Coming of age – China’s leveraging of BEPS
Following years of rapid change to China’s cross-border corporate income tax (CIT) rules and advances in enforcement effectiveness, a more measured approach has recently emerged, reflecting business environment changes and China’s evolved position within the global economy. Chris Xing, Conrad Turley, Grace Xie, and William Zhang, trace the latest trends.
In last year's seventh edition of China Looking Ahead, the chapter, China after BEPS, considered how China's cross-border tax policies had begun to respond to the country's evolved role in the global economy. In particular, it was observed that:
Outbound direct investment (ODI) from China had overtaken inward foreign direct investment (FDI) from 2015, and major external economy policies such as the Belt and Road Initiative (BRI) had come to strongly influence top level strategic thinking for China, and the nature of its international engagement.
Against this backdrop, and to support the outbound investment trend, in 2017 China amended its foreign tax credit (FTC) regime, sought to improve its double tax agreements (DTAs) with BRI countries and other trade and investment partners, and invested resources in better mutual agreement procedure (MAP) assistance for China outbound investing enterprises.
To counter the perceived stagnation of FDI, a measure was announced to defer the imposition of withholding tax (WHT) on outbound dividends, where the dividends were used to finance reinvestment in China. This accompanied announcements, in the 2017-issued State Council Circulars 5 and 39, of plans for major liberalisation of foreign investment restrictions for numerous Chinese industries.
At the same time, there was no let-up in rigorous tax enforcement for inbound investment. In their work, the tax authorities were bolstered by new big data analytical capabilities and better information collection and pooling. Treaty abuse, indirect offshore disposal, transfer pricing (TP) and permanent establishment (PE) enforcement cases were prominently highlighted by the State Administration of Taxes (SAT) and provincial tax authorities through their websites and WeChat social media feeds, the ostensible aim being to let taxpayers clearly understand that they would be monitored and pursued pro-actively. BEPS rollout measures taken, and future plans in this space, were also frequently emphasised to taxpayers.
In 2018, while many of these trends have continued, two key developments originating in the US came to shape the broader context of China's external economic and tax policies:
The major US tax reform passed in December 2017, and effective from January 2018, substantially increased the tax competitiveness of the US compared to its prior position; this is discussed in detail in the chapter, When America squeezes – implications of US tax reform for China.
In parallel, in the course of the year the US placed high import tariffs on an increasing range of Chinese exports to the US. If further proposed tariffs are adopted by the US then virtually all Chinese exports to the US may well be subject to high tariffs by the start of 2019. China responded with countervailing tariffs on US exports to China. See the chapter, In the eye of the storm – how does China act and react in times of trade tension?, for further detail.
The next steps in the stand-off remain uncertain, but it seems possible that the China-US trade issues may become the centrepiece of hurdles confronting the global economy. Under the replacement for the North American Free Trade Agreement (NAFTA), the US-Mexico-Canada Agreement (USMCA), a key provision (Article 32.10) can be used to bar members from entering into separate free trade deals with China (as a 'non-market economy'). Conceivably, the US could look to insert such clauses into its other trade agreements, such as with post-Brexit UK.
China, in turn, may reorient trade and investment towards the trading partners and associated groupings of which it is part. As noted in the chapter, Tax opportunities and challenges for China in the BRI era, this is already happening. In the last year, Chinese investment in the US fell substantially, while BRI investment steadily rose. China is also committed to continuing negotiations on the Regional Comprehensive Economic Partnership (RCEP) together with the 10 ASEAN nations, Japan, Australia, New Zealand, Korea, and India, which would account for 29% of global trade. This happens as the US has pulled out of its earlier commitment to the ASPAC-focused Trans-Pacific Partnership (TPP).
While political developments in the US and China could reverse this momentum, businesses and tax policymakers must now take into account scenarios in which there is a splintering of the hitherto dominant globalisation trend, and plan accordingly.
In the medium-to-longer term, the US trade and tax developments raise questions concerning the future shape of global supply and value chains, and China's role in them as the 'workshop of the world'. Many commentators consider that these developments are likely to accelerate the trend, already well underway, for low-end, low-margin, processing activity for clothes, toys, and so on, to be relocated from China to South East Asia and India. Chinese manufacturing, in the meantime, is pivoting towards middle and high-tech production, including vehicles, electrical and construction equipment, as supported by automation and robots.
Against this backdrop, Chinese tax and regulatory policies, including in the cross-border space, have been evolving to accommodate these changes.
Building on the investment liberalisation announcements in 2017's State Council Circulars 5 and 39, a further important speech by President Xi at the April 2018 Bo'ao Forum, and the June 2018 State Council Circular 19, a string of opening up measures were put into effect in 2018, or timetabled for implementation in the near future.
The number of economic sectors restricted for foreign investors under the 'negative list' was lowered from 63 to 48. The requirements for foreign investors to have Chinese joint venture (JV) partners were signalled for abolition across a whole host of sectors, meaning that 100% foreign invested entities would be permitted to conduct these businesses. These include transport and logistics, ship and aircraft building and repair, wholesale activity, professional services, energy and transport infrastructure and, on a phased basis in the period to 2022, auto manufacture. Perhaps most prominently, on a phased basis in the period to 2021, foreign investment access to the Chinese financial services sector is seeing substantial liberalisation; the details of the latter are outlined in the chapter, China FS sector opening up: Tax opportunities and challenges ahead.
Further sectors are set to be opened up to 100% foreign ownership in the foreign trade zones (FTZs), including a range of telecoms and internet services. The quotas for the various arrangements existing to facilitate portfolio investment cross border in and out of China (i.e. Stock and Bond Connect, QFII/RQFII/QDII) are to be expanded. Finally, a range of measures is promised to ease access to working visas, protect intellectual property (IP), simplify cross-border cash pooling, and involve foreign investors in state-owned enterprise (SOE) reform.
It might be noted that FDI of $98 billion was reported for the first nine months of 2018, up 6.4% from the same period last year, reaching a new high for China inbound FDI. This being said, the past years have seen many high-level announcements of plans for investment liberalisation, only to be subsequently delayed, so foreign investors will be watching keenly to see if these are implemented as promised.
On the tax front, in September 2018 it was provided that the application of the dividend reinvestment WHT deferral incentive would be further broadened; this is detailed in the chapter, Not-so-old wine, in a not-so-new bottle – Perennial tax challenges for M&A with new twists. November 2018 saw the introduction of VAT and WHT exemptions for China corporate bond investments by overseas institutional investors.
A series of enhancements were made to China's innovation tax incentives in 2018, notably in relation to the research and development (R&D) super deduction; see the chapter, R&D 2.0: Taking tax incentives to the next level in China. This goes some way towards bolstering the incentives for conducting R&D activity in China, even in the face of US tax changes which might make this relatively less attractive, such as the base erosion and anti-abuse tax (BEAT) and foreign-derived intangible income (FDII) measures.
Furthermore, and as described below, in SAT Announcement  9, the SAT sought to bring greater certainty to the granting of DTA relief. Much more detailed guidance was provided than was previously the case, though at the same time the SAT decided not to diverge from the demanding commercial substance-focused interpretation of beneficial ownership, which they have adhered to since Circular  601 (Circular 601) was released.
At a broader and more intangible level, there has been a perceptible change in the 'tone at the top' with regards to the previous, highly assertive, China tax enforcement approach. Whereas in previous years the websites and WeChat social media feeds of the SAT and provincial tax authorities insisted vocally that they had the tools to enforce (e.g. big data analysis, information pooling and exchange mechanisms) and would do so vigorously (e.g. notices of enforcement campaigns, and highlighted enforcement cases), the last year has seen a decidedly softer tone. The emphasis in these communications is more on efforts to improve taxpayer services and ease access to incentives.
This is paralleled by observations, in practice, that at least in China's advanced first-tier cities, such as Beijing, Shanghai and Shenzhen, a more reasonable approach is being taken by tax officials to dealing with taxpayer issues; this is detailed in the tax management chapter, Seeing the tax trees from the data forest – how does Chinese tax administration manage in the digital age? China's tax law and formal guidance frequently leaves many grey areas, and there is increasing positive experience of tax officials, in these cities, taking a more holistic view, and applying the law in a manner more sensitive to commercial realities and in line with original tax policy intent. This may be linked to the greater experience and training of tax officials, which has helped them develop a better understanding of increasingly complex taxpayer commercial arrangements. It may also be a function of their increased enforcement effectiveness, as a consequence of the shift to data-driven tax enquiries/audits, use of taxpayer credit ratings, and so on, as this gives the authorities greater leeway for a more holistic approach. The recent general government policy on encouraging business activity and inward investment also forms an important backdrop, in this regard.
The TP chapter, Now that we have data, what are we going to do? – new challenges and opportunities in TP in China, reinforces this view with the observation that TP assessments dropped substantially in number and value over the last year. This was as a result of tax authorities in first-tier cities relying on advance data analysis to enter into early stage discussions with taxpayers on their tax positions, and reach agreement on changes to their positions, and forestalling the launch of formal audit procedures. The TP chapter also observes the countervailing trend, whereby in less developed cities and districts, the tax authorities have become, in some cases, tougher to deal with. Officials in these districts may lack the same experience with advanced commercial arrangements and advanced data analytical tools, and with tighter control and supervision being exercised over their operations from a central level than in the past, they may be reluctant to use their discretion to apply the rules outside the strict wording of the law and SAT guidance. This can lead, on occasion, to commercially problematic applications of tax rules.
Nonetheless, despite this, the broader trend and policy is increasingly clear. In light of the changing external economic environment, and in view of the priority placed on promoting inbound investment, at a central level the SAT has set a goal of facilitating business. Incentivising and supporting investment and business activity is the theme underlying new tax policies and the tone of tax authority-taxpayer interactions with better organised and better (data) equipped tax authorities expected to have the capacity to apply the tax rules effectively, without the need to 'bang the drum' of highly assertive tax enforcement. In the enforcement cases outlined below (which are largely obtained from tax media sources, as the authorities themselves report far fewer cases these days) the role of data analysis and information exchange come through clearly. Firstly though, a round up will be provided on the latest state of play with the BEPS rollout.
In September 2015, even before the release of the BEPS reports by the OECD in October 2015, the SAT issued an omnibus draft BEPS circular. This included elements covering TP, controlled foreign company (CFC) rules, and changes to thin capitalisation rules and the general anti-avoidance rule (GAAR). What is more, senior SAT officials indicated an intent to implement the BEPS permanent establishment (PE) changes, as well as anti-hybrid rules. As noted in last year's international tax chapter, however, events subsequently took a different path.
While overhauled TP rules and documentation requirements were subsequently set out, in 2016 and 2017, the relevant circulars were carved out from the September 2015 document. No developments have emerged with CFC rules, PE rules or hybrids, and only minor changes were made to thin capitalisation rules as part of the TP guidance. This situation, which we reported on in last year's international tax chapter, remains the same in this year's chapter.
China did sign the BEPS multilateral instrument (MLI) in 2017, and elected to have virtually all of its DTAs updated, to the extent they matched to elections by DTA counterparties. Initially, 48 Chinese DTAs matched, and this has now risen, with the adherence of further Chinese DTA partners to the MLI, to 55 (Barbados, Jamaica, Kazakhstan, Malaysia, Saudi Arabia, Ukraine and UAE are now also added). However, China decided to opt for the minimum updates possible, updating its DTAs with the principal purpose test (PPT) and associated new DTA preamble (i.e. that the object and purpose of DTAs is not to facilitate treaty shopping), but foregoing the PE updates, binding arbitration, and any of the hybrid-related changes. In fact, with the release of Announcement 9 (described below), it might well be asked what relevance the PPT update will actually have.
At an earlier stage (including in previous years' editions of this publication) it was speculated whether the SAT might look to disentangle the 'commercial substance' elements from the Chinese beneficial ownership concept, set out in Circular 601, leaving it as a test of control and disposition of assets and income (in line with the internationally understood concept of beneficial ownership). The commercial substance matters might then be considered in the context of a PPT or GAAR assessment of treaty abuse arrangements. However, with Announcement 9, the SAT has 'doubled down' on its commercial substance approach to beneficial ownership. As such, even when the PPT and preamble updates to China's DTAs come into effect (anticipated in 2020 and 2021, depending on when China and its DTA partners ratify the MLI), there may not be much consequential change in DTA anti-abuse enforcement practices.
Putting BEPS in the context of China's evolving position, both economically and from a tax perspective, this does, however, make quite a lot of sense. It has often been said that China was 'doing BEPS' in advance of the launch of the G20/OECD BEPS project in 2013:
The use of concepts such as local marketing intangibles in Chinese TP enforcement practice since the mid-2000s, presaged the 2015 BEPS Actions 8 to 10 recognition of local contributions to intangible value creation under the development, enhancement, maintenance, protection, and exploitation of intangibles (DEMPE) framework. The 2017 updates to Chinese TP guidance, while introducing the BEPS TP concepts into Chinese rules, localised these rules to an extent that they largely copper-fastened the approaches already taken in enforcement practice.
The tough China approach to treaty abuse, applied since 2009, came long in advance of the 2015 BEPS Action 6 proposals on PPT and limitation of benefits (LOB).
The measure recognised as the most important in the entire BEPS programme, the Action 13 CBC reporting, has been adopted by China. The Action 12 guidance on mandatory reporting of tax planning arrangements has also been reflected in recent guidance requiring China tax advisors to register their advisory activities with the tax authorities. China's incentives passed the Action 5 harmful tax practices review, and new procedures facilitate ruling exchange. Hybrids and debt planning remain harder to structure in China due to regulatory factors, including forex controls, and so the BEPS Action 2 and 4 changes were never going to be an overweening priority. For the other major BEPS items, being the updates to PE and CFC rules, the transformation of China's external economy position since the BEPS work commenced made it likely, in retrospect, that action in this space might be looked at again, through an altered lens.
China remains deeply engaged in the Action 1 digital economy work conducted through the BEPS inclusive framework; this is dealt with in detail in the chapter, A Sisyphean task? – Tax plays catch up with China's rapid digitalisation. Work on this may well have a strong bearing on future global standards on PE, TP and CFC rules – to the extent that global compromise can be reached in this space, including by China, such changes would also make their way into updated Chinese rules.
One final point worth mentioning in relation to cross-border anti-avoidance rules is the adoption, in the new Individual Income Tax (IIT) Law passed in August 2018, of a GAAR, as well as TP and CFC rules; these are detailed in the chapter, One giant step forward in Chinese IIT reform. While in many other countries CIT and IIT cross-border anti-avoidance rules have developed in tandem over the years, in China such rules grew quite sophisticated in the CIT space while remaining wholly underdeveloped in the IIT space. International tax practitioners in China consequently focused primarily on CIT. Going forward, IIT rules and enforcement are set to rapidly catch up with CIT, making them a key area to watch in the China international tax space. In this regard it is important to note that following the merger of the local and state tax bureaus (LTBs and STBs) throughout China, the international aspects of IIT and CIT enforcement are being dealt with jointly by combined international tax departments at the level of 36 provincial tax bureaus; IIT and CIT matters were previously dealt with separately by the LTBs and STBs. This means a more structured and effective approach going forward; the STB-LTB merger is covered in the chapter, Seeing the tax trees from the data forest – how does Chinese tax administration manage in the digital age?
Treaty guidance clarifications in 2018
In February 2018, the SAT introduced two important new circulars to clarify the application of relief under China's DTAs.
SAT Announcement  9 (Announcement 9), effective from April 2018, refines the interpretation of the beneficial ownership requirement in the dividends, interest and royalties articles of Chinese DTAs. As noted above, since the issuance of Circular 601 this has been a very challenging area in Chinese cross-border taxation. An evaluation of commercial substance, at the level of the DTA relief claimant, is applied alongside an evaluation of the claimant's control over the relevant income and assets, with reference being made to a series of 'negative factors'. While, with Announcement 9, the SAT has now conclusively decided to stay with a commercial substance driven concept of beneficial ownership, a number of aspects of the new guidance may help to improve access to DTA relief:
The SAT interpretative guidance accompanying Announcement 9 sets out numerous detailed examples which give a much better sense of what level of commercial substance the SAT considers acceptable for accessing relief. As one of the main issues with the existing beneficial ownership concept is the great diversity in local tax authority interpretations on the appropriate level of substance, these examples will be useful in justifying taxpayer positions before the local authorities. This being said, in particular for investment funds, the substance expectations in the guidance could be viewed as quite challenging to meet. Interestingly, the indicative requirements bear some similarity to those outlined in Example K, in the PPT guidance of the 2017 OECD Model Tax Convention (MTC) Commentary, which has also been viewed by practitioners as commercially unrealistic for funds.
An earlier circular, SAT Announcement  30, had provided a safe harbour under which listed foreign companies, and their local subsidiaries tax resident in the same jurisdiction, would not need to satisfy the 'negative factor' analysis to qualify as beneficial owners. Announcement 9 now extends this to companies, held by individuals and governments, and tax resident in the same jurisdiction.
There is now a type of 'derivative benefits' test, under which regard can be applied to the 100% direct and indirect parents of a DTA relief claimant company, in making the beneficial ownership assessment. If the parent company is either tax resident in the same jurisdiction as the DTA relief claimant, or in a jurisdiction whose DTA with China offers equivalent benefits, and it does not breach the negative factors test, then DTA relief will be available to the DTA relief claimant. Multinational enterprises may find this of use (less so investment funds). The provision might be regarded as having parallels in the PPT discretionary clause, which is an optional element of the BEPS PPT rule; this also involves a derivative benefits based let-out. However, in the Chinese beneficial ownership case, this let-out is automatic, whereas under the BEPS PPT rule, granting of the let-out is at the discretion of the competent authority. It might be noted that in China's MLI PPT elections it chose not to adopt the discretionary clause.
It should be noted that, even with the clarifications to the meaning of beneficial ownership, DTA relief remains challenging to access in China in light of substantial deviations and inconsistency in the administrative procedures followed by local tax authorities. This is coupled with the increased challenges of obtaining tax residence certificates in some of the key holding company jurisdictions for China (e.g. Hong Kong and Singapore), which further complicate DTA access.
Separately, also in February, the SAT issued Announcement  11 (Announcement 11), which supplements the earlier DTA guidance provided in SAT Circular  75 (Circular 75). Circular 75 is the most substantive piece of China DTA guidance and draws heavily on the commentary on the OECD model tax convention. Minor clarifications are provided on service PE timeframe calculations, and DTA transport and artist articles, but the most notable clarification concerns the treatment of foreign partnerships.
It is provided that, unless there are specific provisions in a given DTA dealing with partnership transparency, then foreign partnerships themselves must qualify for DTA benefits for any relief to be available. This means that the partnerships need to show that they have registered with foreign tax authorities as tax residents and have paid tax as residents. One cannot just look through to the underlying partners and show that the partners paid tax, and then be able to claim DTA benefits on this basis.
At present, solely the China-France DTA has special provisions allowing for foreign partnership look-through. In practice, for other DTAs, taxpayers have, in the past, had case-by-case discussions with local tax authorities to agree foreign partnership look-through to access DTA relief. The new guidance would seem to close the door on this approach. Given that, in commercial practice (and particularly for investment funds), many partnerships are set up as flow-through entities, and the partnerships themselves are not registered as tax residents, this could create extensive China DTA relief complications. While China could, potentially, look to add new protocols to its DTAs to provide for look-through, this would not assist with the many Cayman and British Virgin Islands (BVI) partnerships used for China investment given the lack of relevant China DTAs.
These were the principal SAT DTA-related circulars during the year. In the meantime, taxpayers and local tax authorities are still coming to terms with the complexities of 2017's Announcement 37 guidance on WHT application and 2015's Announcement 60 guidance on DTA relief administration, both of which remain challenging in application. Apart from these DTA-related guidance developments, China expanded its DTA network by signing new DTAs with Gabon and Congo in 2018. These are the newest China treaties alongside the DTA signed with Kenya in 2017, and the November 2018 signed replacement DTA with Spain and DTA protocol with India, though they all await the completion of domestic ratification procedures before they can go into effect. The limited DTA signing activity of the last two years is partly owing to the fact that China already has one of the most expansive DTA networks in the world, and extensively updated many of its existing DTAs, particularly those with EU countries and some key BRI jurisdictions (e.g. Russia and Romania), earlier in the 2010s. As noted above, 55 China DTAs (and rising) are set for update through the MLI.
As a side note, the China-Chile DTA of 2015 was updated automatically in 2018, by virtue of a novel most favoured nation (MFN) clause included in the DTA. Chile's new DTA with Japan, which includes more favourable interest and royalty WHT rates than the China DTA, entered into force in 2018, and the MFN clause activated those better rates for the China DTA as well. No other China DTA, as yet, contains such provisions (it is rather Chile that has been including MFN clauses in its recent DTAs) but this shows a willingness by China to innovate in DTA design.
Enforcement efforts to further leverage off big data
As noted above, in the last year there has been a perceptible change in the 'tone at the top' with regards to the previous, highly assertive, China tax enforcement approach. The messaging from the SAT and provincial tax authorities is more about assisting taxpayers and providing access to incentives. It has also been observed that, in practice, in China's advanced first-tier cities a more reasonable approach is being taken by tax officials to deal with taxpayer issues. In dealing with the intersection of complex commercial arrangements (e.g. restructurings) and the frequent grey areas in China tax law and formal guidance, officials can be increasingly found to take a more holistic view, and apply the law in a manner more sensitive to commercial realities and in line with original tax policy intent. This may be linked to greater experience and training among the officials in these cities, as well as the echoing down of the new tone at the top. It may also be linked to the increased enforcement effectiveness, as a consequence of the shift to data-driven tax enquiries/audits, use of taxpayer credit rating, and so on. As observed above, and in the tax management chapter, this is by no means universal, and particularly in lower tier cities, managing interactions with tax officials may, in some cases, be even more challenging.
All these trends and developments come through in the selection of enforcement cases documented below. As noted in previous years' international tax chapters, relatively few cases go to court in China and so the main sources of information on tax enforcement cases are business and tax-specialist media. In previous years, the SAT and the local tax authorities also publicly highlighted many cases through their official WeChat social media feeds, with a view to raising taxpayer awareness of tax audit effectiveness, penalty strictness, and encouraging compliant behaviour. With the softer tone in communications this year, far fewer cases have been reported by the authorities, and there is more reliance on the media for details. However, as previously mentioned, the details available are generally limited, with fragmentary technical discussion. Also worthy of mention is that, in contrast to our coverage in last year's international tax chapter, there were no notable cross-border transaction-related court cases on taxation in the last year.
Treaty abuse cases
While the release of Announcement 9 in 2018 has refined the China concept of beneficial ownership, for the enforcement cases reported in the past year, the local tax authorities continued to apply the Circular 601 guidance, and its seven negative factors.
In a case reported by China Taxation News (CTN) in August 2018, the Wujing district tax office of Changzhou (Jiangsu province) State Tax Bureau (STB) denied dividend WHT DTA relief to a Hong Kong (HK) company. In the case, a US company had established the HK company as a holding company for the Changzhou-based company. The Changzhou company in turn held equity in a further Chinese company, and its main source of income was dividends from this latter company. The whole structure appears to have been set up in April 2017.
When the Changzhou company lodged DTA relief forms and documentation with Wujing tax office, the authorities noted from the Golden Tax III system that the company had an 'M' taxpayer credit rating, designating a newly established company; this piqued the interest of the authorities. On further scrutiny of the DTA filing documentation, they noted that the HK company operated out of a 100 square metre warehouse in HK's New Territories, and observed that its minor outlays on management fees and salaries, reported on the HK company's accounts, were dwarfed by the large dividends received by the company from China.
Suspecting a contrived treaty planning arrangement, they initiated information exchange procedures with the HK tax authorities. The latter reported that, in fact, most of the time no-one was working at the warehouse and the costs recorded on the HK company's accounts were fees for daily operation of the warehouse. Presented with this information, the Changzhou company admitted that the arrangement was purely set up for treaty relief access purposes, and the warehouse arrangements were solely for the purposes of giving perceived substance to the HK operations which would support a DTA beneficial ownership assertion. The DTA relief filing was withdrawn, and full WHT of RMB 1.5 million ($215,000) was paid.
In a further dividend DTA relief case, reported by CTN in December 2017, the Qingdao (Shandong province) STB denied dividend WHT DTA relief to two HK companies – RMB 30 million was recovered. 'Web crawler' software played an important role in the identification of the cases for follow up.
The HK companies held equity in several Chinese companies, from which they received substantial dividend payments. The HK companies had made filings with the Qingdao STB in relation to their application of the reduced DTA 5% dividend WHT rate. The authority's web crawler software gathered information from various internet sources, indicating that the HK companies were thinly capitalised and had little operating assets/personnel, and 'red flagged' them for follow up given their substantial China source income. On investigation, the authorities found that the HK companies did not have an office, or any employees, in HK. In fact, all of their operations in equity transactions were undertaken by the employees of a Qingdao company within their corporate group. They concluded, on the basis of the negative factor analysis, that the HK companies did not satisfy the beneficial ownership test, and the DTA WHT relief was clawed back and late payment surcharges (LPS) imposed.
Moving to DTA cases relating to interest WHT, in a CTN case report of November 2017, Anshun (Guizhou province) STB clawed back five years of interest WHT DTA relief claimed by a HK company and LPS. In addition, it had to make up for tax underpaid as a result of failure to adjust WHT for the tax gross up in the loan contract. A total of RMB 1.7 million was paid.
The case was identified for follow up after the Anshun STB performed a comprehensive review of the outbound payments of companies in its district, with a focus on companies that had claimed DTA relief. The relevant interest payments for which the tax adjustment was made covered the years 2011 to 2016, and the tax authority's position was grounded in the Circular 601 beneficial ownership negative factors. The authorities noted that interest payments from an Anshun-based cement manufacturing company to its HK parent were straight away paid on to the latter's BVI parent, meaning that the HK company did not have substantive control rights over the interest income, nor did it assume associated risks. In addition, the HK company had no fixed staff, no fixed office location, nor substantive operating activities, thus conclusively failing the Circular 601 tests.
The variety of treaty abuse situations dealt with using the Chinese tax authorities' approach is highlighted by a recent corporate liquidation case. In a CTN reported case of June 2018, the Wuxing district tax office of Huzhou (Zhejiang province) STB denied dividend WHT DTA relief to a Singapore company which held 80% of the Huzhou company.
The Huzhou based company lodged DTA relief forms and documentation with Wuxing tax office in August 2016. On checking the Golden Tax III system the authorities observed that the company had filed a notice commencing liquidation at the end of June 2016, and that the filed financial statements up to the end of June 2016 recorded substantial intangible assets. Enquiries revealed that this represented land use rights over unused land. On further enquiry with the company it was revealed that an agreement had been reached in June with the local government to buy back this land, and payment was received in July. The dividend payment in respect of which DTA relief was claimed primarily comprised the consideration received for the sale of this land.
The tax authority then moved to push back on the DTA relief claim. Under domestic law tax guidance concerning liquidations, after a liquidation notification is filed with the tax authorities a tax period ends and a new liquidation tax period begins, and specific rules govern the tax treatment of subsequent distributions. Distributions out of amounts included in undistributed profit reserves at the time of the liquidation notification will be treated as dividends; beyond this, distributions of any amounts in excess of registered capital will be regarded as capital gains of the foreign equity investor. Under the China-Singapore DTA, dividends enjoy a 5% WHT rate, while capital gains for holdings above 25% of total capital are subject to the 10% China domestic WHT rate.
The tax authorities took the position that the Huzhou company had accelerated the land use right disposal in order to secure the 5% WHT treatment; the company admitted as much. On the assertion that the arrangements were driven by a tax avoidance motive, and that the land use right sales proceeds should not form part of the pre-liquidation period profit reserves, payment of the supplementary WHT, representing the 5% WHT reduction previously secured (RMB 1.8 million), was demanded and received.
It is striking, in these DTA relief cases, how the authorities make increasingly effective use of their sustained investment in systems and technology. The cases show how taxpayer credit ratings, the Golden Tax III system, web crawler software, international information exchange, and pooling of data with other governmental authorities (e.g. with the forex authorities, in the third example above, for the purposes of an outbound payments review). This is a trend which will continue to grow in coming years. Starting from September 2018, China commenced automatic exchange of information (AEOI) via the OECD common reporting standard (CRS) mechanisms opening a new chapter in the targeted effectiveness of Chinese cross-border tax enforcement. This is expected to be a key dynamic in China tax administration in the years ahead.
While SAT officials have made periodic statements about work on further China PE guidance, it remains unclear when this might be released and what it will contain. As noted above, China made a policy decision not to expand agency PE, with reference to the BEPS PE changes, through the MLI. In contrast to many other ASPAC countries (e.g. Indonesia, Thailand, and Australia), China has not yet sought to introduce any novel digital economy tax nexus concepts. Consequently, enhanced PE enforcement has continued, in the interim, to focus on traditional PE issues in China, notably service PE.
In a case reported on the website of Penglai (Shandong province) STB, a German company had to pay an additional RMB 0.6 million in CIT and value-added tax (VAT) in respect of its PE in Penglai city. The German company was invested in a JV producing offshore oil platform equipment for export, and was providing expert supervisory services to the JV under a services contract. The presence of the relevant staff on the ground in China had given rise to a service PE, as this had exceeded the DTA time threshold. The supplementary tax matter, followed up on by the Penglai tax authorities, was the separate arrangement under which the German company was compensated for the travel, hotel and food costs of the relevant staff.
These payments had been made out of China without need for recordal with the tax authorities, as they fell into a recordal exclusion. The authorities asserted that these amounts should be considered attributable to the PE, and form part of the base cost for the VAT and CIT calculations (a deemed mark-up of 40% on costs applies).
In a case reported by CTN in May 2017, Dalian (Liaoning province) STB asserted that a foreign company, supplying equipment and providing installation services to a Dalian company, had a service PE in China.
Through the Golden Tax III system, Dalian STB found that the Dalian company made a 2015 recordal filing, and payment of WHT (calculated based on recognition of a PE in 2015), in respect of a payment of equipment inspection service fees. However, there was no such recordal (or tax withholding) for previous years, despite the fact that the company appeared to be purchasing a large number of machines and equipment for assembling drilling platforms from the same foreign company in these years. On investigation, Dalian STB found that in the equipment sale contracts covering 2012 to 2014, while engineers were dispatched to the Dalian company for equipment installation work, there was no separate billing of the services and equipment sale. Enquiries with on-site engineers, and a review of the company records revealed the presence of the foreign personnel, and it emerged that the foreign company was engaged in multiple interlinked projects in China throughout the course of the year. With the time presence on connected projects exceeding 183 days, a service PE was deemed to exist and RMB 19 million in tax and RMB 3 million of LPS were collected.
As described in the chapter, Navigating through China's changing M&A tax landscape, another noted PE enforcement development is the focus, by the Beijing tax authorities and others, on 'grandfathered structures' in the real estate investment space. Agency PEs have been asserted due to the fact that the local property manager was granted with broadly defined authority to act and contract on behalf of the foreign companies (e.g. overseas special purpose vehicles (SPVs) of real estate investment funds) which held title to the properties.
Drawing on the cases above, China is certainly getting more proficient at using data to track and challenge inbound PE cases. However, whereas at an earlier point in time China would have been considered a prime candidate for adoption of expanded PE and source nexus concepts, this can no longer be said with the same confidence. It remains to be seen in which direction China tax policymakers seek to bring PE. In particular, it is still uncertain whether the SAT will put forward a revised interpretation of existing treaty PE language to expand its scope, or whether limits will be set on how far China plans to push PE, with an eye to the position of China 'going out' enterprises.
China began to use its CFC rules in 2014, with the Shandong and Hainan cases, and followed this in 2015 with the Urumqi case. The trend for increased use of CFC rules continued in 2017 with the Suzhou Industrial Park case in the Jiangsu province.
In 2018 there were several further reported cases. In a further reported case from Shandong province, Qingdao STB imposed RMB 5.5 million in tax and late payment interest on a Qingdao company whose HK subsidiary had received, and retained overseas, substantial dividend income. Under Chinese CFC rules, the low taxed income of a CFC can still avoid CFC tax impositions if reasonable business purposes for retaining the income overseas (e.g. reinvestment in operations) can be provided. As no satisfactory explanation was forthcoming, and as the dividend income was exempt from HK tax, the income was treated as taxable under the CFC rules.
Further cases from Beijing, reported by CTN in 2017 and 2018, are detailed in the chapter, Both sides, now – tax opportunities and challenges for China in the BRI era.
The future development of China's cross-border CIT rules is, as explained above, clearly contingent on the evolution of China's external economic position. The coming year will bear out whether trade issues between China and the US become a staple feature of the global economic environment. If so, then Chinese cross-border tax rules may well be shaped by the changes in global supply and value chains prompted by a changed global trade environment, and by shifts caused in the direction of Chinese outbound investment (e.g. more investment directed to BRI countries and Europe).
The outcomes of the digital economy work at global level will clearly also have an important influence on the shape of international tax rules, including China's relevant rules. There will be high interest in whether a global compromise on this matter can be reached against a backdrop of deteriorating relations in the trade space. As noted in the chapter, A Sisyphean task? – Tax plays catch up with China's rapid digitalisation, there has been increasing business media commentary on the potential future emergence of 'splinternet', whereby one global internet system is dominated by the US, and a separate system by China. We are certainly not at this stage yet, but there will be a keen focus on how matters develop in this space, and their implications for international tax rules.
At a China enforcement level, while the trend towards a more effective data-driven administration will clearly continue, the prominent question is whether the more reasonable approach, perceived to be adopted in first-tier cities in relation to complex commercial transactions, will seep down to lower tier city level. Such a development, if it eventuated, would greatly improve the business environment.
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Chris Xing is the KPMG Asia Pacific regional leader for international tax. He has assisted numerous international and domestic Chinese private equity funds and corporations on tax due diligence, as well as a wide range of tax issues concerning cross-border transactions, corporate establishment, mergers and acquisitions (M&A) and other corporate transactions in China and Hong Kong.
Chris has also assisted multinational enterprises with undertaking investments in China, restructuring their business operations and devising tax efficient strategies for implementing China business operations and profit repatriation strategies.
Chris is a member of the mainland taxation sub-committee of the Hong Kong Institute of Certified Public Accountants and is an editor of the Asia-Pacific Journal of Taxation. He is also a regular speaker and writer on tax matters, and has published numerous articles on Chinese taxation in various journals. He has also been interviewed and quoted in the New York Times, Wall Street Journal and BBC World News.
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Conrad Turley is a tax partner with KPMG China and heads up the firm's national tax policy and technical centre. Now based in Beijing, Conrad previously worked for the European Commission Tax Directorate in Brussels, as well as for KPMG in Ireland, the Netherlands and Hong Kong.
Conrad has worked with a wide range of companies on the establishment of cross-border operating and investment structures, restructurings and M&A transactions, both into and out of China. He is a frequent contributor to international tax and finance journals including the International Tax Review, Tax Notes International, Bloomberg BNA and Thomson Reuters, and was principal author of the 2017 IBFD book, 'A new dawn for the international tax system: evolution from past to future and what role will China play?'. He is also a frequent public speaker on topical China and international tax matters.
Conrad received a bachelor's degree in economics and a master's degree in accounting from Trinity College Dublin and University College Dublin, respectively. He is a qualified chartered accountant and a registered tax consultant with the Irish Taxation Institute.
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Grace Xie started her career as a professional accountant in 1993 in Sydney, Australia. Grace joined KPMG Hong Kong in 1998 to specialise in China tax matters. She moved to KPMG Shanghai in 2001.
In Grace's career as a tax consultant, she has rendered advice to multinational clients in a wide variety of industries, including the manufacturing, trading and service sectors. She advises clients on corporate taxation and business matters relating to the establishment of business entities in China, legal entity restructuring and business model re-organisations. She also has extensive experience in advising companies in the life sciences sector on the business model transformation and M&A activities in China taking into consideration the specific industry practice and regulations.
Grace is a member of the Institute of Chartered Accountants in Australia and Hong Kong Institute of Certified Public Accountants.
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William Zhang is the practice leader for research and development (R&D) tax and for international corporate tax in central China and is the national tax leader for the auto industry. William has been providing business, tax and legal consultation and planning ideas for various multinational enterprises since 1997.
His experience covers a range of areas, from assisting multinational enterprises in formulating expansion strategies into China, setting up and structuring their business operations in China, fulfilling relevant registration and filing requirements, up to the stage of working out practical solutions to various tax issues and exploring possible tax planning ideas.
In particular, William has assisted quite a number of multinational enterprises in industrial markets in, for example, high and new technology enterprise (HNTE) application review assessments, R&D bonus deduction applications and tax planning for restructuring transactions and cross-border fund repatriation arrangements.
William was seconded to the international corporate tax group of KPMG's London office for one year, during which he was substantially involved in various international tax projects for European companies.
He is a member of the China Institute of Certified Public Accountants and the China Institute of Certified Tax Agents.