Tax opportunities and challenges for China in the BRI era
Chinese governmental authorities remain supportive of rational, well-ordered and healthy outbound investment. Michael Wong, Joseph Tam, Karen Lin, Cloris Li and Alan O’Connor look at key domestic tax and regulatory measures implemented to enhance the competitiveness of Chinese outbound investment on the global stage, including under the Belt and Road Initiative (BRI).
China continues to remain firmly in the spotlight of global investors, with a particular focus in media circles on Chinese outbound investment trends. In this regard, there has been a period of consolidation in Chinese outbound investment over the past 18 months, as Chinese investors have come to grips with greater government regulation both at home and abroad.
Outbound deals by Chinese investors decreased by 38% to $123 billion in 2017 from the 2016 record of $200 billion. This being said, the value of deals during the first nine months of 2018 ($82 billion) has remained relatively resilient in the face of a number of headwinds, including the continuing trade frictions with the US and increased scrutiny over Chinese outbound investment by foreign governments. There has been a notable impact from the interventions of the Committee on Foreign Investment in the US (CFIUS), leading to deal values from Chinese outbound investment to the US plummeting 81% from a record $57 billion in 2016 to $11 billion in 2017 and only $5.9 billion in the first nine months of 2018. There may be even tougher times ahead for US-bound investment, as it has been reported that the US Treasury is piloting arrangements which would impose mandatory CFIUS reporting requirements on deals involving investment in US businesses which produce, design, test, manufacture, fabricate or develop 'critical' technologies for use in one of 27 pilot programme industries.
Chinese authorities continue to express support for rational, well-ordered and healthy outbound investment, particularly BRI investment projects, as noted in the State Council's August 2017 notice on guiding and regulating the direction of outbound investment. This year (2018) is the fifth year since President Xi Jinping originally announced the launch of the BRI in 2013. As implementation of the BRI progresses, China's overseas investments in BRI jurisdictions have grown faster than investments into the US, EU and other traditional investment destinations. Statistics from China's Ministry of Commerce indicate that overseas mergers and acquisitions (M&A) in BRI countries increased 32.5% to $8.8 billion in 2017.
The Chinese authorities have announced a number of tax and regulatory measures to further support the competitiveness of Chinese outbound investment on the global stage. In this article we look at these key domestic tax and regulatory measures implemented by the authorities since late 2017, including the strengthening of cooperation with tax authorities in BRI countries, a broadening of domestic tax credit rules for foreign taxes paid on outbound investments, and the simplification of Chinese administrative measures for outbound investments.
Increasing cooperation and collaboration among BRI countries
In last year's seventh edition of China Looking Ahead, in the chapter, A thousand miles begin with a single step: tax challenges under the BRI, we flagged the issue that most BRI countries are emerging or developing economies. Their tax laws and regulations are not yet fully developed and are frequently subject to different local interpretations and unanticipated changes. Accordingly, Chinese enterprises operating in BRI countries can face difficulties in managing their overseas tax affairs, creating tax risks and costs, and consuming management time and attention.
With a view to enhancing collaboration among the tax authorities of the BRI countries, the BRI Tax Cooperation Conference was held in Astana, Kazakhstan, on May 14 to 16 2018. The event was co-organised by the Kazakhstan Ministry of Finance, the China State Administration of Taxation (SAT) and the OECD. The event drew 252 delegates from 49 tax jurisdictions, academics, and representatives from the UN, OECD, IMF and World Bank.
The conference considered four aspects of tax cooperation among the countries involved in the BRI: the rule of law, taxpayer services, effective and efficient dispute resolution mechanisms, and tax administration capacity building. Delegates considered how taxation should, from these four perspectives, support and facilitate deeper tax cooperation.
SAT Commissioner Wang Jun made a keynote speech in which he highlighted China's commitment to further opening up and increasing cooperation with other countries through the BRI. He noted that taxation is important to fostering trade and investment under the initiative.
The delegates of the conference achieved four common understandings:
A more just and fairer tax environment, governed by the rule of law, should be built to boost trade and investment. Economic liberalisation and investment facilitation are to be promoted by implementing improved global tax rules and removing tax barriers;
Efforts should be made to improve cross-border tax-related services, including through electronic interfaces between tax authorities and taxpayers, and build/improve taxpayer credit rating systems, so as to support economic growth and development;
Multilateral and bilateral cooperation should be expanded to strengthen the capabilities of tax administrations, by sharing best practices and learning from each other; and
Tax dispute settlement efficiency should be enhanced to increase tax certainty, optimise the business environment and strengthen investor confidence.
Delegates also agreed to set up an expert team for in-depth research on a new cooperation framework to supplement the existing systems for multilateral tax cooperation. Decisions on this are to be made at the BRI Tax Commissioners' Meeting in Beijing in 2019.
This conference shows that BRI jurisdictions are eager to harness their collective knowledge and to pool resources to support a growth-friendly tax environment. This is a positive development for the increasing numbers of Chinese enterprises looking to do business in these countries.
Favourable changes to China foreign tax credit rules
China's foreign tax credit (FTC) rules have presented continuing issues for Chinese outbound investors, with some of the problematic provisions including:
Credits granted for foreign taxes paid were limited by 'country baskets', i.e. calculated on a country-by-country basis. This meant foreign taxes paid in higher tax countries, which may exceed the Chinese corporate income tax (CIT) on the same income, could not be used to offset the Chinese CIT arising on income from lower tax countries; and
Credits were only available for 'underlying' foreign taxes (i.e. taxes imposed on income arising to foreign subsidiaries) down as far as the third tier of foreign subsidiaries, in which there was a direct or indirect 20% shareholding. This could lead to double taxation on profit repatriations from subsidiaries held below the three tiers of creditable foreign subsidiaries. It is not uncommon, in practice, for the investment structures used by Chinese outbound investors to have more than three tiers, meaning that loss of FTCs was a real risk.
In the past year, the Chinese authorities have moved to remedy this. Following on from plans set out in the August 2017-issued State Council Circular 39, the MOF and SAT issued Cai Shui  84 (Circular 84) on December 28 2017 to enhance the FTC rules. This retroactively applies from January 1 2017 and provides the following:
Enterprises may elect into a de facto onshore pooling FTC regime. Under this so-called 'integrated credit method', income from all countries (and of all types) will be considered together for the calculation of the FTC limits. Alternatively, enterprises may stay with the existing country-by-country credit method. Once an election to adopt the integrated credit method is made, it may not be changed within five years; and
Indirect tax credits may now be claimed down to the fifth tier of foreign subsidiaries.
These Circular 84 enhancements follow earlier clarifications on the claiming of FTC for overseas contracting projects by the SAT through Announcement  41 (Announcement 41) issued on November 29 2017. Under China's FTC rules, an FTC can only be claimed by the party which actually pays the foreign taxes on the foreign contracting income. This is an issue for overseas engineering, procurement and construction (EPC) projects involving a consortium of Chinese contractors and subcontracting arrangements. This is because an FTC is only available to the general contractor (or consortium leader) which paid the foreign tax while the other parties (e.g. sub-contractors) would suffer potential double taxation on their share of project revenues.
Announcement 41 now clarifies the procedures for claiming foreign tax credit for overseas contracting projects for corporate income tax (CIT) filings from (and including) the 2017 tax year:
Where a Chinese enterprise (general contractor) embarks on an overseas project (including but not limited to engineering construction, and infrastructure construction) by way of a contract arrangement or a consortium, the subcontracting enterprise (or each party to the consortium) may claim the FTC based on the allocation of foreign tax paid. The subcontracting enterprise (or each party to the consortium) will be provided with a tax-paid allocation form issued by the general contractor or the leading party of the consortium for claiming FTC purposes;
The general contractor or the leading party of the consortium must allocate the foreign tax-paid amount based on a reasonable ratio. Elements such as income and work undertaken by each party should be taken into consideration;
The general contractor or the leading party of the consortium is required to perform a recordal filing with the Chinese tax authorities when issuing the tax-paid allocation form. A copy of the tax-paid allocation form should also be submitted by the contracting enterprise (or each party of the consortium) to the local tax authority when claiming the FTC; and
The general contractor or the leading party of the consortium must separately account for each overseas contracting project.
These FTC rule changes and clarifications are a welcome development for Chinese outbound investors and contractors as they can reduce the double taxation exposure for their overseas investments and activities.
Updates to outbound investment administrative requirements
In last year's seventh edition of China Looking Ahead, in the chapter, A thousand miles begin with a single step: Tax challenges under the BRI, we looked at a number of regulatory announcements by the Chinese authorities in the second half of 2017 aimed at overhauling China's administration system for outbound investment. Regulatory updates in the outbound investment space have continued over the past 12 months, with the more notable ones considered briefly below.
In recent years, overseas investments by private-owned companies (POEs) have made up an increasingly larger share of China's total outbound investment. Overseas investment activity by POEs grew from around 30% of total Chinese outward direct investment in 2007 to more than 45% in 2016. This fast growth in private investment was not without its challenges, with highly leveraged and non-core business investment cases increasing. This prompted Chinese regulators to impose measures in late 2016 that increased the inspection and supervision of restricted investments, including those in sensitive countries or regions, as well as investments in certain industries such as real estate, hotels, film studios, entertainment, and sports clubs.
Despite these controls, the Chinese authorities remain supportive of outbound investment from Chinese POEs within appropriate limits. Accordingly, in December 2017, various Chinese regulatory authorities jointly issued Private-Owned Enterprise (POE) Outbound Investment Guidance under Fa Gai Wai Zi  2050. The notable guidance is as follows:
The government supports POEs that possess the necessary capabilities to engage in outbound investment. Both POEs and state-owned enterprises (SOEs) will be treated on an equal basis by the government in relation to their conduct of outbound investments;
POEs are encouraged, based on their capabilities, to make outbound investments, participate in the BRI initiative and international industrial capacity cooperation projects, and promote the transformation and upgrade of the Chinese economy;
POEs that plan to engage in outbound investments are required to: (i) set up an in-house department to administer their outbound investments; (ii) specify decision-making procedures for committing to outbound investments; (iii) establish a system to manage the set-up of overseas entities and improve their internal authorisation system; and (iv) establish a system to control outbound investment risks;
POEs are required to (i) intensify supervision over their overseas entities in terms of fund transfer, financing, equity (and other interest) transfer, reinvestment and guarantees; (ii) exercise prudence when making highly leveraged overseas investments; and (iii) ensure that overseas derivatives investments are adequately monitored and managed;
Where a POE's outbound investment is made in sensitive jurisdictions or industries (such as outbound investment in real estate, hotels, cinemas, entertainment, sports clubs and other specified restricted sectors), pre-approval from the National Development and Reform Commission (NDRC) is required. If this pre-approval is not required, the recordal filing applies (i.e. NDRC will subsequently review whether the outbound investment project complies with relevant law and regulations, on the basis of the recordal); and
POEs are prohibited from engaging in foreign currency dealings, asset transfers, or money laundering, under the cover of simulated outbound investment transactions.
The NDRC also issued administrative measures for overseas investments by enterprises, which came into effect in March 1 2018. These new measures aim to improve the competitiveness of Chinese outbound investment by:
Simplifying the filing and approval procedures;
Eliminating the filing requirement of a project information report before commencing substantive work on the transaction;
Limiting the government processing time; and
Extending the validity of the filing confirmation or approval notice to two years unless there are any material changes in the key terms.
These regulatory changes and guidance, particularly those directed toward POE outbound investors, demonstrate the Chinese government's continuing support for overseas investment. We expect this will be important for supporting continued outbound investment growth given the transition to a higher proportion of POE outbound investment in recent years.
Not all good news – emerging controlled foreign company cases
Under the China CIT Law, in certain circumstances, a portion of the income of a controlled foreign company (CFC) must be included in the taxable income of the Chinese resident enterprise controlling the CFC. Specifically, this is where the CFC is established in a jurisdiction where the tax burden is substantially lower than 50% of the standard rate of 25% (i.e. 12.5% or below) and if the CFC does not distribute, or insufficiently distributes, its profits without justifiable operational/commercial reasons.
Chinese enterprises commonly use structures which have one or more overseas special purpose vehicles (SPVs) for their outbound acquisitions or green field investments; their usage will generally have valid commercial reasons. However, while in the past CFC risk was considered somewhat theoretical by taxpayers or professional advisors, since the SAT issued Circular  38 in 2014 the risk has become more real. Circular 38 required Chinese enterprises that had incorporated, participated in or disposed of an existing interest in a foreign company to provide information on foreign participation and foreign income. Leveraging this information, tax bureau CFC enforcement cases have become more common. Some of the most notable cases include the following:
In a case reported in 2015, it emerged that in 2014 the Shandong State Tax Bureau (STB) had asserted that a Hong Kong subsidiary of a Chinese company lacked valid commercial reasons for not repatriating its profit to China. In this case, RMB 50 million ($7.2 million) in CIT was collected. Further notable cases in Hainan, Urumqi, and the Suzhou industrial park were reported in the years from 2015 to 2017; see the chapter, Coming of age – China's leveraging of BEPS;
In a case reported by China Taxation News (CTN) in August 2017, the Beijing STB collected RMB 70 million in tax following a determination that a Chinese enterprise's Panama and British Virgin Islands (BVI) subsidiaries retained the profit generated between 2013 and 2015 outside of China solely for tax deferral purposes;
In a case reported by CTN in February 2018, the Beijing STB opened another CFC case during its tax risk assessment work on an outbound enterprise. The Chinese enterprise had a BVI-incorporated holding company which did not employ any staff. The undistributed profits of the BVI company were composed solely of dividend income from its subsidiary, and it was unable to show the commercial reason for retaining its profits outside of China; and
A further notable 2018 case, relating to a Qingdao, Shandong province-based company, is also detailed in the international tax chapter.
We expect that the Chinese authorities will continue to ramp up enforcement of the CFC rules as overseas profits earned by Chinese outbound investors continue to accumulate. This work is also set to be facilitated by the availability of information collected through country-by-country tax reporting and the common reporting standard exchange mechanisms. Companies with outbound investments should monitor the profit status of their overseas holding companies (particularly those in low-tax jurisdictions) to ensure they are positioned to support the reasonable commercial purposes of any non-repatriated profits.
More changes to come
Many of the recently announced tax and regulatory measures will no doubt be welcomed by Chinese outbound investors and contractors to mitigate the tax costs and administrative burdens of their overseas investments and activities. We also anticipate a future increase in demand, among 'going out' Chinese multinational enterprises (MNEs) for advance pricing agreement (APA)/mutual agreement procedure (MAP) assistance from the SAT. This will be stimulated both by transfer pricing challenges from overseas tax authorities, and by closer follow up, on the China side, with group service fee and royalty arrangements between Chinese MNE parents and their overseas subsidiaries. This issue is detailed further in the transfer pricing chapter, Now that we have data, what are we going to do? – new challenges and opportunities in TP in China.
China's Minister of Finance (at that time, Xiao Jie), in a People's Daily article published on December 20 2017, entitled 'Speeding up the establishment of the modern fiscal system', flagged plans for continued CIT system reforms to meet the requirements of continued globalisation, the BRI, and enhance the competitiveness of China's tax system. The 2018 escalation in trade tensions between China and the US, while challenging, has not appeared to affect China's plans for globalisation-supportive reforms, with Premier Li Keqiang noting at the World Economic Forum in Tianjin in September 2018 that that trend of globalisation was unstoppable and China's process of opening up would only quicken in the years to come.
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Michael Wong is a partner and the National Head of Deal Advisory, M&A Tax for KPMG China. He is based in Beijing and also leads the national outbound tax practice serving state-owned and privately owned China companies in relation to their outbound investments.
Michael has extensive experience leading global teams to assist Chinese state-owned and privately owned companies conduct large-scale overseas M&A transactions in various sectors including energy and power, mining, financial services, manufacturing, infrastructure and real estate.
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Joseph Tam is a tax partner at KPMG specialising in advising Chinese clients on tax issues arising from their overseas business operations and/or investments. In particular, Joseph has advised his clients on tax structuring, tax due diligence, tax modelling review, sales and purchase agreement (SPA) negotiation, corporate restructuring, etc. Joseph has also assisted clients in applying for tax incentives and advance tax rulings.
Joseph services clients in a wide range of industries including infrastructure, power, industrial markets, real estate and financial services.
Joseph is a frequent speaker at seminars on Chinese outbound investment, the Belt and Road initiative and international production capacity cooperation. He is also a member of the Hong Kong Institute of Certified Public Accountants.
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Karen Lin joined KPMG Hong Kong in 2005 and KPMG Beijing in 2011. Since 2011, Karen has been specialising in international taxation and assisting Chinese multinational corporations with outbound M&A transactions, including international tax structuring, tax due diligence and transaction-related tax advisory services. During 2014 and 2015, Karen joined a NASDAQ-listed multinational media group focusing on managing the group's taxation matters covering the Asia Pacific region.
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Cloris Li has more than 15 years of experience working with KPMG across a wide range of international and China tax advisory areas including M&A, international tax planning, IPOs and related structuring, tax disputes, and indirect tax.
Cloris is now focusing and specialising in outbound investment tax services, including outbound M&A, deal structure advice, international tax planning on outbound investment structures, financing and business operation planning.
Cloris has built up a broad range of industry experience across a number of sectors, including automotive, manufacturing, real estate, technology media and telecommunications (TMT), logistics & transportation, mining, and infrastructure.
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Alan O'Connor joined KPMG Hong Kong from Australia in 2000 and became a director in 2013. He worked in Hong Kong for more than 10 years before relocating to Beijing in 2011 where he continues to provide tax services to Chinese outbound investors.
Alan has extensive experience providing due diligence and transaction related tax advisory services to major Hong Kong and Chinese based clients, and has been involved in international tax planning projects, merger and acquisition transactions and due diligence exercises involving Asia, Europe and North America.