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China Enforces Anti-Avoidance

26 Jul 2010

China's anti-avoidance enforcement has historically been focused on the transfer pricing of contract manufacturing operations, which predominantly involves tangible goods transactions. This year, according to a State Administration of Taxation ("SAT") senior official, "Closer attention will be paid this year to related-party transactions such as intangible asset transfer or share transfers." Taxand China investigates recent case law with a well known multinational and what businesses should be looking out for when investing in China.

On 18 May 2010 a well known multinational company filed and paid non-resident Enterprise Income Tax to the value of RMB 173 million to the Jiangdu Municipal Jiangsu Province tax authority. It is the largest single amount of tax collected by the Chinese tax authorities from a non-resident Enterprise for indirectly transferring the equity of a Chinese company. In this particular case the foreign parent company transferred the shares of its HK subsidiary, when the HK subsidiary owned only 49% of the shares of a Joint Venture ("JV") in Yangzhou, Jiangsu Province. It was concluded by the Chinese tax authorities that the HK company had no employees, no other assets, or liability; no other investment; and no other operation.

Should a foreign investing party (who is the actual controlling party) indirectly transfer the equity of the Chinese resident enterprise by arrangement to the offshore holding company, then the competent tax authorities can re-define the nature of the equity transaction, on the grounds of economic substance, and deny the existence of the offshore holding company. For instance, if the foreign investing party is abusing the organisation for unreasonable commercial purpose to evade paying the enterprise income tax then the tax authorities would step in.

The Chinese tax authorities re-defined the substance of the equity transfer transaction on the well known multinational company and denied the existence of the HK company. The foreign company must now pay tax in China for the transfer of share from JV in Yangzhou, Jiangsu Province.

The automobile and pharmaceutical industries will be the key sectors for transfer pricing audits in the near future.

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 Transfer Pricing Manuals for Developing Countries as initiated by the United Nations.

In recent competent authority cases, the Chinese tax authorities have identified the following points which are of interest to multinational companies:

  • Location-savings: Multinational companies can earn excess profits by setting up factories in China due to access to cheap labour and other resources. Should Chinese subsidiaries be entitled to the whole or part of the profit?
  • Marketing intangible asset: A growing number of multinational companies 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. The Chinese tax authorities identified that the foreign parent company is overlooked due to increasing demand arising from the China market and efforts made by the Chinese distributors in developing the Chinese market.
  • China market premium: China's advantage and potential purchasing power has contributed significantly to the profitability of companies operating in the Chinese market. The Chinese tax authorities believe that China should be entitled to tax on the excess profit derived from China's market premium.
  • Contract R&D: 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. China's tax authorities may ask that Chinese companies be able to enjoy the benefits derived from the R&D activities, especially when the R&D companies are deemed to be substantially involved in the R&D decision-making process.

Taxand's Take

As the case with the well known multinational showed, China's tax authorities reserve the right to collect taxes, should they deem the business to be avoiding tax. Multinational companies should examine their tax arrangements to check whether they can be adapted to develop with China's tax environment. As China's tax authorities pay closer attention to related party transactions and enforce anti-avoidance tax planning, the development of transfer pricing policies of Chinese subsidiaries should be considered by multinationals to prevent investigation and large sums of tax being paid to the authorities.

Your Taxand contacts for further queries are:
Dennis Xu

Kevin Wang

Taxand's Take Author