Over the past few years, the international tax chapter of this guide has looked in-depth at the 15 action items under the G20/OECD BEPS Action Plan, and their outputs, which were finalised in October 2015. This chapter details the Chinese State Administration of Taxation's (SAT) initial moves to roll out a number of these action items in proposed new Chinese rules and guidance.
In contrast to the extremely active tax policy agenda of 2015, the Chinese authorities have, so far this year, issued relatively fewer new cross-border direct tax rules than many people expected. Nevertheless, there has been no let-up in the rigorous enforcement of China's cross-border direct tax rules. China served as host of both the G20 and the OECD Forum on Tax Administration (FTA) in 2016, and this has driven the significant strides made by China in defining and advancing its external tax policy in the course of the year. We foresee that the relative lull in the issuance of new cross-border direct tax rules and guidance is solely temporary in nature. A raft of new rules is set to be released over the next year.
This chapter looks at this year's BEPS developments in three parts:
- The latest state of play with China's 'localisation' of domestic rules in relation to BEPS and other OECD tax initiatives;
- The key enforcement trends in the application of China's cross-border tax rules. This includes the rigorous policing of the treaty shopping and permanent establishment (PE) rules, and increased use of the exchange of information (EOI) and big data to target tax audits; and
- The rapid development of Chinese external tax policy. In this regard, tax assistance to outbound investing enterprises, and an emerging One Belt, One Road-focused external tax policy, sit alongside more rigorous tax enforcement for Chinese multinationals enterprises (MNEs).
China's localisation of BEPS and other OECD initiatives
In the lead up to the 5th edition of this publication and during the course of 2015, the SAT had issued a large number of new and proposed cross-border tax rules. These included new double tax agreement (DTA) relief administrative rules, new offshore indirect disposal rules, as well as a new general-anti avoidance rule (GAAR) administrative measures.
In September 2015, the SAT issued a public discussion draft of the circular on special tax adjustments, proposing updates to controlled foreign corporations (CFC) rules, thin capitalisation rules, GAAR interpretation rules and, most importantly, setting out how China proposed to localise the BEPS transfer pricing (TP) rules and BEPS TP documentation requirements.
This occurred alongside a general update to many of China's key tax treaties, particularly with major EU jurisdictions, to include upgraded anti-abuse measures and exchange of information (EOI) rules. It also occurred alongside China's commitment to the global EOI initiatives, for example China's adherence to the common reporting standard (CRS) multilateral competent authority agreement (MCAA), which China signed up to in December 2015.
China's upgrades to its tax rules and international agreements were also accompanied by generally heightened enforcement of China's cross-border tax rules. This included tax matters that had already been under intense scrutiny for many years, such as the DTA relief, indirect transfers, as well as fields of tax policy seeing a new level of enforcement focus, such as CFC rules and deductions for outbound royalty/service payments, among others.
While 2016 saw a deceleration in the issuance of new SAT rules and guidance, and the revamping of several pieces of guidance proposed in 2015, there was an emergence during the year of a new collaborative approach between the Ministry of Finance (MOF) and the SAT on formulating cross-border tax rules. With the new collaborative arrangement now in place, the pace of finalising the rules picked up again in the second half of 2016.
This chapter runs, briefly, through the BEPS actions which have a relevance for China, apart from Actions 11 and 12 which do not have significant implications for China and are not detailed here.
Digital economy (Action 1)
China has not, so far, indicated an intent to introduce any novel digital economy corporate income tax (CIT) nexus rules. This is in contrast to other countries, such as India, Israel, or Saudi Arabia.
However, with Circular 18 (2016), released jointly by the MOF, SAT and the General Administration of Customs (GAC) in March 2016, China has adopted the recommendations in the BEPS Action 1 report to leverage online shopping platforms and express couriers to collect indirect taxes (as well as customs duty) on cross-border inbound e-commerce transactions. See the chapter, China Customs – pushing the boundaries, for further details.
At the same time, the OECD's VAT recommendations on digital imports have not yet been adopted by China. This is in contrast to the wide adoption of these proposals across other countries, such as EU member states, Australia, and South Korea.
A host of direct and indirect issues will need to be resolved in the future for those new China business models that are seeing explosive cross-border growth, such as cloud services and mobile payment services. See the chapter, Post VAT reform in China – what's next?, for further insights.
Hybrid mismatches (Action 2)
The OECD have supplemented their 2015 hybrid mismatch recommendations with additional proposed rules on branch mismatches, issued as a discussion draft in August 2016. Looking at the uptake of the OECD proposals across countries, the UK and Australia, for instance, have already legislated for rollout of the OECD's proposed hybrid rules. The EU Anti-Tax Avoidance Directive would see an EU-wide roll out of hybrid rules, though the precise provisions have yet to be clarified. While the SAT had earlier signalled an interest in rolling out anti-hybrid mismatch rules in China by late 2016, no firm details on this, or on China's position in relation to the branch mismatch rules, are as yet available.
CFC rules (Action 3)
China's proposed revamped CFC rules, contained in the 2015 draft special tax adjustments circular, have not yet been finalised because the content of that circular has been revised and is now being progressively issued as a series of separate circulars.
It is anticipated that CFC rules will be issued sometime in 2017, but the final form that these rules may take is as yet unknown.
Interest deductions (Action 4)
China has not expressed any intention of implementing the recommended BEPS rule that links interest deduction limitations to earnings before interest, tax, depreciation and amortisation (EBITDA).
Harmful tax practices (Action 5)
The SAT Announcement 64 (2016) on advance pricing agreements (APAs) puts taxpayers on notice that their APAs will be subject to spontaneous, compulsory exchange with other countries' tax authorities in line with the BEPS Action 5 requirements. See the chapter, China transfer pricing – first mover on BEPS, for further detail.
Treaty abuse (Action 6)
Recent DTAs entered into by China, including the new DTA with Chile that was signed in May 2015, and the updated Russia treaty, which entered into force in April 2016, have included limitation on benefits (LOB) provisions based on the Action 6 recommendations.
The Chile treaty went even further, adopting the Action 6 principal purposes test (PPT) and triangular PE rules. However, other treaties signed by China since late 2015 (for example, Zimbabwe and Romania) and protocols to existing treaties (for example, Bahrain, Macau, and Pakistan) have not sought to implement the Action 6 proposals.
China has committed to adopting Action 6 anti-abuse rules in its DTAs as a BEPS minimum standard and may look to achieve this through the Action 15 multilateral instrument (MLI). The MLI was finalised by the OECD in November 2016 and, up until the formal signing in June 2017, countries around the world, including China, will be considering which DTAs to nominate for update through the MLI.
At the time of writing, it is not yet apparent which of the Action 6 rules China will adopt through the MLI, and which of China's DTAs will ultimately be affected.
PE (Action 7)
China was quick to initiate the adoption of the new BEPS PE standard. The DTA with Chile even included the draft BEPS PE language before it was finalised by the OECD in October 2015. Since then, however, none of China's new DTAs, or new protocols that amend existing DTAs, have adopted the BEPS PE wording. The SAT had earlier indicated interest in the adoption of the BEPS PE standards. However, with the MLI having made adoption of the BEPS PE rules voluntary, China is likely to consider the positions taken by other major countries on adoption before making any decision itself.
Two key adoption patterns stand out:
- The Inclusive Framework for BEPS implementation, which was inaugurated in June 2016, has expanded the number of jurisdictions making BEPS commitments to 85, with a further 19 to sign up by the end of 2016. Most importantly for China, these include Singapore and Hong Kong. Popular OECD "hub" countries (e.g. Luxembourg, Netherlands, and Ireland) were already committed to the BEPS updates. This means that, if all of these jurisdictions and China were to opt for the BEPS PE DTA updates through the MLI, then the main platforms for investing into/operating cross-border into China would all, in principle, incorporate the new BEPS PE wording in their DTAs with China;
- However, it is understood that many significant countries (e.g. US and Germany) are lukewarm on the BEPS PE changes. The OECD has consequently built a degree of flexibility into the MLI, allowing countries to forego adopting part or all of the BEPS PE wording. As such, it could eventuate that some of China's DTAs are (partly/fully) updated for the BEPS PE changes through the MLI, while others are not. This would clearly have an impact on the manner in which cross-border operations and investments into China are structured in the future, and the jurisdictions from which they are structured. Ultimately, whether this situation arises would depend, in the first instance, on whether China itself opts for the BEPS PE changes.
The OECD is working on updated PE profit attribution guidance and a draft was issued in July 2016. It may be that this work will not be concluded until after the DTA BEPS PE changes have been made through the MLI. In light of the potential for PE challenges to proliferate globally as a consequence of the BEPS PE changes, PE profit attribution is a pressing concern. This is certainly true for China where a deemed profits approach is generally used for PE income attribution. Officials at the SAT have repeatedly indicated a determination to continue applying the deemed profit approaches, but it remains to be seen how far China is willing to move in the direction of the authorised OECD approach (AOA) to PE profit attribution, when it issues anticipated revised PE profit attribution guidance.
Indeed the risks of PE for enterprises operating in China, and the degree to which business and investment structures will need to be adapted, will only become apparent when the SAT issues its guidance on PE recognition and profit attribution, which is expected in 2017, and the enforcement approaches taken by the authorities in practice begin to be observed.
TP (Actions 8, 9, 10, 13)
A detailed overview of China's TP developments and their inter-relationship with the OECD's TP work under the BEPS project is provided in the chapter, China transfer pricing – first mover on BEPS.
In short, the comprehensive TP guidance in the special tax adjustments SAT draft circular of September 2015 has been set aside in favour of a series of TP-related circulars. At the time of writing, these include:
- SAT Announcement 42 (2016), providing guidance on TP documentation; and
- SAT Announcement 64 (2016), providing administrative guidance on APAs.
Both of these measures are strongly informed by the BEPS TP work. The TP documentation follows the BEPS Action 13 master file, local file and CBC reporting structure. BEPS Action 14 on improving dispute resolution highlights the importance of APAs to mitigate disputes in the first instance. In line with this, China's new APA guidance, along with a planned increase in the number of staff at the SAT focused on APAs and MAP, shows China's proactive approach to limiting and resolving disputes.
At the same time, the new China guidance is strongly influenced by long-standing priorities in China's TP approach. The China local file requirements are more expansive than the OECD's recommendations. It demands that a Chinese entity that is part of a MNE group includes a value chain analysis in its local file. This is to provide quantitative details on the profits attributed to group entities in each country into which the China-relevant MNE value chain(s) extend. This, together with a required analysis of the contribution of China location specific advantages (LSAs) to group profit generation, provides fuel for China's existing TP practices. China's well known TP approach pushes for profit adjustments for China-based MNE group entities based on the creation of local intangibles and contributions to the value of group intangibles, and based on the contribution of LSAs. It might be noted that China successfully pushed for amendments to the OECD TP guidance in the course of BEPS Actions 8-10 work to lend support to its existing practices.
In addition, the new Chinese TP documentation guidance significantly bulks up the related party transaction filing forms with much greater detail on cross-border payments and on their tax treatment in recipient countries. This provides strong support to the Chinese tax authority's ongoing campaign to challenge tax deductions on outbound related party payments of royalties and service fees. These bulked up filings sit alongside the additional data being derived by the Chinese tax authorities through new national and international EOI initiatives, which are discussed below.
The new China APA guidance lends further support to these special Chinese TP approaches. Preferential admission into the APA programme is given to taxpayers who provide in-depth value chain analysis and who give full consideration to the contribution of LSAs to value creation. The APA guidance also gives a neat illustration of how the SAT is putting its new taxpayer risk-targeted enforcement approach at the centre of its tax administrative efforts. Only taxpayers with an "A" rating under the SAT's taxpayer credit rating system are granted access to the APA programme. See the chapter, China tax – big data and beyond, for further insight on how the taxpayer rating system is also being linked to various other tax and administrative incentives and treatments.
As at the time of writing, the highly anticipated SAT circular on TP adjustments, which would roll out the BEPS guidance on intangible asset transactions into Chinese guidance, had not been published. China's ultimate position on the BEPS work on risk and intangibles in Actions 8-10 and its position on the OECD work on profit splits, will have a major impact on how Chinese TP rules interact with those of other countries. It will therefore be crucial in framing the extent to which MNEs in China can successfully manage their TP risks.
Improving dispute resolution (Action 14)
As the host of the 10th annual plenary meeting of the OECD FTA in May 2016, the SAT played a key role in pushing forward the establishment of the Action 14 peer review mechanism. Under this, the FTA MAP Forum will review the fulfilment by countries, including China, of the 17 minimum standard commitments contained in Action 14.
On October 20 2016, the OECD publicly issued the relevant framework documents for the launch of peer review. As noted above, China's revised APA guidance and the ramp up of the APA/MAP staffing resources makes a major contribution from the Chinese side to the Action 14 agenda.
MLI (Action 15)
China worked closely with more than 100 countries on developing the MLI, which was finalised and released by the OECD in November 2016. As noted above this may see updates to China's DTAs with many treaty partners in relation to treaty anti-abuse and PE provisions, and the upgrade of DTA MAP articles. The MLI also allows for the insertion, into Chinese DTAs, of a new transparency clause in relation to the tax treatment of non-residents including partnerships, trusts, etc., which give rise to uncertainties in practice.
The MLI is a highly complex document which allows a great deal of flexibility and options to the participants in relation to how they wish to update their DTAs. Jurisdictions nominate the participants in the MLI, with which they wish to make DTA updates. After that they indicate preferences, from a closed set of alternatives, in respect of each of the update matters (i.e. treaty abuse, PE, hybrids, MAP), and set out the manner in which they wish to make the DTA updates.
A complex "matching" process then follows. If jurisdictions have made the same preference selections then updates are made in that manner; if jurisdictions have chosen differing options then special resolution rules and procedures take effect to determine if an update happens at all, and what form it takes.
In the run up to the formal MLI signing date in June 2017 there is likely to be intensive activity amongst national tax policymakers, across countries, to determine which updates they want to make. This would probably be accompanied by consultation/negotiation with their counterparts in other countries to find out, and influence, what the end effect of their selections will be. For China, as for other countries, the next six months will consequently be a crucial period in determining the new architecture of China's DTA network.
Apart from China's BEPS collaboration, China is also preparing for the launch of the automatic exchange of information (AEOI) platform under the OECD's CRS programme from 2018. As noted above, China signed the CRS MCAA in December 2015 to facilitate these exchanges, but China still needs to identify with which of the other 84 CRS MCAA signatories it wishes to exchange information.
On October 14 2016, the SAT took a major step when it opened a public consultation on a discussion draft setting out China's CRS implementation measures, entitled "Administrative Measures on Due Diligence of Tax-related Financial Account Information of Non-residents".
The draft sets out details of the financial account information to be reported by financial institutions to the Chinese authorities for exchange with other countries. It also sets out the details and timeframes for the due diligence to be conducted by these institutions up to the end of 2017. It is notable that it was at the Beijing FTA meeting in May that the concrete basis for CRS, the common transmission system (CTS) was unveiled.
The activation of CRS from 2018 promises a sea-change in the effectiveness of Chinese tax enforcement. EOI through CRS sits alongside:
- China's commitment to FATCA with the US;
- China's commitment to CBC exchanges through the CBC MCAA (signed by China at the Beijing FTA meeting);
- Tax intelligence sharing through JITSIC (the reform of which was announced at the Beijing FTA meeting);
- Tax information exchange agreements (TIEAs) with the 10 main China-relevant offshore centres; and
- Ongoing upgrades of EOI articles in China's DTAs in line with the 2005 OECD standard.
Information obtained through these channels is starting to be put to effective use, as discussed in our look at 2015/16 China tax enforcement cases. See further information below.
Enforcement of cross-border taxation is leveraging information exchange and big data
While the SAT may have issued relatively fewer new circulars with a direct tax impact in the year to-date in 2016, there has been a continued increase in the intensity with which existing Chinese cross-border tax rules are enforced.
Offshore indirect transfer cases, which can be subject to tax pursuant to SAT Announcement 7 (2015), continue to be a key enforcement focus area in 2016, and further detail is supplied in the chapter, M&A tax in China – practical challenges.
In addition, there have also been a multitude of cases in the TP space. Particularly noteworthy is the continuing national campaign, which started in 2014, that challenges tax deductions for outbound royalty and service payments. This is discussed in more detail in the chapter, China transfer pricing – first mover on BEPS.
In this chapter we highlight the key DTA and PE cases that should be noted, as well as cases where EOI and big data have driven enforcement efforts during the year.
Treaty abuse cases
Following the entry into effect of new DTA relief administrative procedures in November 2015 with SAT Announcement 60 (2015), the tax authorities have maintained a strong focus on treaty shopping throughout 2016.
The new procedures abolished the previous tax authority pre-approval system for treaty relief. They replaced it with a system under which withholding tax (WHT) agents would, on receipt of completed forms and supporting materials from a non-resident and following a cursory review, withhold tax in line with the DTA WHT rates and file the relevant documentation with the tax authorities. The tax authorities would then examine the information in the filings and use follow up procedures to claw back the DTA relief if they considered it to be inappropriate or abusive. This is part of the broader move by the Chinese administrative authorities away from cumbersome pre-approvals towards more data-driven, targeted follow up audit procedures. Although this trend extends beyond the tax sphere, the tax element is discussed in further detail in the chapter, China tax – big data and beyond.
The roll out of the new approach across China has been uneven in some cases, causing complications in obtaining relief in certain localities. At the same time, certain overseas jurisdictions, popularly used to establish holding structures to invest into China (e.g. Hong Kong), have become more conservative in issuing tax residence certificates, which is complicating the DTA relief process in China. This is further discussed in the chapter, M&A tax in China – practical challenges.
PE enforcement cases
Another keenly observed enforcement area is PE. The SAT has stated on numerous occasions that it would boost its PE enforcement, most notably in the October 2015 SAT seminar where the Chinese versions of the 2015 BEPS reports were released. The SAT indicated that national systems for information exchange and data analysis would play a key role in the identification and targeting of PE cases. Given the widened scope of agency PE in the BEPS work and the fact that Chinese enforcement of agency PE has, in general, not been overly aggressive in the past, taxpayers have focused their attentions on enhanced agency PE risk. Foreign enterprises have accordingly been contemplating adjustments to their cross-border sales and procurement structures into China to limit agency PE exposures. However, in 2016 the more notable publicised PE cases were in the historically already vigorously enforced service PE space.
A notable service PE case, publicised by the SAT on their WeChat news feed in August 2016, which has become one of the key channels for public communication by the Chinese tax authorities, involved the simultaneous assertion by the authorities of 19 separate service PEs. As is typical for Chinese tax enforcement cases, the information available on the technical aspects of the case is limited because the main source of publicly disclosed details is generally the media or the tax authorities themselves. It appears that between 2009 and 2014 a foreign enterprise dispatched numerous staff to China to work on separate projects to provide various technical guidance and after-sale services. The relevant DTA with the country of the foreign enterprise required the presence of staff on a given service project to exceed 183 days for service PE to be asserted. Leveraging this, the tax authorities took the position that the various staff activities in China collectively constituted the same or connected projects, and that the time threshold had been exceeded.
Service PE has long been a problematic area for foreign enterprises active in China. Since 2009 there has been a national campaign to investigate and assert service PEs arising from secondments of staff into China. SAT Announcement 19 (2013) provided detailed guidance that allowed for these risks to be better managed. However, as is clear from the 2016 PE case, the tax authorities are becoming more effective at monitoring and aggregating the short term presence of visiting staff in China for asserting service PE. Looking ahead, a greater number of PEs are expected to be asserted due to greater coordination of geographically separate tax authorities in China among themselves, including sharing of intelligence, joint investigations and enforcement.
A notable policy development that may have a further impact in this space in future is the BEPS PE contract splitting rule. Intended by the OECD to deal with the splitting of construction projects into separate contracts to fall under the construction PE time threshold, this rule aggregates the time spent by the staff of separate foreign and domestic entities on a given construction project to determine whether the time threshold has been exceeded. The China-Chile DTA of May 2015 modified this rule so that it could be used in relation to service PE. If China chose to introduce this novel rule across its DTA network through the MLI then this would lead to a significant heightening of China service PE risk.
A further notable China service PE matter relates to digital cross-border service supplies. In 2013, at a meeting of the UN committee of tax experts, which maintains the UN model tax convention (MTC), China and India collectively put forward the novel concept that service PE might be asserted even where there are no staff in the country of a customer. This reasoning was based on the wording of the service PE provision, which asserts that a PE exists where services are "furnished within the source state", and this could occur digitally without a local physical presence. While China and India did not push this concept further at the time, in 2015 Saudi Arabia and Kuwait explicitly introduced this very concept into law. As noted above, China has not yet signalled an intent to roll out any novel CIT nexus concepts for digital economy businesses, but given China's role as a progenitor of this concept, this matter merits continued monitoring.
As can readily be seen, service PE in China is a field rich in current and potential future developments, quite apart from the increase in agency PE risk and fixed PE risk anticipated with the forthcoming roll out of the BEPS PE changes.
EOI and big data
What comes through in many of the tax enforcement cases publicised in 2016, is the increasing use of EOI, big data, and taxpayer risk ratings to drive more targeted audit activity. The tax authorities' extensive use of WeChat to publicise these cases also makes clear that the authorities wish to notify taxpayers that these tools are being used to tackle aggressive tax practices and avoidance. China's adherence to ever more international multilateral and bilateral initiatives for information exchange has been highlighted above. Information obtained through these channels is being pooled with information obtained by tax authorities around China, both by local and state tax bureaus and other government bodies such as forex authorities, administrations of industry and commerce, etc., using new national data systems. For example, EOI cases highlighted in a publication issued in October 2015 by the SAT's international tax department include the following:
- An investigation concluded in 2013 of a Chinese company paying service fees to a foreign related party. Documentation supporting the fees was considered insufficient to properly evidence whether the service fee was excessive when compared to the substance of the services in question. The EOI was initiated to obtain foreign tax authority information on the service fee and adjust downwards the tax deduction;
- An investigation concluded in 2014 of a Chinese company buying machine tools from a foreign related party. It was suspected that the company had overpaid for the equipment and was claiming excessive tax depreciation. The EOI with the foreign tax authority helped to confirm this with details of the original cost of the machine tools; and
- An investigation of a China representative office whose procurement activities exceeded the preparatory and auxiliary threshold protected from PE challenge under the relevant tax treaty. The EOI provided the Chinese authorities with the information required to assert a PE.
The improvements in the mechanisms and systems for using the EOI and big data are explored further in the chapter, China tax – big data and beyond.
Certainty for cross-border tax – increasing court cases and advance rulings
Historically, the courts system has played a very minor role in the interpretation of Chinese tax law and in the resolution of tax disputes. Courts did make decisions on procedural tax matters, but the courts generally declined to opine on the substantive meaning of tax law provisions, considering that the SAT was the more appropriate authority in this regard. Furthermore, taxpayers were generally reluctant to take matters to court because they were keen to preserve good relations with local tax authorities and resolve matters through negotiation. However, recent years have seen a greater formalisation of local tax authority work due to reforms in how taxpayers are selected for audit, and greater higher level tax authority scrutiny of procedural compliance by local tax authorities and their retention of complete on-file documentation. Against this backdrop of greater formality, and the monetary significance of some of the cross-border tax issues coming to a head, taxpayers have become more willing to open formal review procedures for cases, even to the extent of going to court.
Several tax court cases that were concluded in late 2015 were publicised in 2016. TheChildren's Investment (TCI) fund case, heard by the Zhejiang Province People's High Court in December 2015, which followed on from earlier lower court hearings, was the first case in China concerning the application of the GAAR to an indirect offshore transfer of a China investment by a UK managed investment fund – the decision was ultimately in favour of the tax authorities. The second case related to the application of the CIT reorganisation relief provisions to a cross-border restructuring of the China investment arrangements of Illva Saronno Holding SPA. The Shandong Province Zhifu District People's Court decided on the case in December 2015, with the decision in favour of the tax authorities. A further decision, made by the Guangdong Province People's Intermediate Court in November 2015, was the first case in China to deal with the IIT implications of dual employment arrangements into China. The case, involving a US tax resident and concerning the interpretation of the China-US DTA, was decided in favour of the tax authorities.
While the decisions in these cases ultimately went against the taxpayers in question, this emerging new trend for tax cases to be brought to court has the potential to bolster taxpayer certainty with cross-border transactions. Over time, this should generate court interpretations that were previously lacking in Chinese tax law. It should also provide a path for taxpayers to resolve disputes in individual cases beyond informal negotiations with the tax authorities.
In relation to obtaining greater certainty for taxpayers on cross-border transactions, another emerging trend is for tax authorities to grant private tax rulings on cross-border transactions. In November 2015, a municipal state tax bureau in the Jiangsu province issued a private tax ruling, in relation to the application of reorganisation relief on the merger of two non-resident holding companies that involved a change in the registered owner of equity in a Chinese enterprise. The extension of private tax rulings to cross-border transactions (local tax authorities have, with SAT encouragement, been granting these to purely domestic transactions for several years) is important in the context of the 2015 abolition of tax authority pre-approvals for most transactions. A greater expansion of private tax rulings is envisaged from 2017 when the new Tax Collection and Administration Law, which includes specific provisions on rulings, is expected to be finalised. These court and administrative developments, which enhance taxpayer certainty for cross-border transactions, are explored further in the chapter China tax – big data and beyond.
Rapid development in China's external tax policy
In the first six months of 2016 China's outbound direct investment amounted to $99 billion. This was a 50% increase on the year before. For the year as a whole a total of $170 billion is anticipated, a historic high that would significant outstrip foreign direct investment into China for the year. In tandem with this, 2016 saw further significant advances in the development of China's outbound investment tax policy. There are three dimensions to this policy:
- China has been taking steps to increase its scrutiny of Chinese enterprises and individuals investing overseas, and to enforce tax more effectively;
- At the same time, tax policy and administration has sought to encourage and support outbound investment, in particular along the One Belt, One Road; and
- These initiatives dovetail with China's increased engagement with G20 nations and the OECD on initiatives to build tax capacity in less developed countries.
Increased tax enforcement rigour in relation to outbound investment
With regard to enforcement, and as discussed in last year's edition, in 2015 extensive publicity was given to the first reported applications of the Chinese CFC rules in the Shandong and Hainan cases. Both of these cases involved the disposal of equity in Chinese enterprises by Chinese investors through the interposition of layers of offshore companies to enable offshore disposals. These cases, focusing as they did on "round-tripping" arrangements, did not really involve a departure from the historic focus of the Chinese tax authorities on Chinese tax base erosion in inbound investment cases – enforcement in these cases could also conceivably have been by way of the inbound investment-focused indirect disposal rules.
However, 2016 saw crucial advances on this position, with reports being released of truly "outbound"-focused CFC enforcement cases. A case pursued by Urumqi STB in the Xinjiang province (and concluded in 2015) involved a local company that established an overseas subsidiary in a low tax jurisdiction. The overseas subsidiary received largely passive income and the authorities concluded that it did not have a reasonable commercial need to defer repatriation of its earnings to China, which is the principal let-out under the Chinese CFC rules. The CFC rules were applied and the company was charged RMB 2.7 million ($390,000) in taxes, plus penalties and interest. Such cases are likely to make Chinese outbound investing companies that are entering into new markets more cautious about how they manage their operations to ensure they do not to fall foul of the CFC rules.
The Chinese tax residency rules could equally be used to tax outbound investing Chinese companies. However, the reported cases have focused on tackling base erosion in relation to inbound investment, which has been the traditional focus of the Chinese tax authorities. The noted cases involved the Chinese tax residence rules being used by the tax authorities to bring foreign incorporated listing vehicles for Chinese enterprises into the tax net as tax residents. This was in order to tax foreign companies investing in these listing vehicles on their China sourced gains.
These cases included a 2011 case concerning Vodafone's sale of a stake in China Mobile's Cayman-incorporated, Hong Kong-listed holding company for Chinese operating companies, and a further 2013 case involving the sale by a US private equity fund of, similarly, a stake in a Cayman-incorporated, Hong Kong-listed holding company for Chinese operating companies. In both cases the Chinese tax authorities asserted that the Cayman companies were Chinese tax residents on the basis that effective management was exercised from China. The enforcement action was taken to ensure foreign investors did not avoid taxation in China when exiting from Chinese investments. Looking ahead, as with the new Urumqi case for CFC rules, it is anticipated that the Chinese tax residence rules will be used more vigorously to tax genuine outbound investment.
The various new international EOI initiatives entered into by China, together with the 2014 enhancements to CFC reporting in SAT Announcement 38 (2014), and the commencement of CbCR from 2018, mean that outbound investment will be under tax authority scrutiny like never before.
China tax policy promotes outbound investment
The more notable tax policy developments in 2015 and 2016 have been focused on facilitating outbound investment. The SAT has instructed tax authorities at all levels to promote understanding among taxpayers of the benefits of DTAs and to encourage outbound investors to consider putting a bilateral APA in place. Nationwide promotional campaigns in relation to tax administration support for enterprises investing along the One Belt, One Road have been run, and a special tax authority hotline (12366) service has been established to provide guidance on outbound investment tax issues. In addition, a range of detailed tax guides on foreign tax systems, and tax issues typically encountered overseas by Chinese enterprises, have been published by the authorities.
A trend has also emerged for China to enter into particularly preferential tax treaties with jurisdictions along the One Belt, One Road. On August 8 2016, China signed a new tax treaty with Romania that will offer some of the best WHT rates to-date in a Chinese tax treaty. Dividends, interest and royalties are all subject to a 3% WHT rate, while a 0% WHT rate is available for dividends and interest in certain cases. The DTA provision on capital gains is also preferential in comparison to most other Chinese tax treaties.
While Romania is a relatively minor trading partner for China, the signing of the new Romania treaty comes hot on the heels of the entry into force of the new China-Russia treaty, which itself is among the most attractive Chinese treaties, with a 0% WHT rate on interest.
This new generation of tax treaties are significantly more beneficial than the previous 'bests', such as China's tax arrangements with Hong Kong and Singapore. Whether this heralds a new approach underpinning Chinese tax treaty policy going forward, with a preferential leaning towards countries along the Belt and Road, remains to be seen.
In addition, real assistance is being provided by the SAT to Chinese companies encountering tax issues abroad. In line with the SAT's efforts to raise awareness of the assistance that can be rendered to outbound investing companies, MAP cases have been reported with ever increasing frequency throughout 2015 and 2016. However, the details tend to be somewhat limited, being whatever the tax authorities are willing to disclose. For example:
- In a case publicised in June 2015 on the SAT official website, a Yantai City, Shandong province-based, listed company was refused royalties WHT relief under the China-Kazakh DTA. The WHT, imposed at a domestic rate of 20%, had been applied to payments made by a Kazakh subsidiary of Yantai Jierui Petroleum Services Joint Stock Company in respect of the lease from the Chinese parent to the subsidiary of certain equipment. The SAT reported that after the MAP process was initiated by the Yantai company with the Yantai STB, who elevated the matter so that discussions took place between the SAT and their Kazakh counterparts, the DTA WHT rate of 10% was ultimately secured. The SAT reported that a tax refund amounting to RMB 1.5 million was achieved;
- In a case publicised in August 2016 on the Beijing STB website, an overseas subsidiary of a Chinese enterprise had been denied DTA WHT relief on an interest payment made on a loan received from the China Development Bank (CDB). The foreign tax authority focused on the DTA provision which indicated that loans guaranteed by a foreign government could benefit from a 0% WHT rate on interest and disputed that the loan met the terms of the DTA. The Chinese enterprise's position, supported by the SAT in the MAP discussions, was that as CDB was a wholly-owned Chinese government institution and therefore a separate provision of the DTA should in any case grant DTA relief. When the case was concluded in the Chinese enterprise's favour in February 2015 it had taken just 36 days to be resolved and a tax reduction of in excess of $5 million was secured;
- A further 2015 MAP case highlighted by Beijing STB on its website involved a dispute over the attribution of profits to a PE of a Chinese enterprise in a treaty partner state. The Chinese enterprise had entered into a contract for the design and construction of, and related procurement associated with, a power plant project in the treaty partner state. A local project office established by the Chinese enterprise to facilitate the project work, overseeing supplies and conducting certain service activities, constituted a local PE. The dispute related to the attribution of profits to the PE by the local tax authorities. The Chinese enterprise argued that the activities associated with the supply of equipment occurred wholly in China and not in the country of the power plant project and that, consequently, no profits from the supply of equipment should be attributed to the PE. The Chinese enterprise initiated the MAP and the case was resolved by the SAT with their overseas counterpart, with the latter agreeing that the equipment supply profits should not be attributed to the local PE, achieving a tax saving of RMB 10 million; and
- Another case publicised in June 2015 on the SAT's website involved a MAP case with India. Shandong Electric Power Construction Corporation was engaged in a number of power plant construction projects under contracts with the Indian government, some of which were contracts with local Indian entities of the Chinese group and some of which were contracts with the Chinese company itself. The Indian tax authorities sought to treat the contracts collectively, resulting in an additional 2013 tax demand of $38 million. While the SAT has made efforts to resolve the matter through the MAP, the case was reported as being complex and not yet resolved as at the time of the SAT's web posting.
The rapid growth trends for Chinese outbound investments and overseas economic activity are already seeing Chinese enterprises engaged in an increasing number of high profile tax disputes overseas, many of which have ended up in foreign courts. For example, in 2016 in India, ZTE faced a challenge over PE profit attribution for its telecommunication equipment supplies (ZTE Corporation v ADIT, ITA 5870/Del/12 & ors). Zhenhua Port Machinery faced a PE recognition challenge in relation to a port construction project in Gujarat Pipavav Port Limited v. ITO (ITA No. 7878/Mum/2010). Haier, Shanghai Electric, Huawei and Dongfang Electric have similarly all been engaged in high profile Indian tax disputes. This is in India alone, but with Chinese investment ranging over the whole world the tax complexity to be managed is becoming immense.
In the context of the broad upswing in outbound activity associated with the Belt and Road initiative, reliance by Chinese enterprises on APAs and the MAP will become ever greater. Furthermore, Chinese MNEs are buying into existing overseas structures with acquisitions of groups in Europe and elsewhere. The BEPS tax changes overseas will invalidate many of the existing structures, demanding restructuring and potentially entangling Chinese MNEs in further overseas tax disputes in the future. China's overseas investments and operations will also demand, reciprocally, a clarification of Chinese tax law in relation to foreign tax credits.
China's tax capacity in building assistance to developing countries
A third leg of China's outbound tax policy relates to providing enhanced tax capacity building assistance to developing countries. The May 2016 FTA meeting in Beijing moved forward with global initiatives in this space by establishing a Knowledge Sharing Platform and a Capacity Building Network to coordinate assistance from multiple international organisations and national governments to developing countries. Progress on toolkits to guide developing countries in upgrading their cross-border tax rules, which are being developed by the OECD, IMF, UN and World Bank in light of BEPS, was also outlined at the Beijing FTA meeting.
Interlinking with these initiatives, China has implemented 12 bilateral and multilateral cooperation programmes with developing countries, particularly those along the Belt and Road. Under these, the SAT has been providing tax training courses, expert support, experience sharing and technical assistance in building tax capacity. In this regard, workshops on tax administration and taxpayer service were provided to 82 tax officials from 18 African, Asian and Latin American countries in 2015, facilitating further cooperation between those countries and China. In another example, a delegation was sent to Ethiopia in 2015 to help build up its tax administrative capacity and business environment. China also announced the establishment of an OECD-SAT multilateral tax centre in Yangzhou in March 2016 to provide tax-related training for developing countries. This sits alongside the announcement by the G20 following its February meeting that the Chinese Ministry of Finance would establish an international tax research centre in Beijing to generate cutting edge thought leadership in the international tax space.
These efforts may eventually constitute a key pillar of Chinese outbound investment policy. Tax assistance is being channelled in particular at Belt and Road countries such that China is helping to enhance and potentially influence the tax administration of countries in which Chinese businesses will invest and operate. China's more intensive interaction with the tax administrations of such countries, and the manner in which China is interlinking its efforts with those of the international tax organisations, such as the OECD with respect to BEPS and other governments as regards to the CRS, may result in China having greater influence on the overall shape of global tax policy and administration.
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Khoonming Ho is the vice chairman and head of tax at KPMG China, as well as the head of tax for KPMG Asia Pacific. Since 1993, Khoonming has been actively involved in advising foreign investors about their investments and operations in China. He has experience in advising issues on investment and funding structures, repatriation and exit strategies, M&A and restructuring.
Khoonming has worked throughout China, including in Beijing, Shanghai and southern China, and has built strong relationships with tax officials at both local and state levels. He has also advised the Budgetary Affairs Committee under the National People's Congress of China on post-WTO tax reform. Khoonming is also actively participating in various government consultation projects about the ongoing VAT reforms.
He is a frequent speaker at tax seminars and workshops for clients and the public, and an active contributor to thought leadership on tax issues. Khoonming is a fellow of the Institute of Chartered Accountants in England and Wales (ICAEW), a member of the Chartered Institute of Taxation in the UK (CIOT), and a fellow of the Hong Kong Institute of Certified Public Accountants (HKICPA).
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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 the 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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Lilly Li is the partner-in-charge for tax in Southern China. She is based in Guangzhou and specialises in business and tax advisory services for corporate restructuring, cross-border transfer pricing, tax-efficient structuring of mergers and acquisitions (M&A) and initial public offering (IPO) projects.
Lilly provides China-based corporate tax advisory and transfer pricing services to multinational and domestic enterprises. Her experiences cover a wide range of industries, for example, consumer markets, automobile, electronics, property and infrastructure.
Lilly has extensive experience in dealing with tax disputes and tax policy lobbying. For example, she and her team have successfully assisted 13 Asia Games sponsors in applying for business tax exemptions with the State Administration of Taxation (SAT). They also assisted a number of listed groups in lobbying for tax rulings with the SAT, which allows Chinese companies to deduct stock option experiences before corporate income tax.
Before joining KPMG, Lilly worked in the China Tax Bureau and Australian Taxation Office in international tax administration, tax audits and transfer pricing.
Lilly is a member of Certified Practising Accountants (CPA) Australia and the Taxation Committee of CPA Australia, Greater China.
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Conrad Turley is a director in KPMG China's international tax practice. 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 numerous global private-equity groups and multinational enterprises transacting cross-border into and out of China, on a wide range of tax issues. These include establishment of tax-efficient cross-border operating and investment structures, restructurings and M&A, as well extensive tax work on the liquidation of Lehman Brothers Asian operations.
Conrad is a frequent contributor to international tax and finance journals including International Tax Review, Tax Notes International, Bloomberg BNA and Thomson Reuters, and is 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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