Taxes: A 2010 review and the road ahead

1.2 Taxation on Representative Offices (ROs): The SAT issued Guo Shui Fa [2010] No. 18 to codify prior tax rules on ROs. Several crucial prior tax notices concerning ROs are repealed accordingly. In addition to income tax, this notice also deals with business tax and value-added tax (Vat) treatments of ROs.

If an RO can not declare and pay taxes on the actual basis, two deemed profit methods may be adopted to determine its taxable income, based on i) operating expenditures or ii) total revenue. The deemed profit rate is no less than 15% (an increase from the prior 10%). Under the new notice, no application for income tax exemption treatment on ROs will be accepted, and ROs with granted tax exemption treatment will be re-examined. This means that every RO is a taxable presence in China by default unless the RO can successfully claim treaty benefits (for example, claiming it does not constitute a permanent establishment (PE) and should not be subject to Chinese income tax).

1.3 Business purposes in M&A: To implement the income tax rule on enterprise restructuring Cai Shui [2009] No. 59 (Notice 59), the SAT issued the Public Announcement [2010] No. 4 (Notice 4). Notice 4 has clarified many technical aspects of Notice 59, including the determination of the leading party, the date of restructuring, and what materials are to be submitted in order to enjoy tax deferral treatment for each type of restructuring. However, such clarifications appear to be mainly from the domestic transactions perspective and did not otherwise shed more light on cross-border M&A than Notice 59 itself.

Nonetheless, Notice 4 has provided some guidance on how to justify “reasonable business purposes”, one of the key elements for enjoying the tax deferral treatment in all M&A activities. In brief, the business purposes may be explained from the various aspects such as transaction method, form and substance, potential changes to the tax and financial positions of parties to the transaction, unusual economic benefits or potential obligations not available under the market principle, and information on participating NREs.

1.4 Capital gains and indirect equity transfers: While the income tax notice on indirect equity transfer Guo Shui Han [2009] No. 698 (Notice 698) was issued on December 10 2009, and hence beyond the scope of review of this article, given the important impacts of Notice 698 were first shown in 2010, it is still worthwhile to discuss Notice 698 here.

Notice 698 is probably one of the most important PRC tax rules as it has significant impacts on international tax planning involving China because of its extraterritorial application on indirect equity transfer. It requires disclosure of relevant information by an NRE on transfer of equity in an offshore holding company that holds an equity interest in a PRC company. Based on the information disclosed, the SAT may determine whether the offshore holding company has any business purposes or substance. If the offshore holding company is found to lack business purposes or substance, the offshore holding company may be disregarded, and render the transaction being re-characterised as a direct transfer of the equity in the underlying PRC company.

Due to the broad coverage of the indirect equity transfer, almost all offshore equity transfers involving an underlying PRC subsidiary may require an assessment whether the Notice 698 disclosure requirement will be triggered.

It was reported in May that the Jiangsu tax authority received a $25 million capital gains tax payment from an NRE transferor in an indirect equity transfer. This was reported as the largest amount collected to date under Notice 698. However, there is no official document released in disclosing the facts on which the transferred intermediary offshore holding company was disregarded, other than certain general statements as reported in news stories that the disregarded company has no substance, for example, no personnel, no assets, no liabilities, no other investment and no other operation or business. It remains to be seen how the anti-avoidance rule will be interpreted in practice.

1.5 Dividends, interest and royalties: The SAT issued Guo Shui Han [2010] No. 183. It requested the local tax authorities to inspect Chinese-listed companies on tax withholding on dividends distributed post 2008. Chinese-listed companies are required to carry out a tax withholding registration and maintain certain accounting records and inform NREs of PRC tax obligation in the dividend distribution announcements.

The SAT issued Guo Shui Han [2010] No. 266. It clarifies the application of tax treaty to China-sourced interest income received by a foreign or PRC financial institution's branch established in a third country. It follows the principle that a branch is regarded as part of the same legal person entity and hence the branch established in a third country can enjoy the benefits provided under the tax treaty between its home office country and China.

The SAT issued Guo Shui Han [2010] No. 46 to supplement Guo Shui Han [2009] No. 507, a general notice on implementation of the royalty clause of relevant tax treaties. It confirmed the priority of the business profits clause over the royalty clause when dealing with the technology service fees. This supplementary notice has been later incorporated into Guo Shui Fa [2010] No. 75 to be discussed below.

1.6 Transfer pricing audit: The SAT issued Guo Shui Han [2010] No. 323. It requires that the local tax authority to select at least 10% of the enterprises that should have prepared the contemporaneous documentation, as sample enterprises for examination. This means an increased transfer pricing audit risk on those selected enterprises.

1.7 Miscellaneous: The SAT also issued some other income tax rules. Public Announcement [2010] No. 1 provided detailed guidance on how to calculate foreign tax credit for PRC income tax purposes. Public Announcement [2010] No. 6 provides that the loss resulted from equity investment is deductible in a lump sum in the year of loss recognition. Public Announcement [2010] No. 19 provides that all forms of gain from transfer of property including the gain from debt restructuring, income received from donation, and unpaid accounts receivable, shall all be included into the taxable income in lump sum of the year when the income is realised. Public Announcement [2010] No. 20 provides that the upward adjustment of taxable income resulted from tax audits may be used to offset the loss first, and only the remaining amount is subject to tax.

2. Value-Added Tax (Vat)

The SAT issued Order No. 22, amending the administrative rules on recognising the general Vat taxpayer status. The amendments are mainly to lower the criteria and simplify the procedures for being recognised as a general Vat taxpayer. In general, a taxpayer may apply to be certified as a general Vat taxpayer i) when its annual sales amount reaches Rmb 500,000 if the taxpayer engages in manufacture and/or sales activities or reaches Rmb 800,000 in other situations or ii) when a taxpayer newly opens its business. The SAT may impose a training period for small commercial wholesale enterprises and other specified classes of taxpayers.

In connection with Order No. 22, the SAT issued Guo Shui Fa [2010] No. 40 to specify the relevant restrictions during the Vat training period. According to the notice, a small commercial wholesale enterprise, which is subject to a three-month training period, refers to a wholesale enterprise with a registered capital below Rmb 800,000 and with less than 10 employees. The other taxpayers subject to the Vat training period are those with tainted records of Vat compliance such as tax evasion, fraudulent tax filing for export Vat refunds, or issuing fake Vat invoices. Their training period is six months.

3. Tax treaty and technical explanation

In 2010, China added one more treaty with Turkmenistan, which brings the total number of China tax treaties to 92. China also signed a new treaty with Malta in replacement of a 1993 version and signed several new protocols including those with Barbados, Hong Kong and Singapore as well as information exchange agreements with Jersey, Guernsey and Isle of Man.

To clarify the procedural rules Guo Shui Fa [2009] No. 124 on claiming for treaty benefits, the SAT issued a supplementary notice Guo Shui Han [2010] No. 290. In most parts, the supplementary notice just made clerical revisions or clarifications to Guo Shui Fa [2009] No. 124. Notably, this supplemental notice has further increased the responsibility of the withholding agent by requiring the withholding agent to also fulfill a recordal requirement.

Most significantly, the SAT issued the Guo Shui Fa [2010] No. 75) (Notice 75) on technical explanation of the 2007 China-Singapore tax treaty. Notice 75 represents the first efforts of China in interpreting a full tax treaty on an article by article basis. While China has not published its own model tax treaty, in practice, it has been referring to the Organisation for Economic Co-operation and Development (OECD) model treaty and the UN model treaty and their commentaries as applicable. Because the China-Singapore tax treaty was renegotiated in 2007, it reflects the latest treaty positions of the PRC tax authority, and is regarded as a de facto model treaty of China before China formally issues its own model treaty. Notice 75 provides that to the extent that the other tax treaties of China that have the same provisions as those of the China-Singapore tax treaty, Notice 75 shall govern the interpretation and implementation of such other tax treaties and will replace the prior inconsistent interpretation.

Notice 75 has consolidated and updated the Chinese treaty positions as shown in various prior notices scattered from 1980s. While many positions remain the same with more details, there are certain deviations on some aspects. For example, Notice 75 provides that when a Singaporean enterprise establishes a fixed place in China, repairs or maintains the machinery equipment sold by the enterprise to PRC customers, or supplies spare parts solely to PRC customers, because the activities carried on through such fixed place constitute the basic and important part of the services provided by the enterprise's headquarters to the customers, the activities through such fixed place shall not be regarded as preparatory or auxiliary. This literally means that either the repair/maintenance activities or the supply of the spare parts will cause a foreign company to have a PE in China. As this notice is brand new, time will tell if Notice 75 is indeed so narrowly interpreted and implemented to make a simple delivery/supply of spare parts constitute a PE in China. If so, it is going to cause a significant change to the business model of many foreign companies with regard to the supply of spare parts to PRC customers.

On the other hand, Notice 75 provides some good news to foreign companies. For example, it confirms that secondment could be still a viable choice if it can be proved that the secondees are indeed working for the PRC subsidiary, rather than the foreign parent company.

4. Tax incentives

Tax incentives available to only foreign investment were significantly decreased after the new EIT law entered into effect from 2008, and were finally eliminated with the repeal of the exemption on two surtaxes effective from December 1 2010 (See Guo Fa [2010] No. 35 and Cai Shui [2010] No. 103). However, tax incentives as a tool to guide investment are still frequently adopted by China, though they may not specifically target only foreign investment.

For example, a recent tax incentive aims to encourage the development of outsourcing service industry in China. If a company located in one of the 21 Offshore Outsourcing Services in Model Cities is certified as an Advanced Technology Service Enterprise (ATSE), it may enjoy a reduced 15% EIT rate until December 31 2013 (see Cai Shui [2010] No. 65). In the meantime, all outsourcing service enterprises located in the 21 cities are exempted from business tax on income from the provision of offshore outsourcing services until December 31 2013 (see Cai Shui [2010] No. 64).

5. Tax administration

5.1 Procedures for formulating tax rules: To streamline the procedures on formulating the tax regulatory rules, the SAT issued Order 20. All the regulatory tax rules, which refer to the official documents issued by the tax authorities that set out the rights or obligations of the taxpayers and have binding effects on taxpayers within the relevant jurisdiction (such as those bearing the citation of Guo Shui Fa or Guo Shui Han), but cannot establish administrative penalties, must be issued in the form of public announcements and take effect 30 days after. In principle, tax regulatory rules shall have no retroactive effect unless to better protect the rights and interests of taxpayers. The legal department within the tax authority must be consulted before the tax regulatory can be released, and shall make efforts in codifying the tax regulatory rules periodically.

5.2 Tax Administrative Review: The SAT issued the amended tax administrative review rules by Order 21. The most significant change is the adoption of the reconciliation and mediation process into the administrative review regime. The taxpayers and tax authority can now reach reconciliation agreements before the administrative review decision is made. Once a reconciliation agreement is reached by the parties and confirmed by the administrative review authority, and therefore the administrative review process is terminated, the parties cannot initiate the administrative review process again based on the same facts and causes. The administrative review authority may also mediate to settle the disputes. Upon a successful mediation, a mediation agreement will be signed by both parties to the dispute and sealed by the administrative review authority. The mediation agreement can be enforced by the tax authority or by the court.

2011 Prospects

In 2011, it is expected that China may continue tightening its tax administration over NREs including in the areas of indirect equity transfer, treaty benefits, and transfer pricing audits. In China's transfer pricing audits, China may focus more on audits involving services and intangibles, and may apply certain new transfer pricing approaches or methods such as location savings, compensation for environmental cost, market premium, etc. When such new approaches or methods are not accepted by foreign tax authorities, it could cause potential double taxation, which may be resolved through bilateral competent authority procedures or advance pricing agreements. The contemporaneous documentations prepared in 2010 will also provide a good handle to the PRC tax authority for selecting audit targets.

It is reported that the tax collection law will be amended to incorporate certain anti-tax avoidance provisions that are currently only available under the EIT law. In the meantime, the individual income tax law and business tax regulations may also be amended to incorporate certain anti-tax avoidance rules. This would create a tighter and tougher tax environment in China.

It would also be expected that China may offer more clarifications on M&A tax rules, in particular with regard to the cross-border M&A. China may adopt a new Vat law to be promulgated by the National People's Congress in replacement of the current Vat regulations passed by the State Council.

In the meantime, the SAT may follow the procedures on formulating tax regulatory rules in actively carrying out codification work. This will help sort out tax rules that are scattered across numerous tax notices while addressing the same topics and therefore help improve tax compliance.

Peng Tao, DLA Piper, New York