International Aspects of China’s Tax Law Topic: anti-tax avoidance Dr. LI Na

Structure of China’s anti-avoidance rules

Transfer pricing neutral concept determination of prices for transactions between associated parties

Transfer pricing relevant to: direct taxation (enterprise income tax), indirect taxes (customs and VAT), foreign exchange requirements, accounting. etc.

Transfer pricing international trade within MNCs

Transfer pricing two perspectives: international transactions: affiliated parties interact across borders

Transfer pricing two perspectives (cont.): domestic transactions: affiliated parties in one country interact but face different tax regimes

Arm’s length principle based on the concept of comparability: compare controlled contractions and uncontrolled transactions

Five comparability factors

China transfer pricing source of law: EIT Law: Articles 41 – 44 EIT Implementing Rules: Articles 109 - 115 Law of Tax Administration and Collection: Article 36 MOF and SAT circulars

China transfer pricing affiliated enterprises: share ownership debt relationship appointment of personnel concurrent position license of intangible

China transfer pricing affiliated enterprises (cont.): Control over purchase or sales activities Control over receipt or provision of service Control over production, operation and trade activities

China transfer pricing arm’s length principle: unrelated parties abide to when carrying out business transactions in accordance with fair market prices and common business

China transfer pricing Five transfer pricing methods

China transfer pricing burden of proof: taxpayer preparation of contemporaneous transfer pricing documentation

China transfer pricing tax authorities’ discretion to deem the taxable income: by reference to the profit margin of same-type or similar enterprises; based on the enterprise’s cost plus reasonable expenditures and profit;

China transfer pricing tax authorities’ discretion to deem the taxable income (cont.): by reasonable proportion of the consolidated profit of the related party group; and other reasonable methods.

China transfer pricing location specific advantages (LSAs) principle: location saving and market premium China’s position in the UN Transfer Pricing Manual

identify if an LSA exists. LSAs Four-steps approach: identify if an LSA exists. determine whether the LSA generates additional profit. quantify and measure the additional profits arising from the LSA.

four-steps approach (cont.): LSAs four-steps approach (cont.): determine the transfer pricing method to allocate the profits arising from the LSA

LSAs - example

China transfer pricing recent development service fee paid between affiliated enterprises Microsoft was charged $140 million by Beijing tax bureau

controlled foreign corporation CFC rule controlled foreign corporation limit artificial tax deferral by using offshore low taxed entities deemed distribution of dividends concurrent taxation at the parent company or individual

U.K.: CFC rules (not applicable to individuals) legislations: U.S.: Subpart F rules U.K.: CFC rules (not applicable to individuals) Germany: CFC provisions in the Foreign Tax Act

Background of China CFC rule

Background of China CFC rule (cont.) China resident-enterprises: worldwide income China-sourced income; and Non-China sourced income foreign tax credit method

Background of China CFC rule (cont.) establishing subsidiaries at tax havens or low- tax jurisdictions risk: tax deferral

EIT Implementing Rules: Articles 116 - 188 MOF and SAT circulars China CFC rule source of law EIT Law: Article 45 EIT Implementing Rules: Articles 116 - 188 MOF and SAT circulars

CFC must be controlled by the Chinese- resident shareholder. China’s CFC rule two criteria CFC must be controlled by the Chinese- resident shareholder. CFC must be incorporated in a low tax jurisdiction

China’s CFC rule control shareholding control effectively control

China’s CFC rule shareholding control

shareholding control (cont.) China’s CFC rule shareholding control (cont.)

other matters of the CFC China CFC rule effectively control personnel assets business operations purchases sales, and other matters of the CFC

effective EIT rate of CFC jurisdiction less than 12.5% China CFC rule low tax rate effective EIT rate of CFC jurisdiction less than 12.5%

consequence of applying CFC rule "deemed dividend" China CFC rule consequence of applying CFC rule "deemed dividend" concurrent taxation at the parent level (i.e. Chinese resident-enterprises)

exception: white-listed country China CFC rule exception: white-listed country Australia, Canada, France, Germany, India, Italy, Japan, New Zealand, Norway, South Africa, U.K and U.S.

burden of proof is on the taxpayer De minimis operation China CFC rule exception (cont.): active business burden of proof is on the taxpayer De minimis operation annual profit of the CFC is less than CNY5 million

through a “relatively high level” of debt compared to equity Thin capitalisation concept: financing situation a company if financed through a “relatively high level” of debt compared to equity

interest payments are deductible and reduce profit Thin capitalisation why it is an issue? interest payments are deductible and reduce profit dividends payments are not deductible

Thin capitalisation rule two options: ceilings: a maximum amount of debt on which interest payments are deductible ratios: a maximum amount of interest that may be deducted by reference to the ratio of interest to another variable

China thin capitalisation rule source of law: EIT Law: Article 46 EIT Implementing Rules: Article 119 MOF and SAT circulars form: ratio

China thin capitalisation rule ‘‘debt investment’’ financing directly or indirectly obtained by an enterprise from its related parties requires repayment of principal and interest, or other forms of compensation with the nature of interest

China thin capitalisation rule debt provided by an unrelated party: provided by the related party through an unrelated party; provided by an unrelated party, but is guaranteed by a related party with joint liability; or substance of indebtedness is indirectly provided by a related party.

China thin capitalisation rule ‘‘equity investment’’ investment obtained by an enterprise without the obligation of the repayment of principal or interest, and by which the investors have the entitlement to the net assets of the enterprise.

China thin capitalisation rule ratio 2:1 in general 5:1 for financial institutions

China thin capitalisation rule formula ratio = aggregation of monthly average debt investment from related parties in 12 months aggregation of monthly average equity investment in 12 months

China thin capitalisation rule in addition total investment – registered capital ratio requirement for FDIs P&G case (2002) investigated by Guangzhou tax bureau for an increase of interest (CNY 81.49 million) based on arm’s length principle

Tax resident enterprise - TRE China resident enterprise (two types): place of incorporation place of actual management

Jiamusi case

China GAAR source of law: EIT Law: Article 47 EIT Implementing Rules: Articles 120 and 123 SAT, the Administrative Measures for GAAR (SAT Order [2014] 32) SAT circulars

China GAAR tax avoidance transaction: where an enterprise makes any arrangement not having reasonable business purpose, and leading to decrease its taxable income or amount of incomes

China GAAR tax avoidance transaction (cont.): not having reasonable business purpose the main purpose is to reduce, exempt or defer the payment of taxes.

China GAAR tax authorities’ investigation: 4 specific scenarios abuse of tax incentives abuse of tax treaty abuse of legal form of company avoidance of tax by using tax havens

China GAAR tax authorities’ investigation (cont.): 1 general scenario: other arrangements without reasonable business purposes

form and substance of the agreement China GAAR 6 factors: form and substance of the agreement conclusion time and execution period of the agreement implementation method of the arrangement

relationship between each step or part of the arrangement China GAAR 6 factors (cont.): relationship between each step or part of the arrangement changes in financial performance of each party involved in the arrangement, and tax consequences of the arrangement

GAAR consequence: tax authorities following the substance over form principle discretion to make an adjustment: re-characterization of the whole or part of the arrangement

GAAR discretion to make an adjustment (cont.): denial of the existence of a party to the transaction for tax purposes, or treating one of the party and other parties to the transaction as one entity

GAAR discretion to make an adjustment (cont.): re-characterization of the income, deductions, tax incentives and foreign tax credits or reallocation of them between the parties to the transaction; and any other reasonable method

China GAAR penalty: increased interest @ of 500 basis point above the benchmark lending interest rate published by the People’s Bank of China for the year in which tax payment occurs

Xinjiang case

retroactive effectiveness Xinjiang case discussion: retroactive effectiveness changes made to the Article 13 (Capital Gain) China - Barbados Tax Treaty GAAR or substance over form

Chongqing case

Chinese tax authorities’ discretion remedy of the taxpayer Chongqing case discussion: burden of proof Chinese tax authorities’ discretion remedy of the taxpayer

Policy implication China’s approach to the BEPS project counter-tax avoidance vs. keeping MNCs in China limitation on tax authorities’ discretion