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Why the Vodafone ruling leaves China standing alone in the cold

With last week’s victory for Vodafone, a message has been sent out to governments around the world that pursuing the taxation of the indirect transfer of shares is an unsustainable policy. But China won’t listen.

The decision by the Indian Tax Department to issue an assessment for Vodafone’s 2007 purchase of a 67% stake in Hutchison Essar dumbfounded tax professionals around the world, but other jurisdictions liked the move as ambitious and decided to do the same.

The most vocal supporter of this approach was China which introduced Notice 698 in November 2009, in what many believe as a direct response to the Vodafone matter.

Notice 698 states that the authorities will impose a 10% withholding tax on capital gains derived by non-resident enterprises from the transfer of equity interest in Chinese resident enterprises.

Traditional tax planning strategies use an offshore holding company to invest into China and exit from the country by transferring the offshore holding company without paying any China withholding tax. One purpose of 698 is to attack such arrangements.

The circular requires a non-resident seller to disclose an indirect transfer of a resident company to the tax authorities within 30 days after signing the share sale agreement if the tax burden in the intermediate holding company's jurisdiction is less than 12.5%, or if that jurisdiction exempts foreign-sourced income from tax.

To see Vodafone overturned leaves China standing in a potentially very lonely, position in its attempt to extend its taxing jurisdiction beyond its borders in this way.

“The Vodafone decision highlighted the importance of certainty for taxpayers in the tax law, which has been a major issue for companies wrestling with Notice 698 potentially applying to transactions that on their face seem unrelated to China,” said Brendan Kelly, of Baker & McKenzie, Shanghai.

While it is difficult to predict how China might react to the decision, it may put additional pressure on the tax authorities there to clarify a number of questions regarding the scope of Notice 698.

“While we have all hoped for changes to Notice 698, China lacks the level of multinational taxpayer access to an independent judiciary that India has shown with this decision. This puts India well-ahead of China, and while India has carried a reputation as the most aggressive taxing jurisdiction in Asia for years, China may quickly stand alone with this unfortunate distinction unless decisive action is taken,” said Kelly.

The decision also pointed to the lack of specific general anti-avoidance legislation in India, where in China it could be argued that the combination of GAAR rules and Notice 698 are sufficient to provide jurisdiction in indirect transfer cases.

Therefore, while China might feel some additional pressure to clarify the application of Notice 698, it is hard to imagine a wholesale repeal.

“If China were to make changes or clarifications to Notice 698, we expect that the focus would be to limit the scope to go after more empty structures, as they have in most of the published cases in China to date,” said Kelly.

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