TAX NEWS - 2010

China Tax: China considers innovations in anti-avoidance administration

The Shenzhen local tax bureau recently invited taxpayers to attend transfer pricing seminars, including one presented by a senior State Administrating of Taxation official. At the seminar, it became clear that the focal point of the anti-avoidance practice will no longer be merely limited to the purchase or sale of tangible property or traditional simple manufacturing businesses. Rather, China's tax anti-avoidance efforts will embrace an all-around approach.

China's anti-avoidance administration has entered a standardization phase, as the new Enterprise Income Tax law, its implementation rules, and the Implementation Regulations for Special Tax Adjustments (Trial) were promulgated and entered into force in early 2008. At the seminar, the State Administrating of Taxation official discussed the focus of 2010 tax anti-avoidance efforts: "Closer attention will be paid this year to related-party transactions such as intangible asset transfers or share transfers, and we would encourage local tax authorities to explore new methods or ideas when assessing the reasonableness of such transactions. Moreover, we will pay special attention to transfer pricing for outbound investments and controlled foreign corporations (CFCs) issues arising in those Chinese companies that "go international."


2010 anti-avoidance efforts

The automobile and pharmaceutical industries will be key sectors for transfer pricing inspections in the near future. The State Administrating of Taxation continues to constantly strengthen the centralized management of transfer pricing inspections to regulate the nationwide practice. State Administrating of Taxation requires that local tax bureaus obtain its approval for filing or closing all cases to ensure a uniform implementation standard, and to avoid situations whereby audits of companies with similar conditions in various regions yield significantly different results. State Administrating of Taxation also will increase enforcement efforts in the joint inspection of group companies or across industries on a nationwide scale.

The Chinese tax authorities also have growing concern over Chinese companies using tax havens in their outbound investment planning for tax avoidance purposes. In recent years, Chinese companies have created increasingly closer ties with low-tax jurisdictions. In 2008, investment into mainland China from three tax havens (British Virgin Islands, the Cayman Islands, and Samoa) and Hong Kong accounted for 23.43 percent and 44.41 percent, respectively, of the year's total inbound investments. Investment into Hong Kong, the British Virgin Islands, and the Cayman Islands by Chinese companies in transnational programs accounted for 75.61 percent of the year's total outbound investment. The Chinese tax authorities do not view Hong Kong as a tax haven. However, in the transfer pricing area, the Chinese tax authorities do take into consideration the fact that the Hong Kong Profits Tax rate is significantly lower than that of mainland China.


New anti-avoidance developments

China's tax authorities are actively involved in international collaboration regarding tax collection and management, as well as international joint anti-avoidance investigations. China will soon officially become a member of the Joint International Tax Shelter Information Centre (JITSIC), and is actively involved in attending OECD experts' lectures, and participating in the drafting of a Manual of Transfer Pricing in Developing Countries initiated by the United Nations.

The State Administrating of Taxation is actively seeking to enhance China's international influence in its anti-avoidance efforts. The State Administrating of Taxation puts forth plenty of ideas and views from the standpoint of developing countries, and actively endeavors to have a say in the drafting of international anti-avoidance rules, with an aim to protecting the taxation rights and interests of developing countries.

The State Administrating of Taxation is building a national database of corporate information. According to Guoshuifa [2009] No.2, in evaluating whether a company's related-party transactions comply with the arm's length principle, the tax authorities may use either public or nonpublic information (usually known as the "secret database"). The tax authorities are trying to obtain support or cooperation from other governmental departments, such as Customs, Statistics, Commerce, SAFE, and SASAC, for the establishment of information-sharing mechanisms.

The State Administrating of Taxation is planning to form a professional expert team for transfer pricing audit cases to increase the authority of and intensify the anti-avoidance inspection and tax adjustment. If companies hold dissenting views on a tax adjustment, they have access to remedial measures such as applying for administrative review, filing a lawsuit, or going through a Competent Authority procedure.

State Administrating of Taxation acknowledges that some local tax authorities have asked Chinese subsidiaries to carry out self-adjustments to avoid an audit. These self-adjustments may create double taxation, because the tax authorities of the corresponding jurisdictions may not recognize such true-up payments. This only emphasizes the importance of transfer pricing analysis to avoid the necessity of self-adjustments.


New transfer pricing ideas

In recent competent authority cases, the Chinese tax authorities have raised new issues – such as location saving and market premiums – to safeguard the interests of developing countries. China, an emerging market itself, enjoys unique competitive advantages compared to developed countries, including the continuously increasing purchasing power, and cheap land and labor. The Chinese tax authorities have successfully gained respect and acknowledgement from foreign countries in some cases, and they would like to continue developing an analysis basis.

Location-savings – Multinational companies earn excess profits by setting up factories in China that have access to cheap labor and other resources. With regard to such profits attributable to location savings, should the Chinese subsidiaries be entitled to all the profit or only a portion thereof? If the profits were to be shared by the subsidiary and the foreign investors, how would the profits be reasonably split? These issues have increasingly become the focal point of the debate between multinationals and the Chinese tax authorities during transfer pricing audits.

Marketing intangible asset – A growing number of multinational companies, including some famous foreign groups in the luxury industry, have set up trading companies in China as their limited-risk distributors bearing simple functions and risks. Accordingly, the profits of these distributors in China are usually extremely low. In those cases, the tax authorities often challenge whether it is plausible for the foreign parent to claim all the profit associated with the marketing intangible asset merely because it makes decisions in the marketing strategies. Such activities of the foreign parent may be viewed by the Chinese tax authorities as overlooking the contribution of the increasing demand arising from the Chinese market and treating the Chinese subsidiaries as limited-risk distributors fails to recognize the efforts made by the Chinese distributors in developing the China market.

Market premium – As a country with an emerging market, China undoubtedly has made a particular contribution to the profitability of companies operating in the Chinese market. Take the automobile industry, for example. In recent years, China's automobile market has been growing very fast, whereas the traditional European, American, and Japanese markets have experienced a continued downturn. The Chinese tax authorities generally believe that China should be entitled to tax the excess profit derived from the China market premium; however, the methods to quantify such excess profit are still under discussion.

Contract R&D – Under most circumstances, contract R&D companies set up in China by foreign multinationals do not own the intellectual property (IP) rights generated from the R&D activities, legally or economically. These companies are usually compensated for their labor costs and relevant expenses, plus a modest mark-up. In some situations, the tax authorities may consider these arrangements unfair, and may require that the Chinese companies be able to enjoy the benefits derived from the R&D activities, especially when the R&D companies were deemed to be substantially involved in the R&D decisionmaking process.


Summary

The Chinese tax authorities have started to play a more important role in the international anti-avoidance arena. The State Administrating of Taxation has already taken both practical implementation and expertise support into consideration and made arrangement for antiavoidance tax administration. Chinese tax authorities at all levels have been strengthening their efforts in the tax antiavoidance area for the active protection of Chinese taxation rights and interests, including completion of legislation, standardization of working mechanisms, building of professional teams, reinforcement of domestic and overseas promotion, and expansion of international information exchange and communication.

Faced with this trend of tightening tax anti-avoidance administration by the tax authorities, multinational companies must examine their tax arrangements and check whether they can be adapted to the development and change of the taxation environment in China. In addition to the preparation of contemporaneous documentation in accordance with Circular [2009] No. 2, it is also advisable for management to actively seek to enter into advance pricing arrangements (APAs) with the tax authorities on reasonable profit levels, so as to minimize any transfer pricing risks.