Over the past two months, China produced a wave of interesting developments in international taxation. On June 26, just days before the Foreign Account Tax Compliance Act (“FATCA”) took effect, China and the US agreed in substance to a Model 1 intergovernmental agreement (“IGA”). On July 3, China released for public comment a discussion draft of a procedural guideline on how to examine and determine anti-avoidance cases, including indirect share transfers under Guo Shui Han [2009] 698 (“Circular 698”), taking place from January 1, 2008. The guideline will also furnish the Chinese tax authorities with expansive and intrusive investigative authority in anti-avoidance inquiries. Finally, in a rare case, a Chinese tax authority granted tax-free treatment to a cross-border restructuring under Cai Shui [2009] 59 (“Circular 59”). FATCA Update: China Agreed in Substance to Model 1 IGA China and the US on June 26 reached agreement in substance on the provisions of a Model 1 IGA under FATCA. A Model 1 IGA will require foreign financial institutions (“FFIs”) in China to report FATCA-required information to their own governmental agencies, which would then report the required information to the IRS. The agreement in substance with China was concluded just days before the law took effect on July 1. Under FATCA, withholding agents generally are required to begin 30 percent withholding on withholdable payments made to FFIs that are not FATCA-compliant on and after July 1. However, FFI residents in an IGA jurisdiction are not subject to this withholding tax under certain conditions. Jurisdictions that have negotiated, but not yet finalized, an IGA are treated as having in effect an IGA if an IGA was agreed to in substance by the July 1 deadline. Thus, while the IGA with China remains to be finalized, China is treated as having an IGA in effect as of June 26 until December 31, 2014. This will allow the FFIs in China to avoid FATCA withholding on payments received from US sources. Anti-Avoidance: Procedural Guideline for Anti-Avoidance Cases Released China’s central State Administration of Taxation (“SAT”) on July 3 released for public comments by August 1 a discussion draft of Administrative Guidance on General Anti-Avoidance Cases (“Guidance”). The Guidance will set out a procedural guideline on how to examine and determine anti-avoidance cases, including so-called indirect share transfers of resident enterprises of China under Circular 698. Notably, the Guidance will endow the tax authorities with expansive and intrusive information gathering authority in their investigation of anti-avoidance cases. If taking effect, the Guidance will retroactively apply to anti-avoidance arrangements that were made after January 1, 2008, but have not been decided before its issuance. The Guidance is based on the general anti-avoidance principle contained in the Enterprise Income Tax Law. It will apply to special adjustments made by Chinese tax authorities under a substance-over-form approach to arrangements in which a participant attempts to obtain tax benefits in a tax avoidance transaction with no reasonable commercial purpose. “Tax benefits” include reduction, avoidance or deferral of tax. Under the Guidance, an arrangement is characterized as “tax avoidance” where:
- the sole purpose, primary purpose or one of the primary purposes of the arrangement is to reduce, avoid or defer Chinese tax;
- the arrangement lacks economic substance despite its legal form.
The Guidance does not define what constitutes reasonable commercial purpose, which is also the stated test for whether or not China can tax a transfer of shares of non-resident enterprises that directly or indirectly hold shares of resident enterprises in China (“indirect share transfers”) under Circular 698. With respect to indirect share transfers, the substantive rules will be covered in a new regulation that the SAT will issue to replace the existing Circular 698. In terms of the procedure set out under the Guidance, all anti-avoidance cases will be centralized under the SAT. Local tax authorities may find potential anti-avoidance cases through routinely monitoring matters such as annual enterprise income tax filings, contemporary documentation, outward remittances, share transfers and tax treaty matters. To initiate an investigation, the local tax authorities will be required to report the matter level by level to the higher tax authorities and ultimately to the SAT for approval. After the investigation, a similar approval process will be required to decide whether or not to levy tax. However, the Guidance does not stipulate any deadline for the tax authorities to make their conclusion in any particular steps, and therefore the whole process will likely stretch for a lengthy amount of time. During the course of the investigation, the Guidance endows the tax authorities with expansive and intrusive information gathering authority. For example, the Guidance, in its broad terms, provides that the tax authorities can obtain any communication between the taxpayer and its tax advisors. They can also directly approach any units or individuals that provided tax planning assistance to the taxpayer for relevant information. Because China does not have attorney-client, tax practitioner-client or accountant-client privilege or work-product doctrine, very little room to maneuver will exist to avoid disclosing the requested information. A taxpayer has the right to appeal a disputed adjustment through administrative review and judicial decision. If an adjustment results in international double taxation or is inconsistent with the applicable double tax treaty or arrangement, the taxpayer also has the right to seek mutual agreement procedure consideration under the applicable tax treaty or arrangement. Corporate Reorganization: A Japanese Company Received Tax-free Treatment under Circular 59 As published in a book by the SAT on cases of non-resident taxation, a Japanese investor (“Japanco”) received tax-free treatment for its internal group restructuring in 2009. The transaction involved the transfer of Japanco’s equity interest in four resident enterprises of China located in different provinces to its wholly-owned investment holding company in China. This is one of the few cross-border reorganizations that received tax-free treatment under Circular 59. The transaction in China was part of a global internal restructuring carried out by Japanco to consolidate its investments respectively in different regions due to the global financial crisis in 2009. Before the transaction, Japanco directly owned an 81% interest in two resident enterprises of China and a 90% interest in two other resident enterprises of China. It also owned 100% equity interest in one investment holding company (“CHC”) in China, which owned the remaining interest in the four target subsidiaries. All resident enterprises involved in the share transfer were located in different jurisdictions within China. In the transaction, Japanco transferred its equity interest in the four subsidiaries to CHC in exchange for CHC shares and sought tax-free treatment under Circular 59. Circular 59 offered tax-free treatment to reorganizations under certain conditions. If a share transfer qualifies for tax-free treatment, the transferor will not recognize gain or loss for enterprise income tax (“EIT”) purposes through relevant basis rules. To qualify as tax free, a share transfer must, among other statutory requirements, have a reasonable commercial purpose, and its primary purpose cannot be the elimination, reduction or deferral of Chinese taxes. The transaction conducted by Japanco satisfied the form, procedures and representations described in Circular 59, and the key issue was whether Japanco had reasonable commercial purposes or tax avoidance purposes for the share transfer. In this regard, Bulletin [2010] 4 enumerated the following factors in determining whether a reorganization had a reasonable commercial purpose:
- the form and substance of the transaction, including the relevant background, business operations before and after the transaction, legal and economic consequences of the transaction, and normal commercial practice;
- any changes in tax positions of the transacting parties as a result of the transaction;
- any changes in financial positions of the transacting parties as a result of the transaction;
- whether the transaction would result in any benefits or obligations that would not occur under normal market conditions; and
- the non-resident enterprises’ participation in the transaction.
Accordingly, while acknowledging the fact that the share transfer was being carried out to restructure Japanco’s operations in China due to the 2009 financial crisis, the in-charge tax authority noted the potential avoidance of EIT on dividend income coming out of the four subsidiaries as a result of the transaction. Specifically, the four subsidiaries, in the aggregate, had RMB 141 million (approximately US$22 million) of undistributed earnings accumulated before 2008 and RMB 90 million (approximately US$15 million) accumulated after 2007. While dividend income attributable to pre-2008 earnings is exempt from EIT under Chinese tax law, the dividend income attributable to post-2007 earnings generally is subject to a 10% withholding tax in the hands of a non-resident enterprise of China such as Japanco. However, this 10% withholding tax would be avoided as a result of the share transfer because dividend income is exempt from EIT in the hands of a resident enterprise such as CHC. Moreover, at the time of the share transfer, CHC had RMB 780 million (approximately US$120 million) of net operating losses (“NOL”), which would offset the dividend income coming out of the four subsidiaries after the share transfer. Nonetheless, the in-charge tax authority concluded that the transaction did not have a tax avoidance purpose based in part on the fact that the tax-exempt pre-2008 earnings of the four subsidiaries exceeded their taxable post-2007 earnings. Moreover, the tax authority stated that the NOL was due to poor operations of CHC, and it is permissible to use CHC’s NOL to offset its dividend income. Because the tax authority found no evidence of tax avoidance, it concluded that the share transfer qualified for tax-free treatment under Circular 59. According to the tax authority, it also intended to use such tax deferrals and other preferential treatment to incentivize the formation and operation of investment holding companies by foreign investors in China. This case illustrates tax-efficient reorganization under Circular 59 in practice. The scope under Circular 59 for tax-free treatment of a reorganization where the transferor or the transferee is a non-resident of China is narrow, and the reasonable commercial purpose requirement is the main pressure point for satisfaction of the Circular 59 requirements. As a matter of practice, tax-free treatment is rarely granted to cross-border reorganizations or reorganizations involving target companies in different jurisdictions in China. Thus, this case is an encouraging development and sheds some light on how to satisfy the reasonable commercial purpose requirement. That being said, future Circular 59 transactions will still be subject to case-by-case, fact-intensive review by the Chinese tax authorities.
