China Tax/Business News Flash 

The Legislation introduces a general anti-avoidance rule which formally authorises Chinese tax authorities to make an adjustment where the taxpayer enters into an arrangement 'without reasonable commercial purpose'.  This is a strong signal of the tax authorities growing scrutiny on anti-avoidance schemes.  This provision does not specify whether the scrutiny would just be placed on related party transactions or even expanded to cover transactions with unrelated parties.  The key focus is on commercial reasonableness which could sometime be very controversial.  Since the onus of proof falls on the part of taxpayers, so it is imperative for them to justify any special deals (be it with related or unrelated party transactions) with sound commercial grounds, and to compile sufficient documentation in case of enquiry and challenge from tax authorities.

Where the profits of an enterprise that is controlled by a Chinese tax resident (be it an enterprise or individual) are not distributed or distributed in a reduced amount without reasonable commercial operating rationale, Article 45 of the Legislation states that this portion shall be deemed as the Chinese tax resident's revenue and therefore be subject to Chinese CIT.  At this time, given that multinational companies typically do not use FIEs to conduct outbound investment, this provision is most relevant to DEs.  We also note that the provision is not addressing "ownership" but merely "control".  There is no definition of 'control'.  For example, is a regional office in Shanghai deemed to be 'controlling' a Hong Kong entity and therefore be deemed distribution?  This should be carefully followed when the Chinese implementation rules are released.

Close

For the first time, the Legislation introduces a thin capitalisation rule for entities in China.  Specifically, Article 46 states that the ratio of debt investments to equity investments from related parties must follow the 'prescribed criteria'; otherwise the interest from the excess debt would be deemed to be non-deductible for tax purposes.  It is important to note that, unlike many other countries, these thin capitalisation rules make reference to loans from related parties only.  If an FIE obtains loan finance from third-parties (e.g. banks) in addition to related parties, how would the excess portion be treated?  This could potentially lead to certain manipulations in the debt source.  Additionally, the definition of 'debt' is unclear from the wording of this Article - for example, does debt include trade payable?  Legislation in many developed countries often tightly defines what may constitute debt.  The Chinese implementation rules may further clarify these issues.

Close

The CSA regulation contained in Article 41 is good news for taxpayers wishing to use this arrangement.  In the past, multinational companies were less willing to share IP or services with Chinese subsidiaries for various reasons - a key factor being that shared costs were non-deductible in the hands of the Chinese subsidiaries.  Additionally, although there were a few reported cases and circulars providing the greenlight on CSAs, it seemed in practice that the acceptance of a CSA at the local tax bureau level was difficult.  While tax should not be a driver for such group activities, it should also not be an obstacle.  This new provision in CIT Law provides a legal framework and paves the way for China to attract more advanced IP and sophisticated services from overseas which will benefit the whole country in long term.
  
The Chinese implementation rules may help to clarify a number of questions that arise from Article 41.  For example, can group companies share their intra-group service costs within China?  What are the turnover tax implications?  How effective will the implementation of a CSA be in practice?

Close

One of the most significant practical impacts of the Legislation on transfer pricing is the imposition of a special interest levy on anti-avoidance tax adjustments made by the tax authorities.  To date, there is no penalty for any transfer pricing adjustments made by authorities, except for the tax on the adjustment itself.  This limits compliance incentives for the taxpayer until they face a transfer pricing review or audit situation.  The implementation of special interest levy will significantly increase the financial cost associated with any anti-avoidance tax adjustment, not only transfer pricing tax adjustments.  It is understood that the special interest levy may include a true interest component based on the time value of money and a penalty component.  In particular, a retrospective interest charge may have a significant impact given that tax authorities are able to investigate as far back as ten years.  Whether the imposition of a special interest levy will be retrospective or prospective and the rate of interest and methodology to be applied are not disclosed within the Legislation.
  
It is also unknown at this time whether there may be some ways to mitigate the penalty component of the special interest levy through 'good behaviour' on the part of the taxpayer, for example, through the preparation of appropriate contemporaneous transfer pricing documentation.

Close

Article 41 reinforces the Chinese tax authorities' ability to make an adjustment to related party transactions where the arm's length principle is not followed.  The wording states where an Enterprise and its related parties transact on a non-arm's length basis, resulting in a reduction of Taxable Revenue or Taxable Profit of the Enterprise or its related party, the in-charge tax authorities may make an adjustment.  The wording of the Legislation is however very broad and raises questions such as whether this provides the tax authorities with the power to make an adjustment to revenue?  If so, what would be the turnover tax implications?  How about the corresponding profit?  Can an adjustment be made to the Enterprise or its related parties (per the wording), and if so, do tax authorities have the ability to adjust related parties based overseas?
  
The implementation rules may clarify these questions.

Close

Article 42 of the legislation refers to a tax authority and taxpayer's ability to conclude APAs.  While the SAT have previously provided detailed guidance on APAs in the form of Guo Shui Fa [2004] 118, legislating APA arrangements indicates strong support from the central government and potentially enhances the application procedures at local levels.  Additionally, it allows taxpayers a stronger voice to pursue their applications with local tax bureaus.

Close

Article 43 of the Legislation requires taxpayer to attach to its annual CIT return a related party transactions report.  Under current practice, FIE's must prepare either Form A or Form B which requires basic disclosure on its related party transactions.  It is uncertain whether Article 43 is reiterating the same practice or whether the nature of the disclosures will be expanded to include TP methodology, benchmarking, industry analysis, etc.  This is particularly relevant given that the SAT have considered for some time the issuance of contemporaneous documentation legislation.  The interaction between the legislation, the implementation rules and the proposed contemporaneous documentation rules is so far unknown, but should be monitored closely.
  
Additionally Article 43 requires, during a transfer pricing investigation, that the enterprise, its related party and other relevant enterprises provide relevant information according to the rules.  It appears from the wording of this article that the tax authorities may be reaching out to related parties and other relevant enterprises.  This raises questions regarding the definition of other relevant enterprises and whether it includes third parties.  Additionally, for related parties who are overseas, will they be required to provide 'relevant information' during transfer pricing investigations?

Close

Apart from Chapter 6, while no other parts of the Legislation deal directly with transfer pricing, certain changes to tax requirements in other areas of the Legislation may impact an enterprise's transfer pricing strategy in China.  These may include:

• A reduction in preferential tax treatments for certain FIEs.
• Commencement of preferential tax treatments for enterprises operating in encouraged industries and conducting certain business activities.
• Abolishment of general tax holidays on manufacturing enterprises and export oriented enterprises (although grandfathering arrangements will apply).
• Forced commencement of tax holidays by 1 January 2008.
• Grandfathering, to a certain extent, of existing preferential tax treatment.
• The imposition of caps on the deduction of certain expenses.

Using the example of the tax holiday, according to the new Legislation, where an FIE has not triggered their tax holiday due to ongoing tax losses, there will be a forced commencement date of 1 January 2008.  This is likely due to the tax authorities desire to push the old tax holiday regime to an end within a foreseeable period.  If, however, FIEs which have been making a consistent loss in China suddenly become profitable after forced commencement date, the tax authorities may question the reasons for the sudden profit and challenge whether the loss position in the past actually reflected arm's length behaviour.  Additionally, the tax authorities may monitor the profit position after the tax holiday ceases to ensure there is no manipulation to create a sudden fall again in the profit after the tax holiday.  We therefore recommend FIEs properly consider their transfer pricing positions and prepare appropriate transfer pricing documentation to support the arm's length nature of their transactions and explain any material changes in profit over the period.

Close