|Colin Farrell and Matthew Mui PwC|
During 2012, China witnessed a significant growth in its tax collection through anti-tax avoidance efforts. According to the latest statistics published by the State Administration of Taxation (SAT), the 2012 total tax collection contributed from anti-tax avoidance operations amounted to RMB34.6 billion (around US$5.6 billion), representing a year-on-year growth of 45% over 2011, and 74 times the 2005 amount. The Chinese tax authorities initiated 233 anti-tax avoidance cases in 2012. Among the 175 settled cases, the average amount of tax collected per case was RMB26.2 million, and the largest single sum of tax collection amounted to RMB 843 million. Nine cases reclaimed tax of more than RMB100 million and 59 cases reclaimed more than RMB10 million.
China's combat against tax-avoidance activities
In China, the tax authorities' anti-avoidance focus was initially mostly limited to transfer pricing (TP). However, the scope has expanded in recent years, in particular after the new Corporate Income Tax Law (CIT), effective after 2008, which introduced new provisions covering thin capitalisation, controlled foreign corporations and general anti-avoidance rules (GAAR).
In recent years, some tax avoidance areas which have attracted the Chinese tax authorities' concerns are:
Offshore indirect equity transfers
As an "experiment" for the implementation of a GAAR, the SAT started investigations in 2010 on effective transfers of Chinese entities' equity interest through the transfer of offshore China vehicles without a China tax consequence. A closer look at the common features of some reported GAAR cases on indirect equity transfers may help to illustrate where China stands in its anti-tax avoidance efforts:
- Detection: All of these reported cases were detected by local-level tax bureaus instead of being voluntarily reported by the overseas transferor. It is not difficult for these offshore indirect equity transfers to come to the attention of the Chinese tax authorities, for instance, through tax audits of the Chinese entity being indirectly transferred, or from public announcements of the overseas transferors and transferees.
- Methodology to assess a transaction: "Purpose test" is stipulated in the CIT Law as a crucial factor in applying the GAAR. However, in the practice of local level tax bureaus, the "substance test" has dominated because the "purpose test" is rather subjective or abstract and difficult to substantiate in some cases. That has inevitably resulted in more disputes with taxpayers.
- Onus of proof: The Chinese tax laws and regulations do not explicitly state which party shall bear the onus of proof in tax avoidance matters. In practice, the taxpayer is often required to justify that the main purpose of an arrangement is not for tax avoidance, even in the process of an administrative appeal.
Beneficial ownership for treaty benefit purpose
In recent years, China has been intensifying its focus on granting treaty benefits, and at the same time attacking treaty shopping through the assessment of beneficial ownership (BO). In the last couple of years, the SAT attempted to provide several interpretations and guidelines on this issue, but unfortunately they were unclear and impractical. Some local-level tax bureaus had taken rather harsh positions against the treaty benefit applications which caused quite a number of disputes with the applicants. In early 2013, the SAT issued an official reply to local-level tax bureaus regarding their real-life cases on the assessment of BO in respect of dividends under the China-Hong Kong double taxation agreement (DTA). That reply is generally more practical and reasonable.
Exchange of information
The SAT acknowledges that exchange of information (EoI) is an effective tool to combat TP issues, treaty shopping, inappropriate cost deduction issues and other forms of tax avoidance. There is a recently reported case whereby China denied the capital gain treaty protection applied by a Barbados-based transferor. This transferor was then proven to be a branch of a US taxpayer through the EoI via the Joint International Tax Shelter Information Centre (JITSIC) platform.
EoI is also the key to international tax cooperation. The SAT has taken significant steps in recent years in adhering to the high standards of international cooperation in the EoI space.
Going forward there could be more information exchange between China and overseas tax jurisdictions and hence a higher degree of transparency and disclosure of tax information imposed on taxpayers. Taxpayers should therefore be prepared for the possible increased exposure of their financial and tax information to the tax authorities of both the resident country and the source country.
There is a strong signal that the Chinese tax authorities are ready to handle more complex tax-avoidance issues as they are equipped with more technical skills and practical experiences. Looking forward, in light of the international trend to protect the tax base – such as the OECD's base erosion and profit shifting (BEPS) project – doubtless China is moving to a new stage of anti-tax avoidance, not only through legislation, but also through domestic enforcement and international cooperation.
Among other anti-avoidance measures, the SAT is also expected to roll out a set of GAAR procedures soon which would address the selection of suspicious tax avoidance cases, evidence collection processes and analysis at local level tax bureaus, and then examination and verification at the SAT level, probably through a technical panel. The aim is to make the implementation of the GAAR more standardised, sophisticated, efficient and fairer to both tax bureaus and taxpayers.
Interaction between China and Hong Kong
Due to its proximity to China and other economic and political factors, Hong Kong is frequently used as a spring board for multinationals' investments into China. Hong Kong is also a top trading partner of China.
Historically, there were tax avoidance cases reported in China involving Hong Kong parties, including a "forged" BO of China source passive income for obtaining a DTA benefit, an empty shell for offshore indirect equity transfer, and claiming offshore Hong Kong source of business profits to achieve double non-taxation. Such cases have perhaps sent an impression to the international tax community that Hong Kong is an undesirable tax haven.
However, the fact is that Hong Kong tax legislation has built-in anti-tax avoidance measures and has put emphasis on EoI in recent years. There is a third protocol on EoI to the China-Hong Kong DTA, which is consequential to Hong Kong's adoption of the 2004 OECD convention EoI article. It is also understood that there is reasonably frequent EoI between the SAT and Hong Kong Inland Revenue Department (IRD).
Additionally, the assessing practice of the IRD has become even more thorough and tight in recent years. In particular, the IRD is attacking offshore claims forcefully to combat perceived double non-taxation. Several Hong Kong taxpayers are relying on Hong Kong's territorial taxing concept and its geographical proximity to China to achieve a tax efficient arrangement via such claims. For instance, trading and/or service profits are captured by a Hong Kong entity which are claimed as non-taxable offshore sourced profits on the basis that the actual work is performed by travelling employees of the Hong Kong entity in China. If the activities performed in China do not constitute a permanent establishment in China, it is possible to legitimately achieve an outcome where the profits are taxed neither in Hong Kong nor China. It appears increasingly apparent that the IRD is actively checking the robustness of such arrangements, in some cases raising substantial information requests in multiple-year tax queries and audits, with a heavy onus of proof on the taxpayer and a potentially lengthy dispute process (a tax audit can often take three to four years to resolve). There is also tax risk on the other side, in that with China's growing effort in reviewing and uncovering unreported permanent establishments of foreign corporations, it is likely that more of these companies may be required to pay Chinese tax.
At the time of the CIT reform back in 2008, China was determined to tackle aggressive tax planning schemes to protect its tax base. The issuance of many important tax circulars to tighten up administration on non-tax residents as well as vigorous tax audits in recent years is a clear demonstration of this. The Chinese tax authorities are now becoming more and more sophisticated in terms of anti-tax avoidance. In light of this trend, it is inevitable that taxpayers will be subject to more tax compliance requirements, more disclosure and reporting obligations, and even more inspections.
Against this backdrop, the prevailing practical approach for taxpayers is to prepare for all of the worst possible outcomes. Some takeaway points may include:
- Think twice about valid commercial reasons for any structuring or transactions;
- Build substance into existing structures;
- Prepare adequate documentation to defend challenges, which in fact requires a very high standard of internal controls; and
- Build up trust with local level tax bureaus and prepare good communication and strategy to monitor tax audits or enquiries.