will no longer qualify as HNTEs. Notably, Notice 32 only counts S&T related employees engaged in R&D or technology-innovation activities when determining whether the 10 percent minimum threshold is met. This additional qualification was probably added because some enterprises randomly classify their employees as S&T related employees in order to qualify as an HNTE. However, the term “technology-innovation activities” is not clearly defined in Notice 32; therefore, clarification of this term is needed in additional rules or by local tax authority interpretation before we can know whether the additional qualification will constitute a significant impediment to those seeking to inflate their S&T related employee counts. 3. Anshan Case: Transfer Pricing Adjustment on Service Fees On 22 December 2015, China Taxation News reported that the Anshan State Tax Bureau of Liaoning province made a transfer pricing adjustment to outbound service payments and collected RMB11.34 million in EIT and interest from a foreign invested enterprise (FIE).3 Case Facts According to the news report, the FIE was investigated because it paid unusually large service fees to its overseas parent company. The tax authority’s investigation found that the FIE’s service payments had increased significantly: in 2006, the FIE paid RMB180,000 for five service items; and in 2013, it paid RMB19.85 million for 24 service items. The FIE’s previous annual profit rates of 20 to 35 percent dropped to 13.71 percent in 2013. By the end of 2013, the FIE had cumulatively deducted RMB49.9 million in service fees when calculating EIT. On this basis, the tax authority reached a preliminary conclusion that the FIE was likely to be involved in tax avoidance. Their preliminary conclusion led them to conduct a functional analysis on the FIE. According to their functional analysis, the FIE was not a full-function enterprise because it did not have sales functions (the FIE did perform all production and had some procurement, management and contract R&D functions). 3 See http://www.ctaxnews.net.cn/html/2015-12/22/ nw.D340100zgswb_20151222_1-05.htm?div=-1 (China Taxation News is a newspaper indirectly owned by the SAT). 4 China Tax Monthly | February 2016 The tax authority required the FIE to provide a breakdown of the service items. It applied Bulletin 16’s six tests4 to analyze the authenticity and reasonableness of the service items. The tax authority then provided opinions on the service items: • Financial and human resource (H&R) service. The FIE could have operated normally without the parent company’s services; therefore, the financial and H&R services were not provided due to the FIE’s operational needs. • Information dissemination service. The FIE neither owned its own brand nor sold products to third parties; therefore, it could not have benefitted from the information dissemination service. • Planning service for product development. The FIE did not own the patent produced from product development; therefore, it could not have benefitted from the planning service for product development. • Enterprise resource planning service. The parent company had been compensated by previous royalties; therefore, the parent company should not charge a separate fee here. • Market research service. The FIE did not sell products to third parties; therefore, it could not have benefitted from the market research service. • Production process support and technical service. The service content was identical to other services – consulting service and production efficiency planning service; therefore, the parent company should not charge a separate fee here. • Product application supporting service. This service should be provided by a sales company to third-party customers; therefore, it should not be borne by the FIE as a non-sales company. • Technical support service for product development. The parent company controlled and implemented the whole process of product development while the FIE did not have any product development function; therefore, the service was never provided to the FIE. After nearly ten rounds of negotiations, the FIE finally agreed to pay the additional tax and interest. Observations This case shows that the PRC tax authorities have become highly sophisticated in conducting transfer pricing analysis on intercompany 4 Six service categories are not deductible for EIT purposes, including: (i) services irrelevant to the enterprise’ functions, risks or operations; (ii) shareholder activities; (iii) duplicative services; (iv) incidental benefits; (v) services that have been compensated in other related-party transactions; and (vi) other services that cannot bring economic benefits to the enterprise. State Administration of Taxation’s Bulletin on Enterprise Income Tax Issues Related to Outbound Payments by Enterprises to Overseas Related Parties, SAT Bulletin  No. 16, dated 18 March 2015, effective as of the same date. February 2016 | China Tax Monthly 5 services. Coupling this development with the tax authorities’ aggressive auditing of intercompany service payments in response to the Base Erosion and Profit Shifting (BEPS) Project, MNCs may face greater challenges in their intercompany service payments. To meet these challenges, MNCs should conduct a thorough review of whether their intercompany services fall within the six categories of non-deductible services. 4. Beijing Case: Withholding Tax Levied on Disguised Guarantee Fees On 1 January 2016, China Taxation News reported that the Shunyi District State Tax Bureau in Beijing identified a disguised guarantee fee payment and collected RMB7.89 million in EIT.5 Case Facts A PRC airline company entered into a tripartite agreement (“Agreement”) with a French bank and a US bank. According to the Agreement, the two banks would provide financing services to the PRC company for its financial leasing of two airplanes. The agreement expressly stated that another US bank was the guarantor and that the PRC company should pay export credit agency fees (出口信贷机构费) of USD10.8 million to the guarantor via the two banks. The PRC company submitted the Agreement for recordal with the tax authority and applied to the tax authority for tax exemption on the fees. In the application, the PRC company characterized the fees as service fees. However, when reviewing the Agreement, the tax authority thought the fees might actually be guarantee fees because: (i) the fees were calculated at 4 percent of the initial guarantee amount; and (ii) the PRC company had not paid any specifically named guarantee fees to the guarantor. After further analysis of the Agreement and negotiations with the PRC company, the tax authority recharacterized the fees as guarantee fees for domestic tax purposes. Specifically, the fees were recharacterized as PRC-sourced guarantee fees derived by a non-resident, which meant they should be taxed at a rate of 10 percent EIT on the gross amount of the fees6 . In order to avoid paying tax on the gross amount of the fees, the PRC company then argued that the fees, as part of the interest for financial leasing, should be treated as royalties paid for the use or right to use industrial, commercial or scientific equipment under the PRC–US tax treaty. According to the PRC–US tax treaty, a US resident only needs to pay PRC income tax on 70 percent of these fees. The tax authority 5 See http://www.ctaxnews.net.cn/html/2016-01/01/ nw.D340100zgswb_20160101_4-10.htm. 6 See Announcement of the State Administration of Taxation on Several Issues concerning the Administration of Income Tax on Non-Resident Enterprises, SAT Bulletin  No. 24, dated 28 March 2011, effective from 1 April 2011. 6 China Tax Monthly | February 2016 rejected this tax treaty argument because Notice 75 provides that interest paid in relation to a financing lease arrangement should be excluded from royalties paid for the use or right to use industrial, commercial or scientific equipment7 . The PRC company then advanced a final, desperate argument that the fees should be completely exempt from PRC income tax. The PRC company argued that the fees should be characterized as interest for PRC–US treaty purposes and that the guarantor as a government-owned financial institution should be exempt from PRC income tax on the fees. The tax authority rejected this tax treaty argument because Notice 75 provides that guarantee fees charged by a person other than the creditor should not be characterized as interest for treaty purposes. The fees in question were charged by the guarantor rather than the creditor and therefore could not be characterized as interest. The PRC company finally agreed to withdraw the tax exemption application and withhold the tax accordingly. Observations The report does not reveal the final characterization of the fees for treaty purposes. Technically speaking, the fees should be characterized as “other income” because the fees do not belong to any of the specific income items under the treaty. In this case, as the PRC–US tax treaty does not restrict China’s tax rights on “other income” sourced in China, China’s right to tax the fees could not be restricted. The result might be different under other China tax treaties, which provide “other income” shall be taxable only in the resident state unless the taxpayer has a permanent establishment in China. Typical examples are China’s tax treaties with the UK, the Netherlands, France, etc. Under such a treaty, guarantee fees charged by a non-resident other than the creditor could possibly be exempt from PRC income tax. 5. China Issues Reform Plan on Tax Collection and Administration System On 24 December 2015, the General Office of the State Council published a Plan on Further Reforming the State and Local Tax Collection and Administration System (“Plan”).8 The Plan proposes 6 categories of tasks, which are further divided into 31 detailed tasks, to be fulfilled by the end of 2017. Among these tasks, the following have particular importance to multinationals. 7 Announcement on Issuing Interpretations on the Agreement between the Government of the People’s Republic of China and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Tax Evasion with Respect to Taxes on Income and the Protocols thereof, Guo Shui Fa  No. 75, dated 26 July 2010, effective as of the same date. 8 The Chinese version of the Plan is available at http://www.chinatax.gov.cn/ n810219/n810724/c1955421/content.html. February 2016 | China Tax Monthly 7 Beijing Suite 3401, China World Office 2 China World Trade Centre 1 Jianguomenwai Dajie 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 www.bakermckenzie.com To find out more about how we can add value to your business, please contact: Beijing Jon Eichelberger (Tax) +86 10 6535 3868 email@example.com Jinghua Liu (Tax and Dispute Resolution) +86 10 6535 3816 firstname.lastname@example.org Shanghai Brendan Kelly (Tax) +86 21 6105 5950 email@example.com Glenn DeSouza (Transfer Pricing) +86 21 6105 5966 firstname.lastname@example.org Nancy Lai (Tax) +86 21 6105 5949 email@example.com Hong Kong Amy Ling (Tax) +852 2846 2190 firstname.lastname@example.org New York Shanwu Yuan (Tax and Transfer Pricing) +1 212 626 4212 email@example.com International taxation The Plan proposes that PRC tax authorities actively participate in the formulation of international tax rules, strengthen international tax cooperation, crack down on international tax avoidance and evasion, and take initiatives to promote China’s outbound investment. These tasks are restated in Shui Zong Fa  No. 159 (“Circular 15”), which was issued by the SAT on 16 February 2016 to guide tax authorities nationwide on the focus for taxation in 2016. Circular 15 requires tax authorities to improve international tax information exchange mechanisms, strengthen anti-tax avoidance audits, and establish tax risk monitoring systems on multinationals. Tax risk analysis and tax audit The Plan requires the tax authorities to strengthen tax risk analysis and tax audits. The risk analysis will focus on large enterprises that derive high income or have a high net value. Enterprises that are key tax sources should be examined once every five years. Information sharing mechanism The Plan proposes establishing a tax information sharing platform between state tax bureaus and local tax bureaus at all levels and between tax bureaus and other government departments. Furthermore, the Plan proposes including taxpayer credit records in a uniform credit information sharing platform available to the public. Observations As indicated by the Plan, the PRC tax authorities during the next two years will focus on strengthening the tax risk analysis and tax audit on international tax avoidance cases. In response to this tax authority focus, multinationals should refocus as well on ensuring compliance with tax laws and preparing themselves to defend their tax interests if challenged by the tax authorities. 9 Announcement of the State Administration of Taxation on Printing and Distributing the Focus for Taxation in 2016, Shui Zong Fa  No. 15, dated 16 February 2016. This update has been prepared for clients and professional associates at Baker & McKenzie. Whilst every effort has been made to ensure accuracy, no responsibility can be accepted for errors and omissions, however caused. 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