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The age of reason(ableness): Economic shifts impact China’s cross-border tax enforcement

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In the context of a changing global trade and investment environment, and China’s economic slowdown, tax enforcement approaches are evolving and maturing. Chris Xing and Conrad Turley trace the latest trends.

There are a number of key dimensions to the current changes in the economy and trade and investment climate that are impacting China's tax and regulatory policies and enforcement approaches.

In the domestic dimension, the Chinese economy grew by 6.6% in 2018 and is on course for growth of 6.2% in 2019, the lowest rate in 30 years. This has given further impetus to structural reforms, including an accelerated liberalisation of restrictions on inbound investment, as well as efforts to cut red tape and improve the business environment.

In terms of inbound investment, a 'negative list' system governs investment limitations. The government reduced nationally restricted sectors from 63 to 48 in late 2018, and then further to 40, effective from July 2019. They reduced restricted sectors in the free trade zones (FTZs) even further, to 37. The changes open up sectors that were previously off-limits to foreign investors. It also removes, for certain sectors already partially open to foreigners, the requirements for them to have Chinese joint-venture (JV) partners.

There is a strong focus on drawing investment into services and high-tech manufacturing, and the liberalisation covers transport, logistics and wholesale, ship and aircraft building and services, professional services, energy and transport infrastructure, telecoms, auto manufacturing and financial services. July 2019 saw announcements that the liberalisation of the latter would be accelerated from 2021 to 2020, with ownership limits on foreign investors to be scrapped by next year. These changes have the effect of both encouraging further greenfield foreign direct investment (FDI) and opening up potential M&A opportunities.

Commensurate with these changes, FDI has been further increasing. Indeed, FDI hit a historic high of $139 billion in 2018, meaning that FDI once again overtook outbound direct investment (ODI) for the first time since 2015. It has grown further in 2019, with growth of 2.9% for the first three quarters of the year. Official statistics also show FDI in the FTZs to be rising even faster than the national level. China's tax policies in 2019 have aimed to support this liberalisation, such as with a 15% corporate income tax (CIT) rate announced in August 2019 for certain activities in the Shanghai and Shenzhen (Qianhai) FTZs.

Even against the backdrop of existing challenges in the China-US economic relationship, US FDI in China increased (to $6.8 billion) in the first half of 2019, according to data from Rhodium Group. Investment now increasingly takes the form, in the words of Amcham China, of 'in China, for China', as opposed to manufacturing investment in China as an export hub, as in the past. In this context, the reduction in investment restrictions is clearly playing a role – witness in this regard Tesla's new Shanghai factory, which will be the first wholly foreign-owned auto plant in China.

The second focus is cutting red tape. China has been making concerted efforts to cut red tape and reduce regulatory burdens, for example for establishing/liquidating companies, etc. This resulted in China's ranking in the World Bank's Doing Business report rising from 78th in 2017, to 46th in 2018, to 31st in 2019, out of 190 countries. This means that China has now surpassed France, the Netherlands and Switzerland as a place to do business. These efforts continue to be intensified, with central government monitoring of a large number of Chinese cities that have been set key performance indicators (KPIs) for further improvement; for example, a targeted three-day period for new enterprise establishment.

A major element of these efforts is lessening the administrative hassles associated with tax compliance. By way of example, this includes the elimination of requirements for taxpayers to file large amounts of documentation with the authorities up front when claiming reliefs/incentives (documentation may be kept on file for future audit). It also includes improved procedures for issuance of tax residence certificates, and facilitation of most interactions with the authorities online. Furthermore, for complex international transactions, the tax authorities in Tier 1 cities are showing themselves increasingly commercially-sensitive and facilitative in obtaining reasonable tax outcomes (for instance, in treaty or restructuring reliefs).

The global dimension

In 2019, it became more apparent that greater global uncertainty on tariff levels (US-EU, US-China, etc.), as well as increased national restrictions on exports and corporate acquisitions based on sensitivities around technology, may become lasting features of the international economic landscape. This could have several impacts in the international tax space.

The first consideration is customs. In past decades, multinational enterprise (MNE) corporate tax planning could take a generally stable global trade environment, with a tendency towards progressive reduction of tariff levels. It might be said that the relatively low profile of tariffs raised the significance of international tax rules in driving the structure of MNEs. If higher tariff levels and greater volatility in the setting of tariffs become entrenched, then MNEs may need to reconsider, and in some cases restructure, their supply and value chains, and perhaps retain a flexibility to do so with greater frequency.

The emergence and deepening of regional trade pacts, such as the regional comprehensive economic partnership (RCEP) in Asia-Pacific, may impact the shape of new arrangements. It is understood that the Chinese tax authorities are looking at possible improvements to existing guidance on restructuring relief and indirect offshore indirect disposal rules, which could be highly relevant for the emerging world of tomorrow.

It is also worth considering the outbound investment environment. In 2016, Chinese ODI reached its peak to-date ($196.1 billion). It dropped from this level in 2017 ($158.3 billion), 2018 ($129.8 billion) and in 2019. Key factors behind the reduction were China's tightened regulations on ODI, which restricted investment in foreign real estate, sports clubs and other areas, and efforts to rein in highly leveraged acquisitions. Another factor was the stricter review by several governments, in particular the US, of foreign inbound acquisitions.

In consequence, Chinese ODI into the US, including M&A and greenfield, fell by 95% between 2016 and 2018. Since 2016, China ODI has swung further towards the 65 Belt and Road Initiative (BRI) countries. It is estimated by some research institutions that BRI-directed ODI increased from 16.8% in 2016 to 21.6% in 2018; 60% of mainland China's ODI goes through Hong Kong SAR and several Caribbean jurisdictions, so a tracing exercise needs to be conducted. Further increases to BRI investment are anticipated in 2019.

China's policy efforts in the international tax space have mapped this change, with the BRI Tax Administration Cooperation Mechanism (BRITACOM) established at the first conference of the BRI Tax Administration Cooperation Forum (BRITACOF) in April 2019. The tax authorities of 34 countries and regions signed up as BRITACOM council members (with more expected to join subsequently). They have done so with a view to working collectively to resolve tax administrative deficiencies and tax rule frictions, which could frustrate planned investment projects and limit the ability of the BRI to achieve its full potential. Initial collaboration plans have been set for the next two years, including sharing best practices on rule design and administration, providing capacity building support (for example in tax compliance system automation), setting up mechanisms for dispute resolution and achieving greater consistency in treaty application.

In the context of the broader trends mapped out above, 2019 has also seen a number of significant Chinese treaty and policy developments, covered in the article China double tax arrangements: New paths emerge. However, more significant change awaits the emergence of a new international tax consensus at G20/OECD level, expected early in 2020. This is dealt with in the article BEPS 2.0: What will it mean for China?


The question of enforcement is also unavoidable in this context. The past few years have seen an evolution in China's approach to tax enforcement and an associated change in the tone and content of public communications to taxpayers. This was observed already in last year's chapter, where we noted that WeChat and website updates by the State Taxation Administration (STA) and provincial tax authorities focus on providing service and assistance to taxpayers, for example by facilitating access to incentives.

This is a change from the prior approach, where many enforcement cases were highlighted with a view to raising taxpayer awareness of tax audit effectiveness and penalty strictness, in order to encourage compliant behaviour.

The last year has further seen a fall-off in the number enforcement cases reported in the Chinese tax-specialist media, principally by China Taxation News (CTN). There were also, in contrast to earlier years, no notable court decisions on cross-border tax matters.

Our round up of enforcement developments this year draws to a greater extent on the KPMG China client team's experience in the field. Assisting this is KPMG's internal insight sharing system, whereby client teams pool notable cases and their manner of resolution.

Treaty relief

As we noted last year, in 2018 the STA issued revised guidance on the interpretation of beneficial ownership for treaty relief cases. In STA Announcement [2018] 9 (Announcement 9), the STA decided to retain the commercial substance-driven concept of beneficial ownership, which has been used for the past decade since the issuance of STA Circular [2009] 601 (Circular 601). This interpretation treats the beneficial ownership test as a type of anti-abuse concept. This brings it beyond solely looking at whether the income recipient has real control over the disposal of that income and related assets – the aspects central to its interpretation in a number of developed countries (for example, in the Indofoods and Prevost Car cases). However, it is notable that in the 2019 European Court of Justice (ECJ) decision in the Danish beneficial ownership cases, the ECJ linked beneficial ownership with anti-abuse objectives. This decision, and developments in the application of beneficial ownership in other countries, have (arguably) brought the rest of the world more in line with China on this matter.

What is noteworthy then, against this backdrop, is how the Chinese tax authorities have been becoming, at least in Tier 1 cities, more commercially sensitive and reasonable on treaty relief in many instances.

Announcement 9 introduced a form of 'derivative benefits' test, whereby a treaty relief applicant could reference the commercial substance at the level of 100% direct and indirect parents to access treaty relief for dividends. Specifically, relief would be granted if the parent company would have passed the beneficial ownership test and was tax resident in a jurisdiction whose treaty with China gave equivalent tax relief. While helpful for MNEs, this was not considered to be of much use to fund structures. Furthermore, the STA guidance that accompanied Announcement 9 set out illustrative examples of activities that would be considered 'substantive' for investment management activities; for instance, management of investments in 50 companies in 10 countries and significant staff at the level of the treaty relief claimant. This was considered as setting the bar rather high.

However, in practice, some authorities have been willing to take a more pragmatic stance. For real estate investment trusts (REITs) and aircraft leasing structures, in cases seen in practice, certain authorities have been willing to have regard to the commercial substance at the level of REIT managers/leasing companies in the same jurisdiction. This is despite the fact that the latter would not necessarily be the parent of the treaty relief claiming SPVs, or indeed have any equity holding relationship with the SPVs. In these instances, the authorities appear to acknowledge that this is the commercial nature of such business arrangements, and apply the guidance flexibly. However, such treatment may be denied by other local authorities and for other types of structure; for instance, PE funds would generally be thought to have a harder time making such a case.

Tax authorities in some cases have been seen to take more holistic views of taxpayer arrangements when considering whether treaty relief should apply. For example, for dividend treaty relief, Announcement 9 provides a safe harbour under which a subsidiary of a listed company, tax resident in the same jurisdiction, would automatically qualify for relief. While this does not extend to interest per se, in practice, cases have been seen where the authorities were willing to consider the fact that a group finance company had a listed parent in the same jurisdiction, together with the existence of a modicum of decision-making substance at entity level, as a basis for agreeing that treaty relief should apply.

A more reasonable stance by the authorities can be combined with increasing comprehensiveness in case review. For example, the Shanghai tax authorities subject outbound dividend payments, involving treaty relief worth RMB 5 million ($706,000) and above, to follow up review. However, whereas in the past (and still in many places in the country) treaty relief applications might be rejected out of hand where the overseas treaty claimant has limited personnel, the authorities have more recently been seen to give due consideration to taxpayer explanations of the commercial rationale for certain arrangements.

It should be noted though that there are still plenty of enforcement cases going the other direction. Certain local tax authorities can still demand to see levels of staffing, assets and business operations at the level of treaty relief claimants that are out of sync with commercial reality. Indeed, some cases have been observed where the authorities appeared to be drawing selectively (and arguably out of context) from the Announcement 9 interpretative guidance. Quite a number of Tier 2 and 3 city local tax authorities have still not shifted to the treaty relief administrative procedures mandated under STA Announcement [2015] 60, which moved the system from pre-approvals to record filing with follow up review.

However, on the whole, the trend is considered positive. In common with broader Chinese government efforts at cutting regulatory burdens, record filings were recently simplified in STA Announcement [2019] No. 35, cutting out the need to deposit extensive documentation with the authorities upfront, and reducing tax exposures for WHT agents; see the article China double tax arrangements: New paths emerge. Furthermore, there is greater data sharing/pooling across different branches of government; for example, between the tax authorities and the State Administrations for Market Regulation (SAMR) and the State Administration of Foreign Exchange (SAFE). These developments, together with advances in tax authority big data analytics, should make case review progressively more targeted and less bothersome for most taxpayers making routine payments and associated treaty relief claims.

Equity transfer

This section is best read alongside our inbound M&A piece: No pain no gain: Tax challenges in the China M&A market. The Chinese tax authorities continue to focus considerable enforcement efforts on equity transfer cases, including both direct cross-border transfers – foreign company directly sells China equity – and indirect offshore disposals, where one foreign company disposes of another foreign company that holds China equity). The latter cases are governed by STA Announcement [2015] 7 (Announcement 7).

Greater data sharing/pooling across different branches of government, use of 'web crawler' software to find disposal-relevant information from public sources, and big data analysis have all increased tax authority effectiveness in detecting and following up on equity disposals. As a further factor, the merger of state tax bureaus (STBs) and local tax bureaus (LTBs) (STB-LTB merger) last year had led to some disruption of normal activities; with new organisational arrangement now in place, enforcement against cross-border equity transfers could once again take centre stage.

This being said, and in line with the observations above in relation to treaty relief cases, the past two years have seen an increasing commercial sensitivity and reasonableness among Tier 1 city tax authorities.

It has been found in practice that tax authorities are becoming more open to listening to taxpayer and tax advisor interpretations of equity transfer tax rules in complex cases. This may be attributed to tax authorities gaining, both through their work and through training provided by tax advisors, greater experience of and exposure to a diversity of complex cases (for example, MNE group restructurings falling within the scope of Announcement 7). This has helped in resolving cases where there has been ambiguity over whether restructuring relief should be available, or cases for which calculation of transfer consideration or equity cost base has proven problematic.

For cases involving restructuring relief, Tier 1 city tax authorities have been willing, in instances, to adopt a degree of flexibility, such as where the strict terms of the safe harbours have not been met. Thus far, this has mainly been observed for Announcement 7 indirect transfer restructuring cases, while a stricter and more inflexible line appears to be taken, for the moment, in relation to direct transfer restructuring cases falling under STA Circular [2009] 59 (Announcement 59). In the Announcement 7, cases some authorities have been pro-active in consulting with provincial level authorities and the STA to see if they can be permitted to grant relief reflective of the commercial circumstances. Higher level tax authorities have also shown a greater willingness of providing high-level guidance to taxpayers on restructuring cases.

An example of this is cases where an offshore parent company receives the equity of a Chinese sub-subsidiary as a distribution from its (overseas) subsidiary. This is not explicitly relieved under Announcement 7, which requires share consideration to pass between the entities. However, in several cases, local authorities have been willing to accept that, as the transaction is entirely intra-group and does not involve cash consideration, the transaction should also qualify.

For such cases, it can help to give the authorities a full and clear explanation of the context. Where it can be shown that the companies are facing economic difficulties, particularly in the context of the ongoing China-US trade friction, and need to restructure to continue their business operations in China, then this can be factored in. What is more, in cases where restructuring relief can simply not be qualified for, the authorities have shown reasonableness in accepting transfer valuations for China entities that reflected diminished potential future profitability as a result of changed global economic circumstances.

Beyond the above, the cutting of red tape has also facilitated equity transactions. Foreign transferors of Chinese equity, which expected transaction procedures to take months based on past experience, were struck by how procedures could now be handled within a few weeks. At the same time, as with the treaty cases, taxpayers continue to encounter circumstances in which the authorities take a harsh approach. Typical circumstances are where the local authorities:

  • Insist on an equity cost base calculation which only allows the taxpayer to deduct a fraction of the amount that they paid for the disposed of equity;

  • Are unwilling to accept taxpayer arguments around the reasonable business purposes for an offshore indirect transfer, and insist on imposing Announcement 7 tax;

  • Adopt highly restrictive and conservative interpretations of when the restructuring relief terms are satisfied; and

  • Seek to apply (in observed cases) TP rules to adjust equity disposal consideration in third party sales.

As ever, Chinese tax administration in the equity transfer space remains a work-in-progress. Going forward, there are indications that the STA may look again at possible improvements to the existing Circular 59 and Announcement 7 guidance, with a view to making this more facilitative for business restructurings required in the evolving economic climate.

Chris Xing


Partner, Tax

KPMG China


Tel: +86 (10) 8508 7072

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 mainland China and Hong Kong SAR.

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 SAR 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.

Conrad Turley


Partner, Tax

KPMG China


Tel: +86 10 8508 7513

Fax: +86 10 8518 5111

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 SAR.

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 ITR, Tax Notes International, Bloomberg Tax 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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