Broadening the scope

Chris J Finnerty and Joseph Lee report on recent developments related to the Unified Corporate Income Tax Law

As part of China's tax reform efforts, the Chinese Government has announced and approved a new Unified Corporate Income Tax Law (CITL) that became effective on 1 January 2008. The State Council subsequently issued the Corporate Income Tax Law Implementation Regulations (CITLIR). Following the release of the CITL and the regulations, it was clear multinationals (MNCs) investing or operating in China may face higher tax liabilities going forward, due in part to the repeal of broad-based tax holidays and preferential tax rates available to many foreign invested enterprises (FIEs).

The purpose of this article is to highlight provisions in the CITL and regulations which significantly broaden the scope of the PRC's taxing jurisdiction through the introduction of transfer pricing (TP) and various anti-abuse rules. Together, these provisions, which deal with tax residency, thin capitalisation, controlled foreign corporations (CFCs) and permanent establishment (PE), significantly expand the scope of the PRC's taxation of multinational corporations operating in China.

General anti-avoidance

The CITL gives the tax authorities the ability to adjust taxable income when enterprises make business arrangements that give rise to a reduction of taxable income and are not supported by a rational business purpose. Thus, China has enacted, as part of the CITL, a general anti-avoidance rule. The regulations provide that business arrangements without bona fide commercial purposes refer to arrangements whose primary purpose is to reduce, avoid or defer tax payments. Therefore, any future planning should take into account these newly-issued anti-avoidance rules and any cost benefit analysis should factor them into the relevant tax risk analysis, as appropriate.

Transfer pricing

The CITL stipulates a compulsory TP documentation requirement and provides that, upon a TP investigation by the tax authority, the company and its related parties must submit relevant documentation as required. The regulations clarify that the required documentation include contemporaneous documentation regarding pricing policies, calculation methods and explanations, comparables and profit levels, etc. The documentation must be submitted by the taxpayer within the deadline imposed by the tax authority. For related parties of the taxpayer and other companies included in the TP investigation, the documentation must be submitted within an agreed time limit.

The CITLIR clarifies that a fine or penalty will not be imposed for lacking such contemporaneous TP documentation. However, an interest charge will be imposed on the amount of tax payable under any anti-avoidance adjustment that includes a TP adjustment. As long as the taxpayer provides the required contemporaneous documentation within an agreed period of time, no penalties or additional interest will be charged. If the TP documentation obligation is not met within the required time period, the applicable interest on any TP adjustment will not only be at the prevailing RMB lending interest rate published by the People's Bank of China, but also at an additional 5% (so-called excess interest).

Tax residence - definition of effective management

The CITL stipulates that a company incorporated outside China, but having effective management in China, will be considered a tax resident and subject to tax in China on its worldwide income. The concept of effective management is introduced into the law but is not defined within the CITL. The CITLIR defines 'effective management' as the overall management and control of the production, business, employees, finance and assets of a company. It is unclear exactly what this means. However, it appears clear that the analysis goes beyond looking to board of director activities and extends more to the day-to-day management of the business. With such a general definition, the conclusion on tax residency would likely be determined by the tax authorities on a case-by-case basis based on the facts and circumstances of each case. Further guidance in this area would be welcomed.

This is an area that requires special attention as China's approach and enforcement of this concept is not yet fully clear. Even absent additional guidance, MNCs are advised to review their existing operations and operating guidelines to ensure that any significant exposures are mitigated through taking corrective action to avoid the unintended consequences of having a non-Chinese incorporated entity (for example, in Hong Kong or the British Virgin Islands) becoming tax resident in China. If operating guidelines do not exist, MNCs are urged to put the appropriate operating guidelines in place to mitigate potential tax exposures.

Permanent establishment

The CITL provides that a non-resident company having an establishment in China should be subject to tax in China on income arising in China, and also income arising outside of China but actually connected to the establishment. The CITLIR provides a definition of 'establishment' that is very similar to, and in line with, international practice and is similar to the term 'permanent establishment' (PE) that is used in bilateral tax treaties. It appears clear that China is more focused on PE issues and may become more serious and proactive in bringing foreign companies that have operations in China into its tax net (either through a China tax residency or PE argument).

It is important to review structures and transaction flows and analyse any tax exposure under Chinese domestic law, as set forth by the CITL and CITLIR, or applicable tax treaty. From a practical standpoint, these rules may not have any impact for those taxpayers who are covered by a relevant double tax treaty. However, as the implementation of these rules unfolds and they are enforced by the tax authorities, it is advisable to monitor how the Chinese apply these rules in practice, which could vary by location.

Thin capitalisation

The CITL disallows interest deductions on loans from related companies in excess of a prescribed debt-to-equity ratio. The CITL introduces for the first time thin capitalisation rules for tax purposes that apply to interest-bearing debt. 'Prescribed' debt-to-equity ratios for different taxpayers (for example, financial and non-financial enterprises), as well as potential exceptions, were expected to be set forth in the CITLIR. However, the prescribed debt-to-equity ratios set forth in earlier draft versions of the regulations were deleted. Thus, additional guidance is required. The CITLIR simply states that 'prescribed' debt-to-equity ratios shall be jointly formulated by the Ministry of Finance (MoF) and the State Administration of Taxation (SAT). Thus, we will have to wait for the release of future circulars from the MoF and the SAT to learn the specifics. If future guidance is consistent with earlier versions of the draft regulations, a 20:1 debt-to-equity ratio and a 3:1 debt-to-equity ratio would apply to financial and non-financial enterprises respectively.

The above ratios mentioned in the earlier draft regulations govern only related-party borrowing. Taxpayers who are able to secure third-party loans are not restricted by this rule. In addition, in many situations, the new tax thin capitalisation rules may have little practical impact on FIEs due to the existence of potentially more restrictive foreign exchange rules for foreign currency debts governed by China's State Administration of Foreign Exchange (SAFE). Of course, this will depend on the prescribed debt-to-equity ratios as set forth by the MoF and the SAT, and the particular facts of each taxpayer.

Controlled foreign corporations

The CITL stipulates an immediate recognition as taxable income of the undeclared profits, kept without good reasons, by a CFC incorporated in a jurisdiction with a tax rate obviously lower than that of China. The CITLIR provides details of what amounts to control, and provides guidance regarding tax rates that are 'obviously lower' than that of China. Per the CITLIR, a CFC is defined as:

• a foreign entity (FE) with more than 50% of its shares held by qualified China tax resident(s) (a 'qualified China tax resident' is a China tax resident that directly or indirectly holds at least 10% of the voting shares of the FE), or
• an FE not meeting the above holding criteria, but which is effectively controlled by China tax resident(s) in terms of shareholding, funding, operation, and buy and sell, etc. Thus, control can exist irrespective of failing the 50% ownership test.

Further, if the effective tax rate of the CFC is lower than 50% of the China Corporate Income Tax Rate (i.e. lower than 12.5%) and the CFC does not declare dividends or reduces dividend declarations, and such is not due to reasonable business needs, then the profit of the CFC that is attributable to the Chinese entity, although not declared, will be included in the Chinese entity's taxable income. However, the regulations do not define the term 'without good reasons' and further guidance would be useful on key areas.

While the CFC rules will most likely have a significant impact on the outbound investment strategies of Chinese MNCs, the CFC rules should not have a major impact on MNCs, as China is not generally viewed as a location for a holding company due to legal and tax reasons. That being said, situations could arise when the CFC rules are relevant - for example, in the situation where a non-Chinese incorporated entity is treated as being a Chinese tax resident under the new tax residency rules discussed above.

Chris J Finnerty is a partner, International Tax Services, Ernst & Young Hua Ming Shanghai, China, and Joseph Lee, a partner, Tax and Business Advisory Services, Ernst & Young Hua Ming Beijing, China.

Portions of this article appeared in 'Tax Strategies for Investing and Structuring into China (Post Tax Reform) - Part II', published in Tax Management International Journal, Volume 37, no 3 (14 March 2008 edition), and are reprinted with permission of Tax Management Inc.