The long arm of China’s GAAR

In 2008 the China Corporate Income Tax (CIT) law introduced a suite of specific and general anti-avoidance rules (GAAR) that offered an array of new tax law enforcement measures for the Chinese tax authorities. Such measures to date include not only thin capitalisation, controlled foreign companies (CFC), and transfer pricing rules, but also anti-abuse rules, as well as a measure requiring taxpayers to report related party transactions. In keeping with China's growing international economic prominence that necessitates a transparent but effective tax administration system, the introduction of GAAR into the CIT Law was geared towards overcoming a significant perceived gap in the Chinese tax law enforcement landscape.

In the relatively short period since its inception, GAAR has proved to be a flexible and effective tool for the Chinese tax authorities in tackling certain areas of tax abuse that are particularly relevant for foreign investors, due to extensions to include tax treaty shopping, offshore indirect disposals of Chinese enterprises, abusive use of corporate structures and tax haven entities, among others. The introduction of GAAR together with relatively active tax authorities enforcement have given rise to a high degree of interest among foreign enterprises who are keenly monitoring GAAR's continued evolvement.

The GAAR provision in the CIT law is brief and states that arrangements undertaken 'without reasonable business purposes' and resulting in tax benefits to the taxpayer may be adjusted by the tax authorities. The CIT implementation rules provide that 'without reasonable business purposes' means having as a primary purpose the reducing, avoiding or deferring of tax payment.

Further exposition of the scope of GAAR was rendered by the State Administration of Taxation (SAT) under the circular Guo Shui Fa [2009] No.2 (Circular 2), which clarified that the GAAR provision was directed at schemes undertaken by taxpayers that are intended to abuse tax incentives under the CIT Law, double tax treaties or corporate organisation structures, or to avoid tax by using tax havens or other arrangements without reasonable commercial purposes. The circular sets out a list of criteria for the tax authorities to consider in determining whether an abusive scheme is occurring. Importantly, Circular 2 emphasises the application of the substance over form principle and requires that GAAR investigations and adjustments are subject to SAT approval, ensuring central control over the application of this provision to avoid the unreasonable or abusive use of this provision by local tax authorities.

The Chinese tax authorities have applied GAAR far more aggressively and frequently in the area of tax treaty abuse and offshore indirect transfers of PRC companies than many other areas of the specific anti-avoidance provisions under the CIT Law (other than perhaps the transfer pricing provisions). Specifically, GAAR, as applied principally in the circulars, Guo Shui Han [2009] No. 601 (Circular 601) and Guo Shui Han [2009] No. 698 (Circular 698), has become a prominent feature of Chinese tax authorities' tax law enforcement efforts, and both circulars have direct application to foreign investors.

Circular 601 is directed at limiting the abuse of double tax treaties for treaty shopping purposes. Although Circular 601 couches its provisions in the language of beneficial ownership, the adverse factors which the circular sets out for consideration by the tax authorities to make such a determination appear to go beyond what would typically be required by the OECD tax treaty interpretive guidelines and overseas judicial interpretations of beneficial ownership. For example, the Chinese tax authorities will consider the tax rate applied to the income in the relevant jurisdiction in which the tax treaty claim is made, the resources available to that entity in terms of staff and assets, and the presence or absence of business activities, other than mere holding investments, in the holding company. Circular 601 is supported by another circular, Guo Shui Fa [2009] No. 124 (Circular 124). Circular 124 lays down the implementation steps and requirements for applications to be made to the Chinese tax authorities to obtain clearance to enjoy treaty benefits.

Circular 698 sets out the conditions whereby disposals of shareholdings in non-Chinese resident companies which directly or indirectly hold shares in Chinese companies are to be reported to the Chinese tax authorities. According to Circular 698, where the transfer arrangements involve an abusive use of organisational forms and the taxpayer is unable to demonstrate economic substance in the offshore company, the Chinese tax authorities may apply GAAR. Circular 698 was rolled out amid concerns expressed by foreign investors and advisers about the extraterritoriality implications of the rules and the practicability of its application.

A feature of the application of Circular 698, which is generally considered particularly disadvantageous to foreign investment groups, is the seeming lack of a consistent focus by the Chinese tax authorities when applying the GAAR to the purpose of a transaction per se, and the absence of significant weighting of non-tax versus tax purposes. In some respects, the commercial substance test (that the offshore holding company is required to positively show that it has employees, office premises and business operations in the offshore jurisdiction which are commensurate with the level of income) has been used as a proxy for the reasonable business purpose test. Further, due to the lack of guidance on what constitutes the abusive use of offshore holding structures, the application of the provision by local tax authorities still varies and the grounds which they give for its application are also frequently unclear.

There are a growing number of high profile cases in which circulars 601 and 698 and GAAR principles have been applied: for example, the much publicised Xinjiang case and Chongqing case which took place before the issuance of Circular 698.

In the Xinjiang case, the SAT endorsed the enforcement approach adopted by the Xinjiang State Tax Bureau by denying the application of treaty relief on capital gains to a Barbados-incorporated company disposing of an investment in a Chinese company only a short time after acquiring it. In the Chongqing case, the Chongqing State Tax Bureau appeared to have taken a look-through approach in taxing gains derived by a Singaporean investor from the disposal of a Singapore-incorporated special purpose vehicle (which was lowly capitalised and allegedly had no operational activities) that held an equity interest in a Chinese resident company.

These cases have signaled that the tax authorities view the GAAR as an effective primary tool of tax enforcement, and the choice of high profile foreign investors in decided or pending cases indicates a willingness, on the part of the tax authorities, to emphasise their determined stance to eradicate abuses of foreign investment structures.

As China takes an ever more significant role in the global economy, greater certainty in tax outcomes from investments and implementation of commercial transactions in China will be sought by Chinese domestic and foreign investors alike. While GAAR has granted a broad scope of enforcement powers to the SAT, they should equally recognise that a fair and transparent tax system, which allows for greater certainty, is a hallmark of a developed economy, and GAAR provisions thus should be wielded in an even-handed manner.

Although the rules in Circular 601 reach beyond the standard application of the beneficial ownership concept, they are not altogether out of line with developments elsewhere where treaty shopping has been met with a tough new enforcement approach. A similar approach has been seen in the Australian tax authorities' attack on a private equity fund in TPG Myer case, albeit on capital gains, and the German tax authorities' recent new anti-treaty shopping rules. However, lack of clarity in the basis taken for the denial of treaty benefits, and the lack of avenues for advance rulings, makes Circular 601 a key source of uncertainty and discontent for foreign investors.

With regard to the enforcement of the rules in Circular 698, a significant level of uncertainty and difficulty has also arisen for foreign investors in planning for investment exits and group restructuring. In reality, the manner in which the Chinese GAAR are being applied may be seen as having ramifications beyond what even some officials within the SAT may have expected. This may be due in part to the manner of operation and enforcement of tax laws in China and perhaps the failure to recognise the infringement of taxing rights under international tax law. In other jurisdictions the limitations which are placed on the application of the GAAR, in particular the right of appeal or judicial review, help to ensure that the GAAR is applied fairly, consistently and evenhandedly. However, such constraints exist only to a limited extent in China in reality because of the lack of a public consultation process, the lack of strong litigious culture, and because the responsibility for the consistent application of Circular 698 rests predominantly with the SAT in practice. Hence there is inevitably concern on the taxpayer's part about whether the SAT could reasonably balance its dual roles as the enforcer and gatekeeper of GAAR, whilst trying to protect the revenue base.

In an international context, while there has been relatively little resistance by taxpayers in respect of Circular 698, this might change in the future, particularly given the potential for jurisdictional conflicts with other countries which might violate China's treaty obligations, and recent statements by the Internal Revenue Service (IRS) advising US businesses to carefully evaluate their position under the GAAR pursuant to Circular 698. When presenting to the International Tax Institute in New York in April this year, Michael Danilack, deputy commissioner (international), IRS Large Business and International Division, was reported to be advising US corporations to seek advice from the US competent authority before agreeing to pay tax under Circular 698 to avoid the risk of not being able to obtain foreign tax credits back home.

It is expected that the SAT will likely make refinements to the guidance on Circular 698 and other provisions based on the GAAR, and this will assist in providing greater certainty for taxpayers. Progress in this direction has been made to a degree with the recent SAT Announcement [2011] No.24 (Announcement 24), issued on March 28 2011, which gave certain clarification around notification and tax settlement requirements and procedures. However, it remains to be clarified what is considered to constitute abuse of organisational structures and reasonable business purpose, as well as many practical points such as the interaction of tax impositions, pursuant to Circular 698, with China's network of tax treaties. It is further hoped that the SAT would consider relaxing the corporate reorganisation rules to ameliorate the potentially adverse application of GAAR in the context of legitimate and qualifying corporate reorganisations undertaken offshore.

As a way to address uncertainty associated with the anti-avoidance provisions, the SAT may phase in an advance ruling system starting with pilot schemes with selected large transactions. Such a regime may help further the aim of achieving greater certainty in commercial transactions and become a mechanism to curtail the potentially adverse application of GAAR post-transaction. In rolling out an advance ruling system, the SAT will likely draw on China's evolving experience in the unilateral and bilateral advance pricing agreement process.

Such an advance ruling system would likely be welcomed by taxpayers. The dialogue between the taxpayer and the tax authorities in the course of obtaining an advance ruling would give the taxpayer a chance to state its case, and prove that it has a reasonable business purpose, outweighing tax motives, in conducting the transaction. The existence of such a system would enhance the credibility of the SAT, and would mitigate the risk of conflicts of jurisdiction with other tax authorities. Published rulings would provide helpful precedents, which are otherwise lacking given the nature of the judicial system.

China may engage in enhanced exchange of information with other jurisdictions, facilitated by China's extended and improved network of tax treaties and the conclusion of dedicated agreements on information exchange. China's active participation in international tax collaborations, such as the Joint International Tax Shelter Information Centre (JITSIC) and the Study Group on Asian Tax Administration and Research (GATAR) is expected to provide important avenues for the SAT to tap experiences from more advanced tax jurisdictions in terms of tax controversial strategies and best practices. Established in 2004, JITSIC counts Australia, Canada, Japan, South Korea, the UK, US, and China as members, with France and Germany as observers. China is one of the 16 members in the Asia Pacific region of GATAR and has been conducting annual meeting among the members.

To improve the application of GAAR, SAT will likely adopt more purpose-focused audit approaches and enhance its information sources on taxpayers or potential taxpayers. In doing this, the SAT will draw on best practices internationally to enhance their information collection approaches, and they will also see the need to give more consideration to foreign investors' views.

Financial intermediaries may be subject to more comprehensive reporting requirements, as the data sets they can provide on taxpayers have proved instrumental to the tightening of tax administration in other jurisdictions, for example, the EU Savings Directive or the new US Foreign Account Tax Compliance Act (FATCA) provisions. This is likely to be accompanied by stronger efforts to encourage higher levels of disclosure by taxpayers and their advisers in order to allow Chinese tax authorities to bring about targeted enforcement actions with greater precision.

The SAT may refer to foreign best practice measures including the UK tax law requirement for the reporting by tax advisors of tax avoidance schemes they are promoting, or the US accounting requirements around detailing uncertain tax positions (FIN 48 reporting requirement). China has already moved towards greater taxpayer disclosure with the measures in Articles 43 and 44 of the CIT Law, and the annual related party transactions reporting form. More targeted enforcement of tax laws may also be facilitated by greater use of risk-based, automated, computerised audit approaches and participation in multi-country audit programmes.

Furthermore, it is expected that the SAT will likely provide greater training for and exercise stricter control of local authorities in their application of the GAAR. It is likely that the SAT will organise systematic training for SAT officials in relation to the conduct of Mutual Agreement Procedures in anticipation of greater engagement with their counterparts in other jurisdictions in the enforcement of GAAR. Such initiatives should assist in reducing variability in tax treatment and ensuring that greater certainty and consistency can be achieved in the application of GAAR.

It is likely that the SAT will be facing increasing pressures from foreign corporations and tax administrations about the extraterritoriality implications of Circular 698 and the lack of certainty and clarity surrounding the reporting and taxation requirements. To a lesser extent, due to growing taxpayer concerns, the SAT will have to tackle similar issues in the implementation of Circular 601. Nevertheless, the provisions in these circulars will continue to be applied in one form or another as the SAT's view, or as its related rules are applied to protect China's tax revenues in cross-border transactions. In due course, it is expected that the SAT will issue clearer guidance on the implementation of the GAAR and exercise greater oversight on the enforcement of those rules at the local levels. This may be facilitated to a large extent by the advent of an advance ruling system, which provides a forum for the taxpayers to state their case and to obtain clarity on the likely tax results.

Expected key trends and likely changes on China GAAR

Further guidance issued on implementation of Circulars 601 and 698. Concepts such as economic substance and reasonable business purposes to be more clearly defined Issues on interaction between Circular 698 and tax treaty application specifically addressed Greater engagement with overseas tax administration with increasing application of Mutual Agreement Procedures Advance ruling mechanism being actively explored Enhanced tax information collection process and access to wider intelligence sources More focused and targeted audit approach with upgraded training of tax officials

Biography
		John Gu Tax partner KPMG 8th Floor, Tower E2, Oriental Plaza 1 East Chang An Avenue Beijing 100738, China Tel: + 86 (10) 8508 7095 Fax: + 86 (10) 8518 5111 Email: john.gu@kpmg.com John Gu is a partner and leader for tax in inbound M&A and private equity for KPMG China. He is based in Beijing and leads the national tax practice serving private equity clients. John focuses on regulatory and tax structuring of in-bound M&A transactions and foreign direct investments in the PRC. He has assisted many renminbi (RMB) fund formations in the PRC and advised on tax issues concerning a wide range of inbound M&A transactions in the PRC in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.

Biography
		Chris Xing Tax partner KPMG 8th Floor, Prince’s Building 10 Chater Road Central, Hong Kong Tel: +852 2978 8965 Fax: +852 2845 2588 Email: christopher.xing@kpmg.com Chris has assisted a variety of international and domestic Chinese private equity funds and corporations on tax due diligence, and has also advised on a wide range of tax issues concerning corporate establishment, mergers & acquisitions and private equity investment transactions in the PRC and Hong Kong. Chris has assisted a number of clients in undertaking investments in the PRC with regard to transaction structuring and devising tax efficient strategies for implementing PRC business operations and arrangements. Chris has also advised a variety of private equity clients on tax issues arising from transactions and foreign direct investments in PRC industry sectors including infrastructure, real estate and consumer markets.

Biography
		William Zhang Tax partner KPMG 50th Floor, Plaza 66 1266 Nanjing West Road Shanghai 200040, China Tel: +86 (21) 2212 3415 Fax: +86 (21) 6288 1889 Email: william.zhang@kpmg.com William has been providing PRC tax and business advisory services and planning ideas for various multinational companies since 1997. His experience ranges from assisting multinational companies in formulating expansion strategy into the PRC, setting up and structuring their business operations in the PRC, fulfilling relevant registration and filing requirements to finding practical solutions to various tax issues and exploring possible tax planning ideas. William worked with the international corporate tax group of KPMG London office for one year during which he was substantially involved in various international tax projects for European companies. William is a member of the China Institute of Certified Public Accountants and a member of the China Institute of Certified Tax Agents.