Tax Strategies for Funds Investing In China: China Tax Authorities Aggressively Enforcing GAAR (General Anti-Avoidance Rules)
Chinese tax authorities have been aggressively enforcing the application of its GAAR and are likely to scrutinize exit tax residency and permanent establishment issues as they relate to nonresident funds and management companies. This trend is also accompanied by a set of recent tax changes in China. Moreover, China has recently renegotiated treaties with Barbados, Mauritius, and Singapore, and continue to introduce new rules to address potentially abusive structures or transactions aimed at mitigating Chinese capital gain tax, particularly those based on double tax treaty claims or indirect transfers. These rules include general anti-avoidance rules (GAARs)reflected in various pronouncements, i.e., Guoshuifa [2009] 2 ("Circular 2"), 3 Guoshuihan [2009] 698 ("Circular 698"), 4 Guoshuihan [2009] 601 ("Circular 601"), 5 Guoshuifa [2009] 124 ("Circular 124"), 6 and Guoshuihan [2010] 290 ("Circular 290"). Potential Investment Fund Structures in China As most tax practitioners who work with outbound investment into China, there are several structures for effectuating cross-border investments by non-Chinese resident funds in China. One approach is to set up an investment fund in the Cayman Islands as an investment holding company which fund would adopt as its tax residence a jurisdiction which has a tax treaty with China, such as Hong Kong, Ireland or Mauritius. As a holding company, the Caymanian fund would invest in companies doing business in China. A management company could either set up a subsidiary ("wholly foreign owned enterprise" (WFOE) or a representative office in China. Chinese GAAR Provisions The corporate Income tax law, as revised, in China (CITL) has included several GAAR rules. Such anti-avoidance provisions permit the taxing to make adjustments when enterprises enter into business arrangements that give rise to a reduction of taxable income and are not supported by a reasonable business purpose. Under Chinese tax regulations, business arrangements without a bona fide business purpose refer to arrangements the primary purpose of which is to reduce, avoid, or defer tax payments. Guidance in this areas has been issued by the Chinese tax authorities which are very broad and cover a variety of contexts, including abuse of tax incentive policies, tax treaty provisions, legal vehicle forms or structures, tax havens, and other arrangements without bona fide business purposes. The Chinese have also adopted principles tax lawyers in the States are familiar with including, step transaction, substance over form, and book-tax differences. The GAAR rules provide the Chinese tax authorities with the power to make adjustments to certain transactions or deny tax benefits, and allow local tax bureaus to disregard legal entities that are deemed to lack substance. These rules are being used to examine back-to-back loan or financing structures made by off-shore investment funds. China Treaty Circulars: A Brief Summary In Circulars 601 and 698 the Chinese taxing authorities will attack structures that exploit tax treaties, such as prohibited treaty shopping, and tax avoidance. combating tax treaty shopping and tax avoidance. These Circulars were preceded by some high-profile cases (citations omitted)and the issuance of other guidance aimed at strengthening the taxation of nonresidents. In Circulars 124, the Chinese tax authorities introduced detailed administrative rules for treaty residents to claim treaty benefits, with an effective date of October 1, 2009. The rules provide that nonresidents will not be automatically granted the benefits under DTAs, and will be required to comply with administrative rules to receive them. Income derived by nonresidents is divided into two categories and is subject to different procedures for claiming treaty benefits. For benefits attributable to passive income, including dividends, interest, royalties, and capital gains, nonresidents must adhere to an "application-approval" procedure. For active income, such as business income of permanent establishments, independent personal services, and dependent personal services, nonresidents must satisfy the "record-filing" procedure. Different documentation is required with respect to the two procedures. Once the application for treaty benefits is approved, the nonresident does not have to reapply to the tax authority to be entitled to benefits for three calendar years (including the year in which the initial application is made) with respect to (1) dividends derived from the same equity investment in the same enterprise; (2) interest derived from the same debt and due from the same debtor; and (3) royalties derived from granting the same right to the same person or enterprise. Eligible nonresidents under the DTAs that fail to apply for approval may cure this failure by filing an application within three years from the date of the tax payment to obtain a refund. Approval may be revoked by the Chinese tax authorities in certain circumstances and the nonresident may be required to pay the taxes plus surcharges, interest, or penalties. Query, how would a US based company issuing GAAP financials set up appropriate reserves under FIN 48 for such procedures and the risk of facing tax assessments in China? In Circular 290, supplementary rules pertaining to local PRC tax authorities were promulgated including subjects on the timing of internal review procedures, tax filing requirements, and tax residency certificates for nonresidents seeking tax benefits under DTAs. Circular 290 requires a withholding tax agent to complete tax filing procedures regardless of whether the taxpayer has submitted related documents to the tax authority. Circular 290 clarifies that to obtain DTA benefits, a tax residency certificate must be issued exclusively for that purpose or in accordance with the requirements of Circular 124. Additional Circulars Issued after 2008 Additional Circulars were issued by the PRC in 2009. For example, in Circular 601, rules for determining the "beneficial owner" for the purpose of claiming DTA benefits by treaty residents with respect to dividends, interest, and royalties. Agents and conduit companies (i.e., companies established to avoid or reduce tax or shift profits) are not beneficial owners for purposes of Circular 601. In Circular 698, the PRC addressed issues related to gains from equity sales (i.e., capital gains), specifically to increase the administration and taxation of direct and indirect capital gains derived by nonresidents. The Circular provides that the substance-over-form approach extends to capital gains derived indirectly by nonresidents on share or equity transactions and highlights the willingness of the Chinese tax authorities to disregard certain entities under GAAR if they were established to avoid tax and lack a business purpose and commercial rationale. The rules cover both direct and indirect equity or share transfers by nonresidents, the nonresidents' obligation to report and the Chinese tax authorities' jurisdiction over such gains, subject to certain conditions for indirect equity or share transfers. The "share transfer" under Circular 698 refers to nonresidents transferring shares of a Chinese resident enterprise or company. Nonresidents are generally exempt from the Circular 698 reporting requirement for the disposal of listed shares of Chinese companies that were purchased and sold on a public stock exchange. For an indirect sale, Circular 698 asserts the Chinese tax authorities' right to invoke GAAR to disregard one or more intermediate holding companies if their existence serves no business purpose except avoidance of Chinese tax liabilities, thus effectively treating the indirect sale as a direct disposition of the Chinese company or enterprise.
There have been several cases that were prosecuted by the Chinese tax authorities under its GAAR Circulars in attacking transactions which the PRC taxing authorities believe does not comport with commercial substance. In the area of treaty shopping, a case arose in Tianjin (2010). The Tianjin case involved a Mauritius nonresident enterprise (MCo) that transferred its direct equity interest in a PRC non-land-equity joint venture (EJV) to another nonresident shareholder in Bermuda (BCo). The PRC tax authorities denied treaty benefits on capital gains derived by MCo from the direct disposal of equity interest in the EJV based on the following points: (i) MCo was merely a conduit company and was effectively managed by the U.S. parent company (USCo); and (ii) USCo is the beneficial owner of the capital gain in question. The PRC tax authorities determined , based on all facts and circumstances, that USCo had absolute control over MCo based on facts including: (i) the majority of EJV's sales were conducted through USCo; (ii) USCo sent its technical personnel into China to conduct product testing on EJV's products; (iii) EJV paid a royalty fee to USCo; (iv) USCo exercised substantial control over the production and operation of the EJV; and (v) USCo controlled the production, operation and funding of EJV. In another recent case, Fujian (citation omitted), that was issued last year, the Fuzhou State Tax Bureau successfully assessed and collected taxes from a Hong Kong holding company after denying it a tax exemption under the China-Hong Kong DTA for capital gains on its transfers of the stock of a Chinese resident company. The disposing Hong Kong company alone owned less than 25% of the shares in the Chinese resident company and thus was otherwise eligible for relief under the DTA. However, its shareholder, a Hong Kong individual, owned additional shares in the same Chinese resident company through another intermediary Hong Kong holding company such that, in aggregate, the Hong Kong individual owned indirectly more than 25% of the shares in the Chinese resident company. The view of the Fuzhou State Tax Bureau was that the Hong Kong individual shareholder was the ultimate beneficial owner of the income and imposed a 10% withholding tax on the capital gains. Practitioners working with outbound investments into China through an offshore holding company should review recent protocols entered into force under the China-Mauritius Treaty, the China-Barbados Treaty and the Singapore Treaty. These developments in the PRC will cause tax practitioners and their clients investing in China to re-assess their tax structures and assess their present tax risk to challenge under the GAAR rules being enforced by the PRC. There are a host of potential problems in this area including the proper use of management entities, tax consequences of equity sales, eligibility for treaty protection, transfer pricing issues, permanent establishment issues, and location for the exercise of corporate governance.
It seems like the "economic substance doctrine", "business purpose", "substance over form", "step transaction", "sham transaction"., improper treaty shopping and related issues are now part of the tax landscape in the PRC.
