Foreign companies could be caught in China's new indirect transfer rules

This article originally appeared in International Tax Review, a sister publication of China Law & Practice


Notice 7 is effective from February 3 2015, though applies to transactions from January 1 2008 that have not received an assessment from the tax authorities. China's Notice 698 was introduced in December 2009, but was effective for transactions dating after January 1 2008.

As Chinese authorities do not issue notices if they do not believe transactions to be taxable, the new regulation opens up all prior transactions that have not received a judgement to potential review under the new guidelines.

For the first time, Notice 7 expands the coverage of taxable activity beyond just equity. Transactions such as transfer of partnership or other China-based interests could also come under the scope of the tax.

"To close the insufficiencies of the existing regime, they needed to further elaborate on the relevant subject matters on indirect transfer," said Andrew Choy, a partner at EY.

Circular 698 was criticised by some tax professionals who hoped for greater transparency and expansion of technical details. While the new regulations have provided some positive changes, including the introduction of safe harbour rules on intragroup organisations, tax professionals say the new laws are open to ambiguities.

Jinghua Liu, tax partner at Baker & McKenzie, says that the new safe harbour rules are a "welcome change" in the regulations, but expressed concern that the new laws will impose a withholding duty on offshore buyers before the tax authorities have even determined taxability.

"The withholding obligation requires the offshore buyer to pay tax within seven days of when the tax obligation arises - that means when the contract is signed or becomes effective. In that case, because this is anti-avoidance regulation, the taxpayers won't even know if the transaction is taxable until they go through the entire analysis and the tax authority makes a determination that the transaction is taxable. In that case how can the offshore buyer withhold the tax without even knowing if there is a tax obligation?" said Liu.

Transactions which have no direct Chinese element could still potentially be caught under the scope of the new law – for example when one party to a transfer holds a Chinese branch or entity. Buyers and sellers who fail to withhold the tax liabilities can be given a stiff penalty of 50% to 300% of the unpaid tax.

Article 3 of the provision lays down guidelines for establishing the reasonable commercial purpose of an entity or operation, relying heavily on economic substance. However, under article 4, the regulation also included guidelines that would automatically deem indirect transfers to lack reasonable commercial substance.

"This is quite a problematic approach because when it comes to tax avoidance, under the income tax law, you need to determine whether a transaction has reasonable commercial purpose. You can't automatically deem transactions [to be] without commercial purpose. You have to look at all the facts to determine this," said Liu. "The deeming approach really allows no opportunity for the taxpayer to make that argument."

Choy also believes that the deeming approach is a significant feature of the regulations for both taxpayers and regulators as it simplifies determining if transactions are tax liable.

"If a transaction meets those requirements, it will automatically become a taxable transaction. The good thing is, from a taxpayer perspective, this improves certainty in an M&A situation," said Choy.

"It seems that the Chinese authorities want to tax a transaction because the major operations or assets are located in China - so they want to assert much broader taxing rights over these offshore transactions," said Liu.

"This approach effectively moves the tax burden from the seller to the buyer. It's really questionable whether there's any legal basis for this approach."

New GAAR in effect

China's new general anti-avoidance rules (GAAR) came into effect February 1 to target abusive arrangements and those lacking economic substance, with the burden of proof lying on the taxpayer.

"There's been this disconnect in the practice where the legal standard was the purpose test but the actual application focused on economic substance," said Jon Eichelberger of Baker & McKenzie. Eichelberger says that proving substance is fairly simple, though purpose is much more subjective.

"This new GAAR rule brings the two together – a purpose test and a substance test. What they seem to be saying with the substance test is if a company has substance then it probably won't run afoul of the GAAR," said Eichelberger. "In my mind it doesn't quite address the problems that we've experienced over the past six years because the difficult cases are ones in which the company doesn't have substance but the primary purpose of its existence is not tax avoidance. That issue, from my point of view, is not addressed by this rule."

In early February an editorial in the government-run China Daily said: "multinationals, especially small, foreign companies, should pay extremely high attention to their regulation compliance, as failure to do so would lead to huge losses."


By Meredith McBride, International Tax Review