Tax Risk Management

China (People's Rep.) Tax Risk Management Authors Tracy Zhang Partner KPMG China Conrad Turley Senior Manager KPMG China Latest Information: This chapter is based on information available up to 27 March 2015. Please find below the main changes made to this chapter up to that date: Completely rewritten chapter.

1. Introduction The general objectives of tax control frameworks used in China are to ensure sound compliance with tax laws and regulations to avoid penalization; to tax plan sensibly and take advantage of applicable preferential tax policies; and to minimize tax uncertainty which would be reflected in financial reporting outcomes. At this high level, tax risk management in China is the same as in all other countries.

However, the unique features of the Chinese tax risk landscape mean that the extent to which tax risk can be controlled, and the means of controlling it, may differ from elsewhere.

The challenges of tax risk management in China need to be understood against the backdrop of the continuing rapid transformation of the Chinese economy and the related seismic shifts in the structure and orientation of the Chinese taxation system, which stretch the abilities of both tax authorities and taxpayers to keep up. Peculiarities in the nature of Chinese tax law, the interpretation of which does not involve the courts system, and the involvement in tax policymaking and administration of thousands of lower tier tax authorities, responsible to different levels of government, can lead to a high degree of tax uncertainty. The manner in which, in the still very heavily state regulated business environment, permission to conduct commercial activities, such as business licenses and foreign exchange remittances, are linked to compliance with tax obligations, adds an important additional commercial dimension to tax risk management.

China has been eagerly adopting some of the innovations from developed economies designed to foster better tax risk management practices by inducing large enterprises into a more open and trust-based ongoing relationship with the tax authorities. China's policy is to offer a combination of “carrots” and “sticks” to induce more compliant tax behaviour. As "sticks", China is requiring greater tax disclosure and reporting, introducing rules providing for greater executive responsibility for tax and rolling out tax risk rated audit targeting, while the "carrot" lies in the establishing of cooperative compliance and ruling regimes. The close cooperation between taxpayers and authorities is to be supported by new guidance for taxpayers on putting in place the information systems and corporate governance, which © Copyright 2015 Tracy Zhang,, Conrad Turley,. All rights reserved. © Copyright 2015 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information.

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gives assurance of tax risk control to the authorities. However, such developments are still at a relatively early stage of implementation.

1.1. The restructuring of the Chinese economy and the rebalancing of the tax system The challenges of tax risk management in China must be understood in the context of the extensive changes in the structure and enforcement of the tax system which has accompanied the transformation of the economy.

Since 1978, bold economic reforms and record levels of foreign direct investment (FDI) have transformed China from an autarkic, largely agrarian economy, in which four out of five Chinese worked in agriculture, into an industrial powerhouse at the centre of global supply chains, with gross domestic product (GDP) growth having been at close to 10% per annum over the entire period. Today, China is the second largest economy in the world in nominal GDP terms, having overtaken Japan in 2010, and in purchasing power parity (PPP) terms is reckoned to have overtaken the United States, to become the world’s largest economy in 2014.

At the same time, China’s economy has undergone substantial structural shifts, with the service sector having doubled as a percentage of GDP (to 48%) since the beginning of the reforms, exceeding manufacturing and construction as a percentage of GDP (43%) for the first time in 2013. Of great significance also is that domestic consumption in 2014 surpassed investment to become the strongest driving force of the Chinese economy. In 2014, total consumption accounted for 51% of GDP growth in that year, compared to 49% from investment, showing that a new growth model is now emerging. The growth of the service sector and of consumption occurs in tandem with and in support of the increasing preponderance of privately owned enterprises (POEs), which now account for 60% of Chinese GDP, as against the once dominant state owned enterprises (SOEs) in the Chinese economy.

In addition to the shifts in the composition of the Chinese economy, the interrelationship between the Chinese economy and the world economy has undergone a significant shift. In 2014, for the first time, China became a net exporter of capital, with outbound FDI overtaking inbound FDI in value terms.

China has become the world’s third largest investor after the United States and Japan. While SOEs account for the bulk of this outbound investment, supported in many cases by China’s USD 3.8 trillion in foreign exchange reserves, the world’s largest, the proportion of outbound FDI accounted for by POEs is growing.

At the same time, inbound FDI, which has long supported a significant part of the Chinese economy, is declining in relative significance. Foreign invested enterprises (FIEs) still account for approximately half of China’s foreign trade, but the contribution of FIEs to national industrial output has decreased from 36% in 2003 to less than a quarter in 2015. FDI as a contributor to China’s fixed capital formation peaked even sooner at 17% of fixed capital formation in China in 1993 and has declined since then to approximately 2% today.

These seismic shifts in the size and composition of the Chinese economy and in the interrelationship of the Chinese economy with the global economy, together with a step change in the sophistication of Chinese business organization, have been shaping and are continuing to shape fundamental changes to the manner in which the Chinese tax system operates.

When, up to the early 1990s, the private sector remained small as a proportion of the economy, taxation played a relatively minor role in financing the government. Education, housing assistance,

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health care and other basic social services, commonly supported by governments in other countries, were provided directly to workers through the SOEs (or primary-production communes) which employed most Chinese people. Government revenues came directly as profit distributions from the SOEs. It is only since the transition to a “socialist market economy” in the 1990s, a short 20-year period, that the Chinese government has come to depend primarily on tax revenues for its financing. Consequently, the government has had to construct a tax system which other countries have had over 100 years to build and refine, and against a backdrop of much more gradual economic growth and change.

As SOEs have been privatized or wound down, the pressure for tax revenue has grown, and recent years have seen a distinct ramping up of tax collection efforts. This is notable, for example, with the tighter rein exercised by the central government State Administration of Taxation (SAT) over the lower tier Chinese tax authorities at provincial, municipal and county levels, to stamp out these reaching negotiated tax settlements with taxpayers which compromise national tax revenues, as discussed in the section on local incentives, see section 2.2.

Further, as services and consumption are progressively supplanting manufacturing and investment as the key drivers of the economy, the tax system has been subjected to a major overhaul to better suit this, such as with the VAT reforms discussed in section 2.3.3.

China’s decreasing dependence on FDI for capital and for technology as the domestic capital stock has expanded and as domestic enterprise has become more sophisticated, has been paralleled by the elimination, since 2008, of earlier tax preferences for FIEs from the tax code. This has been matched by a step change in enforcement against offshore tax structures, a process being spurred further by China’s involvement in the G20/OECD Base Erosion and Profit Shifting (BEPS) global tax reform initiative.

Of course, with burgeoning outbound investment by Chinese enterprises, such measures are also increasingly directed against Chinese Multinational Enterprises (MNEs).

As can be seen, much of the structural tax law change and modification in enforcement practice observed in China can be related to the transformations in the Chinese economy. The continued speed of this economic evolution makes it hard for both taxpayers and tax authorities to keep up with the related revolutions in the tax law. This is a key inherent challenge to tax risk management in China as both the authorities and taxpayers struggle to keep on top of new laws and adapt their tax collection and compliance systems, respectively.

2. Description of Tax Control Framework A consequence of the high speed of economic, social and institutional evolution in China is that different parts of the economic and institutional infrastructure, including the tax system, have seen divergent levels of development. As a result, China is leading the world in the development of some areas of sophisticated tax law and rolling out sophisticated tax enforcement mechanisms, while at the same time certain fundamental and routine questions in Chinese tax law remain unclear and some aspects of the operating model of the tax authorities have become outdated.

Consequently, an overview of tax risk management in China must both consider the highly sophisticated systems and practices, as well as highlighting basic pitfalls. The inherent tax environment challenges for effective tax risk management in China derive from the following factors:

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the rapid transformation of the Chinese economy has led to seismic shifts in the structure and orientation of the Chinese taxation system, which stretch the abilities of both tax authorities and taxpayers to keep up (see section 1.1.);

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the unique nature of Chinese tax law making and interpretation (see section 2.1.);

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the tiered and dispersed geographic organization of the Chinese tax authorities (see section 2.2.); and

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the specific risk management challenges from key Chinese taxes (see section 2.3.).

This section 2. overview of the inherent challenges for effective tax risk management in China, coupled with the section 3. overview of the impact of legislation and regulation on the tax risk management environment, provide a basis for understanding the workings of the Tax Control Framework in practice, detailed in section 4.

2.1. The nature and operation of Chinese tax law Tax risk management is complicated in China by the inherent, and perhaps irreducible, uncertainty in the tax law and by difficulties in keeping abreast of changes.

The tax law making process in China While formally the National People’s Congress (NPC) is the supreme legislative body of China, in practice it rarely meets and tax law making power is wielded by subordinate bodies. Although laws passed by the NPC form the centrepiece of Chinese tax law, they are brief and very high level. For example, the Corporate Income Tax (CIT) Law, the basis of the Chinese corporate tax system, is a bare ten pages of text, against thousands of pages of primary legislation in other countries. In fact, as regards extant tax law, the NPC has only issued the CIT Law and the Individual Income Tax (IIT) Law, with the NPC Standing Committee having issued solely the Tax Collection and Administration Law. The State Council, the equivalent of a cabinet and the chief executive organ, is authorized to issue regulations to supplement the NPC’s laws, but equally is rather scant in issuing these. For example, the “Detailed” Implementation Rules for the CIT Law come to a brief 25 pages.

As such, the responsibility for clarifying the tax law ultimately falls primarily to the SAT, as a subordinate ministry-level agency under the State Council, which issues circulars, announcements and orders (numbering in the thousands), either solely by itself or in conjunction with other ministries and agencies such as the Ministry of Finance, Ministry of Commerce, the State Administration of Industry and Commerce, the General Administration of Customs (GAC).

As discussed further in section 2.2., provincial level People’s Congresses and lower level municipalities are empowered to make local tax regulations in line with NPC laws and State Council regulations. Lower level tax authorities, either under the SAT or reporting to local governments around China, also issue tax circulars, which should be in line with the SAT circulars and the primary law. These instruments also number in the thousands.

Chinese courts limit their involvement in tax law to decisions on matters of administrative procedure, only ever dealing with matters such as whether the tax official signed the assessment in the right place or whether the taxpayer filled out the right part of a form, but they do not decide on matters of substantive interpretation of tax law provisions. Even in relation to matters of administrative procedure, taxpayers are very unlikely to take matters to court, fearing to upset the tax officials and thus leaving the courts

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effectively absent from all tax matters. As such, even though SAT circulars are not laws per se, they are de facto laws insofar as they cannot effectively be challenged. As such, SAT circulars may be considered to go even beyond the public rulings decided by tax authorities in other countries. This is reflected in the fact that circulars are treated by tax advisors as de facto law when arguing tax positions with local tax authorities.

Circulars issued by local tax authorities do not have such lofty status, and these can be challenged and overturned by the SAT. Indeed, mechanisms are being put in place for taxpayers to initiate a review of such local circulars by the SAT. Taking in the whole picture, as the SAT (i) issues the circulars which local tax authorities must follow and vets and adjusts the circulars issued by local authorities; (ii) provides instructions to the lower tax authorities on tax assessment and collection procedures and on tax audit targeting activity; and (iii) requires, in many cases, for individual tax cases, including taxpayer appeals and disputes between individual tax authorities, to be referred by local authorities up to SAT level for final decision making, the SAT is, in the final analysis, (a) the legislator, (b) the administrator and (c) the arbitrator of the tax law of China.

The need for taxpayers to work with the SAT in managing tax risks Insofar as the meaning of the law is what the SAT decides it to mean, taxpayers and advisors do not add value by looking for a meaning of the tax law beyond the SAT’s interpretation. Beyond seeking to persuade the SAT of the merits of their individual tax case, there is no further legal remedy taxpayers can invoke against the SAT on individual tax cases.

Rather, as part of a tax risk management strategy, taxpayers and tax advisors can seek to steer the development of circulars by the SAT by participation in SAT consultations on new tax circulars, which are increasingly structured and open.

Once the SAT circulars have been issued, the SAT plays a crucial role in ensuring that local tax authorities generally apply these provisions consistently in line with the circular and that circulars issued by local tax authorities and local government tax incentives are in line with the SAT’s overarching policy.[1] As such, it is fundamentally important that the SAT makes its position clear in its circulars and taxpayers/ advisors should ensure that crucial clarifications are inserted in the circular at the consultation stage.

The SAT can also play a key role in individual cases. Where a taxpayer has operations in multiple locations in China, the interpretations of an SAT circular from different localities may be inconsistent so causing compliance difficulties. Taxpayer access to SAT officials to discuss appropriate interpretations of the law will be crucial in such cases, as the SAT can potentially impose an agreed view on the local authorities in their individual case.

It is notable that the SAT has, in recent years, enhanced its efforts to ensure all new local circulars are in line with underlying law, are non-retroactive, and such local circulars can be appealed up to the SAT for review and amendment if not consistent with underlying law.[2]

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The SAT has enhanced its efforts to ensure all new local circulars are in line with underlying law, are non-retroactive, and such circulars can be appealed up to the SAT for review and amendment if not consistent with underlying law; SAT ministerial regulation “Administrative Measures for Formulating Normative Documents in Taxation” (2010); and SAT Decree No. 21 “Measures for Tax Administrative Review” (2010) providing for SAT review of local authority assessment decisions, which has been included in, for example, the new GAAR Measures (2014).

SAT ministerial regulation “Administrative Measures for Formulating Normative Documents in Taxation” (2010).

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The SAT has also moved to put in place mechanisms through which taxpayers can apply for SAT review of local authority assessment decisions[3] in their individual cases, and this mechanism has been included in a number of recent circulars, such as in the new GAAR Measures (2014). Such mechanisms are set to be bolstered under the new Tax Administration and Collection Law, due to be issued later in 2015, which also provides that initiation of such review proceedings cannot be punished by levying a higher level of tax. In addition, the new law will remove the current requirement that tax payment or tax payment guarantee needs to be settled before the application for tax administrative reconsideration.

Knowing the tax law and the role of tax advisors It might be noted that there is currently no centralized register or other official source in China where all legislation enacted by central and provincial authorities is made available to the public. Legislation or regulations, particularly for local applications, can be enacted without any prior notice or subsequent publicity. Consequently, the legislative databases used by tax advisors can be incomplete, making close monitoring of tax law developments and ongoing engagement with knowledgeable officials in the local tax authorities relevant to a given taxpayer highly important.

Tax advisors will tend to draw on reported enforcement cases in drawing their conclusions on how tax laws and circulars are being applied by tax authorities in practice. However, given that, as noted above, the Chinese courts are themselves not involved in the substantive interpretation of Chinese tax law, the reports tend to come from the media or from information posted on tax authorities’ websites.

The details tend to be partial, with the precise rationale of the tax authority and the arguments of the taxpayer generally not clear from the reportage.

As such, even well-informed tax advisors can only provide so much guidance as to how tax law is likely to be enforced, in particular if the tax law in question leaves certain implementation matters to local discretion (e.g. infrastructure project tax depreciation incentive qualification criteria). This makes consultation with local tax authorities an essential part of tax advisory in China.

However, even at this, in the current absence of a formal tax rulings system (except in the case of advance pricing arrangements), any commitments given by tax officials are likely to be solely oral.

Furthermore, adherence by the tax authorities to this treatment may be highly dependent on the relevant official remaining responsible for the tax matter on which agreement has been reached.

This being said, a recent SAT circular[4] would see the details of more case decisions published on tax authority websites. This requirement is aligned with the moves by the SAT to ensure that, where local tax authorities wish to make tax adjustments in taxpayer assessment cases, they are required to gain approval from higher level tax authorities (i.e. county-level authorities from province-level authorities) rather than simply acting in their own discretion. Under Guoshuifa [2012] No. 14, those approvals by the higher level tax authorities would need to be published within 30 days of approval. This should provide more information on tax authority approaches and assist tax advisors in guiding their clients.

Furthermore, the upcoming new Tax Administration and Collection Law is to provide for a system of formal private rulings which should allow for greater tax certainty going forward.

As such, while tax law remains unclear, efforts are being made to publish more information on decided tax cases, provide for more mechanisms for higher-authority approval of tax adjustments, provide 3 4

SAT Decree No. 21 “Measures for Tax Administrative Review” (2010).

SAT Disciplinary inspection office, “Standardisation of tax case approvals – Limitation of lower authority discretion”, published on 22 February 2014

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mechanisms for local authority circulars which contradict national rules to be reviewed by the SAT, and for individual assessment cases to be appealed to the SAT, in addition to providing for a system of private tax rulings.

Aggressive but legal tax planning A key tax risk management implication of this paradigm for Chinese tax lawmaking, interpretation and enforcement is the different slant it puts on “aggressive but legal tax planning”. In many jurisdictions, a central aspect of tax risk management for enterprises is determining to what extent there is an appetite for applying aggressive technical interpretations of legislation, backed by legal opinions, which are considered to be winnable in courts if contested by the tax authorities. An enterprise board of directors may conclude that balancing its desire to maximize share value against the measurable risks of a loss in the courts and the potential reputational issues, it still wishes to go ahead with the tax planning.

Accounting standards will require it to recognize tax risks on an assumption of full knowledge of the tax arrangement by the tax authorities.

However, with the SAT being the final arbiter, implementing “aggressive but legal tax planning” would turn moreover on finding an SAT or local tax official who informally agrees with the tax treatment and who hopefully will still be in place in a few years and/or not change his mind or get challenged by superiors.

“Aggressive but legal tax planning” might alternatively be based on perceived lack of detection risk.

This might be regarded as being the case with Circular 698 indirect offshore disposal reporting in recent years; non-reporters often considered that they had a good legal basis for non-reporting, but were moreover relying on perceived lack of risk of detection. Detection of a tax arrangement, which is perceived as aggressive by the tax authorities and which was not cleared with them in advance, effectively means that taxation will follow. Once detected, the attitude of the authorities will be determinative – it is not a matter of how the arrangement stands on its tax technical merits before a court, as it would be in a country with court-interpreted tax law.

Clearly then, “aggressive but legal tax planning” means somewhat different things in a Chinese context than in the context of a country with court-interpreted tax law. With the planned introduction of a formal ruling system with the new Tax Administration and Collection Act, the ongoing efforts to limit local tax authority discretion (see section 2.2.) and the increased risk of detection with better tax authorities data pooling platforms, data analytics and access to cross-border information sharing, the conduct of “aggressive tax planning” vis-à-vis China may be set to change in future.

2.2. Organization of the Chinese tax authorities Tax risk management is complicated in China by the tiered and dispersed geographic organization of the Chinese tax authorities and by the manner in which the local tax authorities may apply tax laws inconsistent with tax policy set at SAT level and inconsistent with application by other local tax authorities.

Tiered system of tax authorities China is a unitary state but given its huge scale and the resulting necessity for power to be exercised in a more decentralized way, it operates in many respects like a federal state. In this regard it should be

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appreciated that China is broken down into 32 provincial-level governments,[5] these are then broken down into 333 prefecture-level divisions (which include many large municipalities), the latter are then broken down into 2,862 county-level divisions, and lastly these are then broken down into 47,000 township-level divisions. All levels of government possess an administrative apparatus which is a “mirror image” of the central government, with a People’s Congress to set local laws and, of course, their own tax administration. As there are 18 types of tax in China, a business operating over a wide area in China is potentially subject to tens of thousands of individual “taxing points”.

As a result of the above system of political organization there are thus two types of tax administrations in China: -

the State Tax Bureaus (STBs), which are established at every level of government described above (e.g. province, county, township), collecting the SAT administered “national taxes”; and

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the Local Tax Bureaus (LTBs), also established at every level of government described above (e.g. province, county, township), by contrast, are primarily accountable to the respective local level of government, rather than to the SAT. They are solely accountable to the local level of government for the assessment and collection of purely local (i.e. non-national) taxes, such as taxes relating to real estate and land use, for which the relevant rates and criteria are set by the local level of government. However, the LTBs may also assist STBs with national tax collection, thus creating a responsibility link between the LTBs and the SAT.

The revenue from the “national taxes” is shared[6] between the central government on the one side and the local governments on the other (i.e. the province, county, township governments).[7] The task of collecting the “national taxes” is also shared between the LTBs and the STBs. However, the ratio in which the taxes are collected by the LTB and STBs may not reflect the ratio in which the revenue from the “national taxes” is shared between the central government and the local governments.

The collection ratio may just reflect administrative convenience[8] and then, in principle, the STB or LTB should ensure that the collected tax revenues are remitted to the other level of government (i.e. the STB gives the local government its share of the revenues, and the LTB gives the central government its share of the revenues). While there is a certain logic to these arrangements, they give rise to a number of tax risk management headaches.

Local incentives To the degree that an LTB collects a given national tax, this provides an opportunity to the local government controlling the LTB, often in divergence from the SAT’s national tax policies, to offer tax incentives to enterprises investing in their locality. Local governments clearly had an incentive, where 5 6

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In China there are 23 provinces, 4 municipalities (Beijing, Shanghai, Tianjin and Chongqing) directly under the Central Government and 5 autonomous regions (ethnic minority areas). The two special administrative regions of Hong Kong and Macau possess the same status but have separate tax systems.

It should be noted that even though the local authorities take a direct share of the national taxes and take all of the land taxes, this only covers a portion of their expenditures. Currently, 43% of Chinese national tax revenues are raised directly by local authorities but they take on 79% of the national expenditure. Direct transfers from central government to local government as block grants make up the difference. The Chinese premier Li Keqiang, in his 2015 work programme overview released on 7 March 2015, noted that reform of the transfer payments system, with clearly defined powers and adjustments to the division of revenue between central and local government levels, is a key priority for 2015.

These “local governments” in turn have their own, highly idiosyncratic, arrangements for sharing the “local” share of the revenue from the “national taxes” along the hierarchy of the province, county, township governments.

Thus, in 2009 there was a realignment of the tax collection system whereby the STBs were put in charge of collecting tax from businesses which were subject to both value added tax (VAT) and corporate income tax (CIT), whilst the LTBs were in charge of businesses subject to either local business tax (BT) and CIT or only CIT.

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they collected all of the revenue from a given “national tax”, including the central government’s portion, to waive this tax or limit their efforts in collecting the tax in the first instance. In this manner they could incentivize local investment without excessively eroding local tax revenues, as they would be waiving tax revenue which would have otherwise gone to central government in any case.

While the central government has at various points cracked down[9] on such local government/LTB practices, such incentives continue to be offered. For example, IIT incentives have been offered in recent years to attract private equity and asset management businesses to Beijing, Tianjin, Shanghai and Chongqing. These typically limit themselves to paying “bonuses” (i.e. tax refunds) to locally employed senior executives up to the amount of “local fiscal capacity”. That is, they use the share of IIT allotted to the local government for granting the relief. As this does not waive the central government IIT allocation, some local governments have considered that the central government may be less likely to seek to challenge the incentive as it does not directly erode central government tax revenues. Of course, such local governments have more flexibility when it comes to rebating/relieving the land taxes, such as deed tax and real estate tax, which are “non-national” taxes.

From a tax risk management perspective such incentives are problematic as enterprises which have secured local tax incentives are at risk of having these revoked where the SAT reviews local tax authority conduct and concludes that incentives were granted which were not in line with national tax law.

This may be true of either a locally created tax incentive (such as the IIT incentives for private equity) or of a tax incentive in the national tax law (e.g. the infrastructural investment CIT depreciation allowances).

The national tax incentive may be at risk of review and claw-back where the local authorities have been granting the incentive in a liberal fashion, either for projects which the SAT had not intended to be incentivized or without the level of documentary support which the SAT considers sufficient.

As the question of whether a local tax incentive is or is not in line with national tax policy and the question of which activities/projects qualify for national tax incentives are frequently very unclear on the basis of published law and guidance, it can be very difficult for taxpayers to gain any certainty on the sustainability of incentives and many prudent taxpayers simply provide for potential tax liability in their accounts.

Efforts are, however, underway to limit local authority discretion in creating tax incentives and to “cleanse” existing reliefs, which are not consistent with national tax law. Guofa [2014] No. 62 “Notice of the State Council on putting in order tax incentive policies”, issued in 2014, requires the State Council sign off on new incentives and requires all provincial governments to ensure that all reliefs inconsistent with national law are abolished.[10] The upcoming new Tax Administration and Collection Law will also introduce measures to exclude introduction of reliefs by local authorities not authorized by central government authorities. It remains to be seen how effective this is at bringing greater certainty and limiting tax risks.

Allocation of taxing rights between local authorities A further complication for tax risk management, caused by the organizational structure of the Chinese tax authorities, arises from the fact that separate tax districts (be they provinces, counties or townships) 9 10

For example, in 2000 there was a campaign against provincial governments and LTBs for use of “refund after collection”. This policy used the loophole that while the local authorities could not waive the liability to a national tax they were authorized to make refunds out of collected national taxes as an “expenditure” item in the local budget.

It is noted, however, that this campaign has been temporarily suspended by SAT Circular 25 issued May 2015.

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are frequently at loggerheads with each other over their entitlement to tax businesses. This stands in surprising contrast with their battle with the central government, as outlined above, in relation to the local government’s entitlement to grant tax incentives.

A Chinese incorporated enterprise must register for all taxes (CIT, VAT, etc.) in all of the tax districts in which it operates in China. This is on the basis that it has a local “tax branch”, separate of its HQ (i.e. the tax district in which it is incorporated) in each of those districts. The allocation of revenue between each of the tax districts may be disputed by local tax authorities, which wish to raise more revenue, and become a source of tax risk in an analogous manner to transfer pricing disputes in an international context.

To the extent that certain taxes are earmarked solely for local governments, taxpayers may face tax risks where tax reforms go into effect which impact the tax balance between central and local government.

The roll-out of the nationwide transition from business tax (BT) on services (the revenue from which is purely local) to VAT (the revenue from which is shared between central and local government), insofar as it affects local government revenues, can lead to transitional issues which have an impact on taxpayers, and close communication with tax authorities is needed to resolve such issues. Indeed, tax law changes which lead to a reallocation of tax payment obligations between local LTBs and STBs can also land taxpayers in the middle of turf wars.

This fragmentation of domestic tax jurisdiction can also create problems for, inter alia, obtaining local tax authority approval for tax restructuring relief. Where an intra-group merger, for example, would result in the local legal entity in a given tax district ceasing to exist, the local tax authorities may oppose granting the relief on the basis that taxing the merger transaction gives them their last chance to tax the enterprise. They may in any case wish to dissuade the merger by signalling that they will withhold merger tax relief. The complications can become even greater where approval of both LTB and STB in the district are being sought.

This being said, efforts are underway at a national level to lessen the need for local tax authority preapprovals for various deductions and exemptions. Going forward, the intent is that, as in developed countries, such treatments will simply be adopted and can be audited and adjusted at a later time if claimed inappropriately. For example, per Shui Zong Fa [2014] No. 107, the local tax authority preapprovals for VAT exemption for designated “exported services”, the deduction of asset losses, and the R&D expenses bonus deduction are now all abolished, with taxpayers to claim in their tax filings as appropriate.

In addition, the upcoming new Tax Administration and Collection Law, at section 16, provides that where disputes between local tax authorities over taxing jurisdiction cannot be resolved, they are obliged to elevate these disputes to a common higher tax authority for resolution, a measure which should hopefully lessen the tax risks faced by taxpayers at present.

2.3. Specific risk management challenges from the key Chinese taxes The wholesale reorientation of the Chinese tax system to adapt to the transformed Chinese economy, as outlined above, means that many of the main Chinese taxes are only now ‘settling down’ in their newly modified forms. This novelty of much of the law, together with the above-mentioned fact that the law can be vague and subject to divergent application at a local level, leads to a great deal of complexity when dealing with tax risk management issues. Some of the central risk management challenges for the key Chinese taxes are set out, for each tax type, in the comments below. © Copyright 2015 Tracy Zhang,, Conrad Turley,. All rights reserved. © Copyright 2015 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information.

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Of the 18 types of tax in China, the most frequently[11] encountered by sizable enterprises, including foreign enterprises, are the income taxes (Corporate Income Tax and Individual Income Tax), the turnover taxes (VAT, Consumption Tax and Business Tax, as supplemented by the City Maintenance and Construction Tax which operates as a surcharge), a number of taxes related to property and land acquisition, holding and disposal (Deed Tax, Urban and Township Land Use Tax, Urban Real Estate Tax and Land Appreciation Tax), the Customs Duty and the Stamp Duty, which apply at a low rate to a variety agreement documentation used for property transactions and other business purposes.

Tax Type

Revenue (RMB BN)

%

Domestic VAT

2,240

24.70

Domestic CT

675

7.44

Import VAT &CT

1,067

11.76

BT

1,307

14.41

CIT

2,101

23.16

IIT

570

6.28

Real estate tax

135

1.49

Stock Exchange SD

40

0.44

UTLUT

146

1.61

LAT

299

3.30

Vehicle Purchase Tax

215

2.37

Customs Duty

214

2.36

Deed Tax

306

3.37

Total Tax Revenue

9070

100

The table above, which sets out revenue collected for the first 9 months of 2014, gives a sense of the relative importance of the taxes in China. Very notable is the relatively low percentage of taxes arising from personal income tax, which constitutes the principal source of tax revenue in many developed countries, the predominance of indirect taxes and the relative importance of CIT, which in most OECD countries makes up much less than 10% of total tax revenue. This comparison of the taxes gives a sense of their importance to the tax authorities and a measure of the rigour with which they will be enforced.

It might be observed that, perhaps with the exception of the international tax provisions of the CIT Law, Chinese tax law, on the face of it, is not overly complicated. Tax law in China, unlike in some other countries, is not riddled with “deeming provisions”, which are grist to the mill for aggressive tax planning.

A lot of the provisions which lead to complexity or facilitate tax planning in other countries, such as grouping reliefs and comprehensive entity classification rules, are not included in the Chinese tax law.

11

Quite a number of the taxes will not be of any real impact on businesses, or only on specialized businesses, including tax on certain agricultural products and activities (Farmland Occupation Tax, Tobacco Tax), a variety of transportation taxes (Vehicle and Vessel Usage Tax, Vehicle Acquisition Tax, Tonnage Tax), the Resource Tax for natural resource exploitation, and the House Property Tax.

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As noted above, as the courts have no role in the Chinese tax system, tax planning based on highly technical, “arguable interpretations” is not a feature of the Chinese tax landscape.

For the most part, consequently, tax advising in China is not rocket science. Rather, taxpayers and their advisors, in dealing with tax risk management issues, attempt to pick their way through the expanding thicket of SAT and locally-issued circulars, monitor enforcement cases and liaise very extensively with the SAT and local authorities with a view to arriving at common understandings on the taxpayer’s uncertain tax positions. This is the principal focus of tax risk management in China, which might be described as complex rather than being complicated, per se.

Complicated tax structuring does, however, enter the Chinese tax space to the extent that offshore tax structuring can be “bolted” onto Chinese investment structures. As the SAT has developed increasingly sophisticated anti-avoidance rules to deal with these, and these rules all fall within the CIT Law, most of the discussion below on complicated tax risk management challenges arising from specific Chinese taxes focuses on the CIT Law. This, however, should not distract us from the fact that, as said, the main tax risk management challenges in China are in relation to the complexity of dealing with the inherent uncertainty of the tax law and the multiple tax authorities, which can be as true of other tax heads as it is of CIT. 2.3.1. Corporate Income Tax (CIT) As seen above, CIT accounts for a quarter of overall Chinese tax revenues and thus is a key focus of tax collection efforts. Since the introduction of the new CIT Law in 2008, China has a single system of corporate income taxation for foreign and domestic enterprises with a common rate of 25%.

Previously, a separate CIT system for FIEs existed which provided for a lower tax rate, multi-year tax holidays, as well as an exemption from dividend withholding tax on repatriations out of China. Treaty benefits could be claimed without excessive scrutiny and treaty shopping could be readily used to the extent needed to protect interest, royalties and capital gains on direct disposals of Chinese equity from tax. In any case, given the fact that transactions in Chinese assets were customarily carried out in an “offshore market” (i.e. the purchase and sale of Cayman/BVI companies holding Chinese enterprises by foreigners and by Chinese founders who used round-tripping arrangements), Chinese tax was not a consideration on exits. Transfer pricing strategies could also readily be used to shift profit out of China.

In light of the above, foreign MNEs did not feel the need to commit substantial resource to their Chinese tax risk management activity.

While domestically owned enterprises might be taxed at a higher rate, in practice many POEs negotiated their income tax liability with local tax authorities or maintained a double set of accounting records, with tax records showing minimal taxable profit. As noted above, the tax system was a relatively new construct in the 1990s, with the state expenditures and income still largely going through SOEs, and effective central control over local tax authorities was only slowly being built up. The tax authorities did not, in practice, share much information with other government agencies and lacked the use of third-party reporting (e.g. from banks or from third-party service providers), and indeed the use of sophisticated information systems to crunch such data, and consequently much tax revenue slipped through the cracks.

It can safely be said that domestic enterprises did not have sophisticated tax risk management systems in place; taxes would be dealt with as an administrative matter through enterprise accounting departments. In the absence of a tax environment where sophisticated tax structuring could be allied

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to the business model, tax was not a matter in which enterprise boards took great interest. What is more, the large SOEs, which formerly dominated the economy, had little incentive to manage their tax bills. Apart from being state-owned, they might receive awards for being the largest taxpayers in their localities, and, as such, their management teams could take pride in their payment of tax, to the extent they actually made money (although most did not).

The CIT reform process begun in 2008 has seen a two-fold development whereby, for foreign investors and FIEs, the preferential treatments have been abolished and sophisticated international antiavoidance provisions directed at offshore planning structures have been rolled out. These international anti-avoidance provisions have also come to concern those domestic enterprises which are increasingly involved in cross-border activity. Even for domestic enterprises whose activity is solely in the local market, CIT issues have jumped up the list as the tax authority’s pre-approvals for reliefs and deductions are abolished, necessitating greater internal controls and procedures for monitoring that tax treatments have been appropriately adopted, as the room for negotiating tax bills with local tax authorities has been limited by stricter SAT oversight and as tax authority non-compliance detection capabilities have improved (see section 5.).

Among the key CIT provision changes which have preoccupied foreign MNEs from a tax risk management perspective are: (i)

Offshore indirect disposals: from 2009 (but retroactively effective from 1 January 2008), rules were put in place under SAT Circular 698 [2009] which required foreign enterprises transferring offshore companies which held equity interests in Chinese enterprises to report these transfers to the Chinese tax authorities. The authorities could then choose to use the GAAR to recharacterize the transfers as direct transfers of the Chinese equity and impose CIT on the gain at 10%.

Following a number of high-profile enforcement cases, in particular vis-à-vis US private equity firms, the rule quickly became one of the key tax risk management concerns for foreign investors into China. Transferors were unsure whether they should report (given ambiguity in the reporting rule and in its legal basis, and widespread non-reporting by some companies), and transferees were concerned lest the base cost of their acquired shares would be adjusted downwards by the Chinese tax authorities to recover the tax unpaid by the vendors. The absence of a restructuring relief made MNEs particularly concerned to have monitoring systems in place to identify transfers occurring as an incidental part of wider global group restructuring, and transaction buyers frequently negotiated for transferors to be obliged to report “flush out” tax authority tax claims or otherwise take a price adjustment hit.

The introduction of new rules in SAT Announcement 7 [2015] will further heighten tax risk management concerns with, and focus on, indirect offshore disposal as one of the leading China tax issues for foreign investors. This expands the scope of offshore transactions caught (indirect transfers of Chinese taxable assets through offshore share dilution arrangements or offshore transactions in convertible bonds or partnership interests) and the types of “Chinese taxable property” caught (assets of Chinese permanent establishment and Chinese immovable property holdings).

It also spreads the tax risk management headaches more clearly to enterprises beyond the seller with the introduction of a withholding tax (WHT) mechanism and heavy penalties. As the WHT and tax payment obligations are to be determined by applying a GAAR analysis to the

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transactions (looking to see whether it has reasonable business purposes) and as there is a lack of clarity in allocating sales consideration/acquisition costs and acceptable-over-valuation techniques, dealing with Announcement 7 is sure to preoccupy tax risk management personnel for much of their time.

Consideration will need to be given, for each individual transaction, to qualification for safe harbours, the substance and functions of offshore entities, the costs and benefits of voluntary reporting, the availability of foreign tax credits for Announcement 7 tax in home countries and the need for escrow arrangements or withholding when negotiating contractual terms for transfers.

On an ongoing basis, detailed documentation will need to be retained to support reasonable commercial purpose or economic substance of transfers and much greater use of professional tax advisors will be needed for communication with authorities on reporting, investigations or appeals.

Historic transactions, reported under the Circular 698 rules but not yet settled, may be a particular tax risk management issue as the tax authorities plan to apply the Announcement 7 WHT obligation retroactively to buyers (payers) on transactions concluded before 3 February 2015, with a focus on transactions already reported to the tax authorities. (ii)

Tax treaty shopping: also from 2009, the SAT radically tightened up the procedures for the grant of tax treaty relief. The old FIE exemption from dividend WHT had been abolished from 2008 with the new CIT Law so this was relevant for all foreign investors in relation to their dividends, interest and royalties from China. SAT Circular 601 [2009][12] and Circular 124 [2009], respectively, set out an interpretation of beneficial ownership which emphasized a need for commercial substance (staff, premises, business activities) at the level of the offshore company claiming treaty benefits and a treaty relief pre-clearance procedure requiring extensive documentation to be supplied to the relevant local tax authority. While the approach was an unorthodox application of the beneficial ownership concept (and more like an anti-conduit rule), it was effective in stemming treaty shopping and meant that, from a tax risk management perspective, efforts would need to be made to consolidate holding structures to leverage MNE group substance and develop and retain extensive documentation on hand.

The challenging of treaty relief for capital gains raised similar tax risk management concerns and requirements for action. The issuance of the new GAAR measures in SAT Order 32 [2014] is likely to lead to a clearer path to arguing for treaty relief for capital gains and will steer the manner in which tax risk management personnel will need to oversee the structuring of transactions and develop documentation. Notably also, as Order 32 provides that the tax authorities may demand documentation directly from tax advisors to transactions, this may well impact on how taxpayers interact with their advisors, going forward.

It should be noted that the existing tax authority pre-clearance system for DTA relief is set to be replaced in the near future with a ‘self-certification’ system under which it will be at the discretion of the WHT agent whether to apply DTA relief or not, with extensive reporting by the non-resident DTA relief claimant (via the WHT agent) to the tax authorities to facilitate GAAR follow-up procedures. This will introduce new risk management challenges for WHT agents.

12

Circular 601 has been supplemented by SAT Announcement 30 [2012] and Announcement 24 [2014], clarifying when offshore nominees can be looked through for granting relief to the ultimate offshore owner, and SAT Opinion 165 [2013] calling for local tax authorities to make a rounded “all factor” determination of beneficial ownership, not solely guided by commercial substance factors.

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14

(iii)

Transfer pricing (TP): the Chinese tax authorities had already begun to tighten their transfer pricing enforcement in the run-up to the issuance of the new CIT Law in 2008, however, Chinese TP enforcement has truly taken off and obtained a global reputation for aggressiveness, in the period since the CIT Law came into effect. This is supported by an ever-increasing number of specialized TP tax auditors heavily recruited into the Tax Administration Department for Large Enterprises which handles the majority of the transfer pricing audits. TP is now the leading tax risk management issue for major MNEs operating in China, and the risks can best be understood as follows: -

TP philosophy: the SAT has evolved, over the past decade, its own particular philosophy on TP, and it has explained this in its contributions to the UN Practical Manual on Transfer Pricing For Developing Countries[13] and in high-profile speeches by leading SAT officials.

It is a reaction against the historic use by MNEs of TP methods, such as the transactional net margin method (TNMM) and the cost-plus method, to support a limited allocation of the profits in their global value chains to China on the basis that the Chinese operations conducted simple, routine functions. It also reacts against the perceived diversion of profits from China through the structuring of MNE group affairs so that overseas entities within the MNE group contractually bear the key MNE business risks, being funded by allocation of MNE group capital to bear such risks, and by making such overseas group entities the legal owners and financiers of group “intangibles”, including IP. The Chinese TP approach emphasizes the importance of “location specific advantages” (LSAs), such as the “market premium” which MNEs selling into the burgeoning Chinese market can achieve and “location savings” arising from the clusters and concentrations of contract manufacturers, and other key supply chain services, for a range of different industries, in centres such as Shenzhen and Dongguan.

LSAs are used to support TP comparability adjustments, while it is also argued that local marketing efforts and the experience of manufacturing give rise to marketing and production intangibles, respectively. In making TP determinations, the Chinese tax authorities emphasize such “local market assets” and local functions (by which the SAT means the execution, rather than the making, of decisions) and de-emphasize or ignore offshore capital concentrations, contractual allocation of risk and offshore IP ownership rights. This approach to TP profit allocation is seen to better achieve attribution of the value created, within MNE global value chains, to China. As a consequence of the above, the SAT sees a greater role for profit splits.

The SAT is now drawing support for the direction of its TP policy from the work of the BEPS initiative, into which the SAT has significant input and which reflects SAT positions and thinking.

-

13

Enforcement: the development of this TP approach by the Chinese tax authorities has led to particular tax risk management issues as MNEs have to decide whether they can adequately support their existing tax structures or whether these structures will need to be adapted to the new TP environment.

UN Practical Manual on Transfer Pricing For Developing Countries, chapter 10.3 “China Country Practices”, issued by the United Nations Committee of Experts on International Cooperation in Tax Matters in June 2013.

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As noted, particularly in the TP audit spotlight are Chinese entities conducting activities that are viewed by the tax authorities as creating non-routine value (e.g. certain R&D, brand building or market penetrating activities), but which are allocated routine returns due to risks being removed by contract terms (e.g. contract R&D, limited risk distribution), as these may well be adjusted going forward.

Coupled with this is an SAT initiative, launched with SAT Circular 146 in August 2014, to have all local tax authorities in China conduct a nationwide survey of all companies in each local tax district which have charged service fees or royalty payments to related parties between the years 2004 and 2013. This was followed by Announcement 16 [2015] issued on 18 March 2015, providing that payments of royalties to foreign related parties which (i) solely held the legal rights to intellectual property and (ii) made no contribution to the development of the intellectual property (say, through research) would be denied tax deductions. A similarly strong rule was set out for service payments to foreign related parties without substantive business operations where the services are regarded as being not needed by the China subsidiary or of no real value to their business. This reflects the SAT’s sceptical view on the value of cross-border service provision set out in earlier submissions to the UN and speeches by senior SAT officials.[14] As local tax authorities are called on, in Announcement 16, to cast back their application of these new approaches to the past 10 tax years, this initiative promises to be a major tax risk management headache for MNEs operating in China.

From a tax risk management perspective, it is important to note that tax audit is just a secondary element of the Chinese TP enforcement efforts. These efforts are described as “three-dimensional”, including: (i)

investigation (TP audit);

(ii)

service (advance pricing agreements (APAs) and mutual agreement procedure (MAP)); and

(iii)

administration (meaning so-called “taxpayer self-adjustments”).

“Self-adjustments”, a voluntarily upward adjustment to the amount of income tax paid, are the tax authorities’ preferred[15] approach, though they have been criticized as something of a “shakedown” by local tax authorities.

With SAT Circular 54 [2014],[16] the SAT has tried to get better oversight of and bring greater formality to such local authority practices. Such adjustments can still be problematic, as given their voluntary nature other countries may not be willing to adjust their TP position and double taxation can consequently arise. Furthermore, making of self-adjustments by enterprises does not limit the ability of tax authorities to conduct a transfer pricing investigation and to make any subsequent adjustments.

14 15 16

SAT's April 2014 letter to the UN working group on TP issues China’s Views on Service Fees and Management Fees; BNA Transfer Pricing Report, June 2014, “Liao Tizhong, Director General of the SAT’s International Taxation Department, introduces China’s six tests on services”.

Chinese authorities’ anti-tax avoidance efforts have increased 2013 tax revenue by RMB 12.3 billion over the previous year, of which about RMB 9.4 billion (USD 1.5 billion) generated by administration and RMB 2.9 billion by service efforts, with a minor increase in tax revenue through investigation.

“Announcement on Monitoring and Administration of Special Tax Adjustment [2014] No. 54”.

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16

As a rule, however, greater SAT involvement and oversight of local tax authority practice is welcome, given the consistency which the SAT can bring to assessments, and in this regard the Circular 13 [2012] and Circular 16 [2015][17] requirements for reporting by local authorities of proposed TP adjustments to the SAT, and SAT review of such proposed adjustments, are welcome.

-

Documentation and risk mitigation: much TP risk management effort must be devoted to meeting the Chinese TP documentation requirements which consist of the three following elements of (i) contemporaneous TP documentation, (ii) the related party transactions (RPT) annual reporting forms and (iii) the thin capitalization report.

Contemporaneous documentation requirements currently capture large[18] foreign firms with substantial activities through WFOEs/JVs in China, but the thresholds are set to be reduced in 2015 to capture even more firms. The documentation itself is set to be substantially expanded with the planned revisions for 2015 to SAT Circular 2 [2009], the existing SAT TP guidance, which will likely see the incorporation of the OECD BEPS country-by-country reporting (CbCr).

The RPT reporting forms part of the annual CIT return and covers transactions relating to trading, service provision, intangibles, fixed assets and financial relationships, as well as relating to outbound investments and payments.

With the potential for tax disputes arising from the SAT’s unique TP approach, and with the SAT’s reluctance to participate in the BEPS development of multilateral dispute resolution mechanisms given the implicit sovereignty restraints, APAs have become of greater significance in China TP practice. While APA numbers concluded had increased substantially in recent years, the APA programme (which is concluded solely at SAT level), has currently been put on ice, as the SAT has committed its limited TP resources to participation in BEPS negotiations and to the new targeted audit initiatives.

(iv)

Further CIT Law developments highly significant for tax risk management: Outside of indirect offshore disposals, treaty relief and TP, a number of other aspects of the CIT Law are of key importance to large, domestically owned and internationally active domestic businesses, as well as foreign-owned businesses, from a tax risk management perspective: ‒

Tax incentives: with the abolition of the FIE-specific tax holidays and incentives, most of the remaining national tax incentives focus on pushing forward high-technology and environmentally friendly projects (e.g. energy and water saving conservation projects and key public infrastructure), though there are also incentives to invest in underdeveloped Western China.

CIT holidays and reduced rates, accelerated tax depreciation, lower VAT rates and reduction of the local land taxes may be available. The SAT can insist that granting of these incentives is limited to those projects on national development plans while local tax authorities, as noted above, may be more liberal with the projects they treat as qualifying and with the supporting evidence they demand to see. Ensuring that such incentives were

17 18

Circular Guoshuifa [2012] No. 16 “Internal Working Guidelines for Special Tax Adjustments (Trial)”.

Apply where trading transactions exceed RMB 200 million or passive income transactions exceed RMB 40 million (excluding APA cases or minority foreign owned local companies).

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17

properly secured and are not sensitive to revocation on an SAT review can be a key tax risk management task.

Equally, the interaction of tax positions across tax heads is important if incentives are being claimed and demands a holistic view of Chinese tax positions for effective tax risk management. For example, a super deduction (e.g. 150%) of R&D expenses can be provided alongside a 15% CIT rate for high and new technology enterprises. However, certain FIEs have fallen foul of TP audits where the taxpayers claimed, for TP purposes, to be carrying on routine, low margin activity and at the same time were claiming the technology incentives, which undermined the TP position.

–

Permanent establishment (PE): from the issuance in July 2009 of SAT Circular 103 (2009), in which the SAT instructed local tax authorities to scrutinize the secondment arrangements of non-resident enterprises in the motor vehicle and pharmaceuticals sectors to identify disguised service arrangements and impose PE tax accordingly, management of secondments has been a key tax issue in China. The subsequent SAT Announcement 19 (2013) provides clearer guidance for MNEs on the management protocols, contractual arrangements and documentation needed to support a “no PE” assertion but it remains a key tax risk management focus.

The SAT has, at various points in time, indicated an intention to begin enforcing Agency PE more vigorously. With the BEPS discussion draft on PE proposing a significant expansion of the Agency PE concept, this could be quickly leveraged by local tax authorities to push PE claims against the staff of representative offices (ROs) and WFOEs in China who are involved in any way in marketing and sales for foreign enterprises. This is an important area for enterprises to watch from a tax risk management perspective as it could invalidate existing tax-efficient sales models into China.

‒

Withholding taxes: the Chinese tax authorities are quick to regard cross-border provision of services as involving transfers of “know-how” or other technology and to demand royalty withholding tax, requiring careful structuring of arrangements to avoid tax exposure. As tax pre-clearance was previously needed for banks to process remittances out of China, the tax authorities had taxpayers over a barrel in respect of their demands for tax payment.

While Announcement [2013] No. 40 replaced tax pre-approvals with a tax recordal system, whereby the tax authorities stamp a document noting receipt of notification of the payment, so as not to hold up payments, some tax authorities operate the recordal system like a pre-approval system, withholding the stamp without pre-settlement of tax.

Coupled with the complexity around obtaining tax treaty relief, dealing with WHT remains a complex area in Chinese tax risk management.

‒

Outbound investment: historically, as a capital importing country, for its cross-border taxation provisions, China focussed mainly on inbound investment. Becoming in 2014 a net capital exporter, efforts are gearing up towards taxing Chinese MNEs expanding overseas. The SAT’s Jiangsu branch office issued in April 2014 an “International Tax Plan” which noted a focus on establishment of offshore investment and financing structures, and outbound transfers of IP, by Chinese MNEs to tax havens and noted an intention to combat this with TP and CFC rules. The issuance of SAT Announcement 38 in July 2014 set up a new system for the detailed reporting on the interests of Chinese enterprises in

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18

CFCs, and test cases for enforcement of CFC rules are now known to have been opened, notable a widely reported case dealing with an enterprise operating in Shandong province.

The SAT also announced an intention to issue anti-hybrid mismatch rules in 2015.

Consequently, the tax risk management capacity of Chinese MNEs, thus far relatively undeveloped, will need to see a significant upgrade going forward to deal with such enhanced enforcement.

2.3.2. Individual Income Tax As in other countries, enterprises in China are responsible for withholding IIT, as well as employee social security contributions, from employee salaries, in addition to obligations to pay employer’s social security contributions. Related reporting obligations must also be fulfilled.

Local tax authorities across China have been focussing much more closely in particular at expatriate IIT compliance, and it is a key matter which tax authorities want reviewed by enterprises in the self audits which are so beloved by the tax authorities (see section 4.).

In 2014, the tax authorities have also been monitoring more closely whether employee equity incentive income (e.g. Stock Option, Restricted Stock Units, Stock appreciation rights) has been correctly reported for Chinese IIT and this is becoming an increasingly important tax risk management issue.

Another key tax risk management area is whether the employer’s contributions to overseas social security/commercial insurances for expatriate employees have been included into the taxable income to calculate IIT. Furthermore, the authorities are focusing more keenly on whether the IIT exemption claimed on certain benefits paid to expatriate employees have properly qualified for exemption.

2.3.3. Turnover taxes: VAT, BT and Consumption Tax As seen above, China derives the bulk of its tax revenue from indirect turnover taxes and so these are a central focus of Chinese tax enforcement.

China operates both a system of VAT, which until recently applied solely to sales of goods and repairs of movable goods, and a system of BT, which, until recently, applied comprehensively to provisions of services as well as to the transfer of intangible assets and the sale of real property in China.

In 2012, the Chinese government embarked upon an ambitious reform program which was designed to replace BT with VAT throughout the services sector of the Chinese economy, in order to overcome the problem of tax cascading arising whenever business-to-business (B2B) transactions took place under the BT system. The reforms were intended to overcome mismatches occurring whenever BT taxpayers purchased goods for which they were unable to claim input VAT credits, and similarly overcome the problem of VAT taxpayers being unable to claim credits for the BT incurred on the services they purchased.

The VAT reforms were rolled out on a staggered basis, with transportation and some “modern services” (i.e. consulting, research and leasing of movable assets) moving from BT to VAT in Shanghai in 2012, and this treatment progressively being spread to the whole country. Other industries were progressively transitioned to VAT; television, radio and film broadcasting services (in 2013), and postal and telecommunications services (in 2014). The main sectors yet to transition to VAT are financially the most significant for the government, the most challenging from a technical perspective and the most economically interdependent. Those sectors are the real estate and construction industry; the financial

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19

services and insurance industry; and “lifestyle services”, which comprise food and beverage, hospitality, entertainment and a general catch-all of all “other services”.

From a tax risk management perspective, the turnover tax challenges faced by businesses operating in China extend beyond those faced in other countries. Clearly, handling the transition from BT to VAT properly presents particular challenges which need to be monitored and actioned. This sits alongside the complications which still arise from earlier transitions in the VAT regime, as it moved from a production-based to a consumption-based regime (for example, the move to allow input VAT credit for the purchase of fixed assets from 2009 onwards).

Beyond this, the need to VAT-register branches in every tax district in China in which an enterprise has branch operations and to account for VAT on intra-company transactions between those branches, which is a function of China’s atomized tax administration apparatus, can create headaches. Equally, transactions between individual subsidiaries in a corporate group can give rise to VAT complexity in the absence of fully developed VAT grouping rules.

VAT exemptions for export of services only recently being introduced and variably applied, there can be challenges with cross-border transactions. Full refunds of input VAT on the export of goods may also not be available, and a clear awareness of where refunds will be available needs to be factored into tax risk management.[19] It might be noted that as the GAC administers VAT to imports and controls the process of VAT refunds for exports, rather than the SAT, this dealing with additional authorities creates further complexity.

As a more general point it must be noted that China does not allow for refunds of excess input VAT credits so cash flow issues arise where there is a timing mismatch in the occurrence of output and input VAT events. This encourages the transfer of shares instead of assets because the new owner will generally prefer to inherit the input VAT credits (consequently making due diligence on input VAT balances on a share acquisition a key tax risk management matter). It might be noted that there are some indications that, in parallel with Announcement 7 on CIT on indirect offshore equity transfers highlighted above, China may in future look to apply also VAT to the underlying transfer of Chinese assets caused by such transactions.

China’s VAT system is also very documentation-heavy. Since 2012 a “Golden VAT System” is in place.

Under this system, for every invoice issued to a customer, which itself will claim a VAT input credit (a so-called “special VAT invoice”), information is electronically transmitted to the tax authorities who then provide a unique Golden System code for the invoice. The special VAT invoices issued under this system are a crucial focus of tax risk management efforts as absence of valid special VAT invoices can lead to inability to claim VAT input credits, as it can lead to an inability to claim CIT deductions and tax depreciation. It is in particular a crucial tax risk management matter in Chinese M&A transactions, particularly given the large problem with counterfeit special VAT invoices in China.

As a final China VAT observation, it may be noted that China has multiple VAT rates for different goods and services and this creates risks where an entity is supplying services/goods with more than one VAT rate, given the need to account for VAT correctly and split the price components as appropriate.

Consumption tax, at rates of up to 40%, is applied on the production/import of certain motor vehicle and consumption products but its upcoming reform and expansion to deal with high energy consumption 19

The export VAT rate has fluctuated depending on the government's desire to stimulate exports on the one hand and to increase tax revenue on the other hand. There remains an effective VAT of at least 3% on exports of almost all goods.

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20

and high pollution, a priority item in the governments 2015 work programme, will likely make such taxes a greater issue for businesses in future.

2.3.4. Taxes related to property and land acquisition, holding and disposal The taxes specifically related to property and land acquisition (Deed Tax), holding (Urban and Township Land Use Tax, Urban Real Estate Tax) and disposal (Land Appreciation Tax) fall largely within the realm of local tax authorities and show great variance within China which is a challenge to tax risk management. The incidence of these taxes is accompanied, of course, by CIT and VAT/BT, and by stamp duty[20] applying to acquisition, sale and any financing agreements.

Deed tax: levied at a rate determined by the provincial governments, between 3% and 5% of the total value of the transfer of land use rights or buildings and payable by the transferee, subject to exemptions available for business reorganizations. A major tax risk with Deed Tax in practice is that inbuilt immovable equipment may fail to be taken into account in calculating the tax basis.

Urban and township land-use tax (UTLUT): levied on the ownership of land-use rights located in urban, industrial and mining areas and calculated based on a progressive range (i.e. RMB 6 to RMB 30 /m2) depending on the location of the land, with local authorities having discretion to set the rate. Local tax authorities frequently provide reductions/exemptions from the tax in their efforts to attract investment, but informality in the manner in which these exemptions are granted makes it important for tax risk management to ensure that the legal authority for the authorities to do so, under SAT guidance, is sound, lest the incentive be clawed back.

Real estate tax (RET): levied on the ownership of real property located in urban and industrial areas at (i) 1.2% annually on the net value of owner used buildings and (ii) 12% of the annual rental income if leased. Largely the same tax risk management considerations apply as for UTLUT, further RET-specific issues being uncertainties in the current regulations on how to calculate the “net value” and difficulties in distinguishing private use from rented areas.

Land appreciation tax (LAT): also termed land value added tax (Land VAT), this tax is levied on gains from the transfer of land and buildings at progressive rates that range from 30% (on the portion of appreciation not exceeding 50% of the sum of deductible items) up to 60% (on the portion of appreciation that exceeds 200% of the sum of deductible items). The purchase price and development expenses, and certain related costs (valuation costs, interest during construction and taxes) may be deducted in calculating the taxable gain.

LAT can result in significant tax leakage and is important to observe in tax risk management. The principal risks with LAT in practice are that (i) the taxpayer may not be able to obtain valid invoices, in particular from small vendors, for tax deduction purpose and consequently may lose tax deductions; and (ii) regulatory ambiguity in relation to applying LAT to certain transactions, e.g. sale of car park lots.

2.3.5. Customs duties Customs duties and import taxes, levied on the value or quantity of goods imported or exported, have rates ranging from 0% to 50% of the value of the goods. Key tax risks in practice include:

20

Stamp duty is very low in China compared to some other jurisdictions, with rates varying from 0.005% to 0.1% of the value of the underlying asset or at a fixed amount (normally RMB 5 apiece), and so it is not a major concern for tax risk management.

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-

Related party transactions: customs assesses import duties on the transaction value which is defined as the price actually paid or payable for the imported goods. In most cases this would refer to the value indicated on the commercial invoice. However, if the importer and exporter are related, the importer may be required to demonstrate to Customs that its price for that particular import transaction is arm’s length. Customs may run a series of tests known as “circumstances of sale” tests to determine this. If the importer is not able to successfully prove that its relationship with the exporter did not influence the price, then Customs may reject the transaction value and impose a higher value as the basis for Customs imposition.

-

Post-importation payments: since transaction value is defined as the price actually paid or payable, payments that are due to the exporter or an overseas entity after the importation (e.g. royalties and license fees related to the imported goods/equipment) may likewise be subject to Customs duties. Since these payments are often based on a percentage of sales, they are not reported to Customs upfront. However, if they remain unreported and are uncovered during a Customs audit, corresponding penalties may be applied on top of the tax or duty deficiency.

To the extent that not all types of royalties are subject to Customs duties, it is important for enterprises to confirm in advance whether the royalties they pay will be dutiable.

-

Proper tariff classification of products: the exact duty rate applicable to an imported product is determined by the appropriate tariff code under the Harmonised System (HS). The declared HS code would also indicate whether any other special taxes (e.g. consumption tax) or certain licensing requirements (e.g. quarantine) apply to that product. At times, this could be a straightforward exercise especially if the product is expressly described or named among the 5,000 HS codes that comprise the China tariff book. However, in other cases it is not that easy to find the correct code and an enterprise may end up struggling with multiple contending classifications for its product with different rates of duty. This is often the case for complex and sophisticated products such as chemicals and specialized equipment. Improperly classifying the product could result in an underpayment of customs duties or an unauthorized import of a licensable product for which penalties would be exacted. It may also trigger an investigation as to whether the misclassification was purposely done to evade customs duties or circumventing a licensing requirement, which could lead to harsher penalties. It is therefore advisable to first seek guidance on the product’s classifications and the correct rate of duty before importing them into China.

3. Impact of Legislation and Regulation on Tax Risk Management Environment The inherent challenges for effective tax risk management in China arising from the nature of Chinese tax law, the organization of the Chinese tax authorities and the specific risk management challenges presented by the key Chinese taxes, outlined in section 2., overlap with the legislation and regulation on corporate governance and executive responsibility for tax, to create the overall Chinese tax risk management environment. Understanding this legislation and these regulations is important for understanding the workings of the ‘Tax Control Framework in Practice’, detailed in section 4.

It must be said that China’s legislative and regulatory framework directed at influencing the tax risk management environment is only slowly being pieced together. While in some countries different industry bodies have developed pan-industry codes of conduct in relation to tax, in cooperation with

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the tax authorities, this has not yet been in evidence in China. Furthermore, the emergence of tax responsibility as a Corporate Social Responsibility (CSR) issue has not, as in other countries, yet had any perceivable echo in China. However, a framework of laws to shape the tax risk management environment is emerging.

Corporate, civil and criminal law Unlike in other countries, China has not yet introduced, through company law, requirements for CFOs/ financial managers to sign financial statements to confirm the validity of the financial and tax information of the company. However, in practice every tax return provides a specific space requiring the signature of the competent person in the company.

Although China’s tax laws and administrative regulations generally do not target an enterprise’s directors or officers, there are instances where this may happen. For example, the legal representative of the enterprise (normally the chairman of the board or the general manager) or the person in charge (e.g. the finance manager) may be held legally responsible for the behaviour of the enterprise in cases such as false declarations, refusal to pay tax, illegal sales of VAT invoices or forgery of fake VAT invoices to claim input tax deduction and other illegal acts.[21]

Stock exchange and listed company rules In response to a number of accounting scandals with Chinese listed companies, the Shanghai Stock Exchange and the Shenzhen Stock Exchange in 2008 amended their respective listing rules and imposed more stringent disclosure requirements,[22] demanding directors to provide written opinions on whether they agree with the content of prospectus reports released at the time of listing (which would cover the company’s tax position). The accountant of the enterprise must provide his audit opinions on the reports as well.

On an ongoing basis, Chinese enterprises listed locally and abroad are also impacted by internal control requirements and disclosure obligations which may impose discipline on the conduct of tax risk management.

A significant number of Chinese enterprises are listed in the United States, which in many cases is the result of “reverse mergers” where a US incorporated company, listed in the United States, is put on top of a Chinese group. This may result in the Chinese enterprises being subject to full US regulatory filing requirements, including the Sarbanes Oxley (SOX)/FIN 48 rules for internal control self-assessment.

These include an obligation to file quarterly Form 10Q reports, which include an assessment of internal controls (including tax controls) and a requirement to get auditor review of these filings. While most US listed Chinese companies, being classified as foreign private issuers (due to their having a Cayman/ BVI company as listing entity), are only required to make annual filings, the same internal control assessment and disclosure, and auditing requirements apply.

As many other countries have done, China has adopted, since mid-2008,[23] US-style SOX rules (“China SOX”) for internal control self-assessment by Chinese companies listed both in China and overseas.

21 22 23

Arts. 201, 202 and 207 PRC Criminal Law. The Stock Listing Rules of Shanghai Stock Exchange were approved by the CSRC, effective 1 October 2008. The Stock Listing Rules of Shenzhen Stock Exchange were approved by the CSRC, effective 1 October 2008.

Notice of the Basic Standard for Enterprise Internal Control (Caishui [2008] No. 7) issued on 1 July 2009; Circular (Caihui [2010] No. 11) on Enterprise Internal Control Configuration Guide issued on 15 April 2010; Circular (Caihui [2012] No. 3) on Enterprise Internal Control Standard System Implementation Related Problem Explanation Note 1, issued on 23 February 2012. All issued jointly by MOF/CSRC/NAO/CBRC/CIRC.

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These provide that the board of directors is responsible for establishing and implementing an effective internal control system (which would also indirectly cover tax risk internal controls) and that the chairman of the board is required to personally sign off on the annual internal control evaluation report which is to be released to the shareholders every year. An internal audit committee must monitor the effective operation of internal controls although, unlike in some other jurisdictions, no external audit opinion on the effectiveness of the controls is required.

Tax authority circulars While non-listed large and medium-sized enterprises are also encouraged to implement the China-SOX rules this is not obligatory. Consequently, most Chinese and foreign funded companies in China are not subject to any obligation to put an internal control system covering tax in place.

This being said, in 2009 the SAT issued Circular 90 [2009], which was in 2011 supplemented by Circular 71 [2011],[24] setting out guidelines providing that the board of directors of large enterprises should establish and oversee a structured and comprehensive tax risk management system. The efforts of the SAT to prompt large enterprises to put such systems in place is allied to the 2008 establishment of the special Large Enterprise Department within the SAT, and is done with a view to facilitate the adherence by large enterprises to the SAT’s “Tax Compliance Agreement” programme for closer cooperation with the Large Enterprise Department. In the fullness of time the SAT is looking to make adoption of comprehensive tax risk management systems obligatory. These developments in the taxpayer relationship with the tax authority, and the future trends in the tax authority enforcement approach, are discussed further in sections 4. and 5.

In terms of tax authority rules compelling tax disclosures, starting from the year 2008, some local tax authorities, such as Beijing, have been requesting certain categories of taxpayers to submit a separate tax audit report (termed a “Tax Verification report”), in addition to the audited financial report, which shall be prepared by a certified tax agency firm to confirm the accuracy and completeness of tax adjustments made in the company’s annual final tax settlement.

However, China does not yet have in place arrangements comparable to Australia’s “reportable tax position” filing requirements on transactions and arrangements involving substantial tax technical uncertainty or in relation to matters for which there may be a higher risk of tax revenue loss. There is no mandatory disclosure regime for tax shelters, as in use in the United States, Canada or the United Kingdom. This being said, as China is strongly committed to the OECD BEPS initiative, and a key action is a proposal for rules requiring mandatory disclosures of tax avoidance schemes to tax authorities, China may well follow with adoption of such rules in 2016. While given the ambiguities of tax and commercial law (see section 2.) tax shelters are not a feature of the China tax landscape, a broadly drafted rule capturing offshore holding and financing structures would have a significant enterprise tax risk management impact and a knock-on effect on the attractiveness of the new rulings regime.

4. Tax Control Framework in Practice The section 2. overview of the inherent challenges for effective tax risk management in China and the section 3. overview of the impact of legislation and regulation on tax risk management environment, 24

Guidelines on Tax Risk Management of Large Enterprises, Guoshuifa [2009] No. 90 issued 5 May 2009; Circular (Guoshuifa [2011] No. 71) on Taxation Services and Administrative Procedures of Large Enterprises (Trial Implementation) issued by the State Administration of Taxation on 13 July 2011.

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provide a basis for understanding the workings of the ‘Tax Control Framework in Practice’, detailed in this section.

Section 4. considers the tax control frameworks used by taxpayers in practice in light of efforts by both the tax authorities and taxpayers to put comprehensive tax management systems in place (section 4.1.). It also looks at the key issues which a tax control framework used by enterprises in China will need to address in terms of (section 4.2.) the potential “knock-on” effect on wider business operations of failures to adhere to tax requirements and (section 4.3.) the issues with tax audit which a tax control framework will need to take on board. Section 4. thus provides a basis for proceeding to section 5.’s discussion on the new ‘Approach of the Tax Authorities’ which is being rolled out for the future.

4.1. Efforts by taxpayers to adopt, and tax authorities to ensure greater take up of, comprehensive tax management systems As explained in section 2., the tax modernization process begun in 2008 has seen, for foreign investors and FIEs, the abolition of preferential treatments while sophisticated international anti-avoidance provisions directed at offshore planning structures have been rolled out. These international antiavoidance provisions have also come to concern those domestic enterprises who are increasingly involved in cross-border activity.

Even for domestic enterprises whose activity is solely in the local market, tax risk management has jumped up their list of priorities as: (i)

the tax authority pre-approvals for reliefs and deductions have been abolished, necessitating greater internal controls and procedures for monitoring the adoption of tax treatments;

(ii)

the room for negotiating tax bills with local tax authorities has been limited by stricter SAT oversight; and

(iii)

tax authority non-compliance detection capabilities have improved.

Consequently, particularly for foreign enterprises, there has been a step-up in tax risk management efforts and investment in tax risk management systems and resources. The global tax teams in MNEs have had to hire significant numbers of Chinese tax professionals, whether for their ASPAC regional tax teams based in Hong Kong or Singapore, or directly into their Chinese entities.

Given the greater demand for external Chinese tax advice, the Big 4 accounting firms have substantially expanded their China tax practices, including advisory resources committed to helping clients put the requisite IT systems and corporate governance protocols for escalating tax matters to the C-suite in place. Advisors have been urging enterprises in China to: -

Determine at board level how their tax strategy aligns with their overall corporate business strategy and, if they have not done so already, to establish an internal tax management department.

-

In parallel, advisors have suggested that businesses identify control points (“tax risk owners”) throughout the business for tax control procedures, supporting this with automation and standardization of the procedures to the extent possible. In this regard, for the proper conduct of the control procedures the business should set up checklists of major tax risks and establish tax manuals and protocols.

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The need for such controls is particularly important in the area of invoices, given the peculiar emphasis in the Chinese tax system on special tax invoices. Invoices are a key focus of tax investigations and numerous cases exist where taxpayers lost expense deductions and were penalized due to loss of invoices. As such, setting up and implementing an effective invoice management system would be a key control procedure to put in place. This is set to become even more important as the SAT rolls out the new e-invoice system in 2015.

-

Tax risk communication mechanisms, which streamline information sharing and reporting flow group-wide, need to be put in place, and it needs to be ensured that the tax and finance departments share the same data, as well as the same related technology and processes.

-

Finally, regular “health checks” of tax compliance and reporting systems, as well as postimplementation review of tax planning ideas need to be conducted, alongside evaluating the professional ethics and capabilities of tax staff. Clearly, given the nature of China tax law-making as described in section 2., a procedure to become aware of and to react to changes in China’s regulations and interpretation would also need to be implemented.

These increased efforts by enterprises, assisted by their advisors, come at the same time as the SAT is looking to encourage better and more systematic management of tax risks.

As noted above, SAT Circular 90 [2009] and SAT Circular 71 [2011] sought to prompt boards of directors of large enterprises to establish and oversee a structured and comprehensive tax risk management system. The Circular 90 guidelines set out (i) the ideal composition of a tax risk management system, (ii) processes for identifying and assessing tax risks, (iii) a list of major tax risk factors, (iv) strategies for handling tax risks discovered, (v) the management of tax-related information and (vi) use of professional organizations to evaluate the companies’ tax risk management function.

The SAT expresses the view that taxpayers should manage their tax risks proactively, with self-review of compliance systems, and that with good tax risk management systems put in place by taxpayers, the tax authorities will be able to redirect their resources towards higher risk taxpayers. The SAT suggests that in parallel with this, tax authorities and taxpayers can look to enhance their ongoing communication and leverage their common industry expertise to collectively focus on emerging industry practices and pre-emptively solve emerging tax issues, giving greater certainty to taxpayers and to the authorities.

This thinking, expressed in Circulars 90 and 71, is borne out in line with the allied Large Enterprise Department and Tax Compliance Agreement initiatives outlined in section 5.

To further “nudge” adoption of sound comprehensive tax risk management systems, the SAT (from 2013) has started to include the routine evaluation of tax risk management systems into the normal process for tax “self-investigation”, for selected large accounts, with low scores leading to further audit and review.

A number of province level (provincial and municipal) tax authorities have also adopted a practice of selecting a number of large enterprises falling under their purview and requiring these to (i) establish or improve their internal tax risk management systems and then (ii) self-evaluate, on a regular basis, the soundness of these systems. The results of this evaluation are used as an input for evaluating the taxpayer’s risk prevention and minimization capability and for giving them a ranking.

Taking this further, the SAT is understood to have an ultimate goal of making tax risk internal control systems compulsory rather than voluntary, and, to this end, it is understood to be working with the

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State-Owned Assets Supervision and Administration Commission (SASAC), the Chinese government body overseeing many of China’s SOEs, with a view to including tax risk management as part of SOEs’ internal control supervision and evaluation systems.

It is also understood that the SAT ultimately plans to incorporate risk control assessment as a standard part of a normal tax investigation/audit and where the tax control system falls beneath the requisite standards, the enterprise will be deemed to have failed to meet its compliance obligations.

4.2. Taxpayer compliance with Chinese tax registration and reporting requirements Maintaining compliance with Chinese tax registration, reporting and documentation requirements is a very heavy bureaucratic burden, in particular due to the sheer number of tax authorities with which an enterprise may need to communicate and the frequency with which tax filings and payments need to be made.[25] Tax reporting requirements are linked to the registrations with and approvals from the various other state agencies with which an enterprise needs to interact, including local administrations of industry in commerce (AIC), departments of commerce, public security bureaus etc. For example, changes to enterprise registered capital amounts, business scope, undergoing a restructuring, merger, spin-off or termination of operations, which will need approval from or registration with local AICs departments of commerce in numerous districts, will also require amendments to tax registrations in all those districts.

Given the curious manner in which tax collection is split between LTBs and STBs, such changes might even lead to a change in the tax authority in respect of whom the enterprise needs to account in respect of certain taxes.

Many transactions, which would perhaps not require so much governmental notification in other countries, require registrations with the tax authorities and other authorities in China.

-

Under SAT Decree 19 [2009],[26] agreements for provision of cross border services into China need to be registered with the tax authorities, by both the service provider and recipient, within 30 days of the conclusion of the contract and a range of documentation and information related to the service provision must be supplied. Not registering the services could lead to challenges being faced in remitting cash from China.

-

“Transfers of technology” into China (which are defined very broadly, including service arrangements where it is considered that technology has been transferred) need to be registered with local departments of commerce,[27] otherwise challenges may be faced in remitting cash from China. This may be communicated to the local tax authorities and may lead to challenges that service payments amount to royalties and should be subject to withholding taxes. Payments have been known to be held up for 2 years or more on such disputes.

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For CIT, for example, enterprises usually must file and pay taxes on a quarterly basis according to the actual quarterly profits, and tax returns shall be filed within 15 days of the end of each quarter.

Provisional Administrative Measures Governing Tax Collection on Contracted Projects and Provision of Services by Non-resident Enterprises (Decree No. 19) promulgated by the State Administration of Taxation on 20 January 2009. These services include processing, repair and replacement, transportation, storage and lease, consulting, design, culture and sports, technology, education and training, tourism, entertainment.

Administrative Measures Governing the Registration of Technology Import and Export Contracts [2009]

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-

Remittances greater than USD 50,000 need to be recorded[28] with the tax authorities, as the banks will not process the remittances without tax authority stamps. The tax authorities may withhold the stamp if they wish to dispute the treatment of the payment as not subject to WHT and, in practice, many enterprises concede and pay the WHT, even if they have good technical arguments why they should not do so, in order to meet their commercial commitments to make payments.

-

The tax authority’s pre-clearance process for DTA relief provided for under SAT Circular 124 (2009) is an arduous procedure, involving extensive documentation, and particularly smaller local tax authorities can be utterly confused as to how the process is supposed to work. Relief applications can take a lot of time and engagement with the authorities to get processed. As remittances out of the country may not be possible without tax clearance (depending on the manner in which the tax authorities police the recordal system), this can hold up commercial arrangements. It should be noted that the existing tax authority pre-clearance system is set to be replaced in the near future with a ‘self-certification’ system under which it will be at the discretion of the WHT agent whether to apply DTA relief or not, with extensive reporting by the non-resident DTA relief claimant (via the WHT agent) to the tax authorities to facilitate GAAR follow-up procedures. This will introduce new risk management challenges for WHT agents.

-

To operate within the law, all businesses need businesses registrations with the AIC. The AIC will periodically report new business registrations to the tax authorities. If these have not been registered for tax, the AIC will revoke their business licenses.

-

A new measure launched in 2015[29] sees certain companies put on an A-list or designated as “black listed” based on their history of tax compliance and on the basis of the state of their tax control systems. While those on the A-list can look forward to less tax authority interference (in the same way as the tax risk rating systems in use in other countries), the companies on the “black list” may find themselves banned from investment, purchase, import.

As can be seen, the intertwining of tax registration requirements and commercial procedures such as bank remittances means that proper procedures and monitoring controls for ensuring that all tax registration requirements are made in a timely fashion are essential to the proper commercial operation of enterprises in China. As such, tax risk management in China is not just about avoiding tax penalties but central to ensuring that the whole commercial operation of the organization does not gum up. The very tight timeframes set for various tax registrations make clear procedures and controls essential.

Apart from the above formal mechanisms by which tax non-compliance leads to difficulties with conducting business operations, the informal risks are also worth bearing in mind. In certain instances particular foreign businesses, whose relations with the local governmental authorities have soured, can find their historic tax positions being combed through for grounds to be found for revoking their business licenses and investment approvals. To the extent that in China approvals for investment and business operation are needed from a welter of different government agencies (e.g. administrations of industry and commerce, departments of commerce, particular government ministries for specific products, public

28

29

The tax recordal requirement is governed by Announcement [2013] No. 40. This notice is relevant to many payments out of China as it covers payments for services (e.g. transportation, tourism, telecommunications, construction, installation, insurance, finance, information technology, and entertainment), intangible licensing, finance lease, real estate transfer, equity transfer, equity investment (e.g. dividend), foreign loans (e.g. interest), guarantees, as well as China-sourced salary income earned by foreign individuals.

Circular Guoshuizong [2014] 40.

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security bureaus) all that is necessary is that one of these bodies revokes a permit or approval for the whole business to become untenable.

For this reason many foreign businesses in China make great efforts to keep their tax affairs squeaky clean so as not to leave themselves open to such action. However, given the vagueness of much of Chinese tax law and practice this can be an uphill struggle.

4.3. Taxpayer handling of tax audits The tax audit function is decentralized in China except for important cases and to some extent for large TP initiatives. The state and local tax bureaus of all provincial, city and county levels have their own Tax Audit Bureaus (TABs) to conduct tax audits on enterprises under their jurisdiction.

Audit selection Tax audit target selection uses sample selection software (using a mixture of financial performance and tax history criteria).

Tax audit selection is also driven by national programs of auditing specific industries. In this regard, some industries or classes of enterprises have higher tax risks than other industries. For example, listed companies are easier targets for tax audit due to their visibility, financial institutions may face higher tax exposure due to the ambiguity of tax treatment on transactions involving complex securities or financial derivatives, while enterprises in the sectors of pharmaceuticals, real estate development, and the tobacco and liquor businesses also have higher tax risks due to specific focus of the tax authorities and specific taxes directed at the industry, such as LAT and consumption tax.

Tax audit selection is also driven by whistleblower tip-offs and through use of public information (e.g. for indirect offshore disposal cases, tax officials would sift through the websites of private equity companies announcing new transactions related to China).

For TP audits, sophisticated audit selection analysis is used with a focus on: -

enterprises which have a large amount of related party transactions or have multiple types of related party transactions;

-

enterprises which maintain a continuous loss, break-even status or a sudden jump in profitability;

-

enterprises whose profit level is lower than the industry level;

-

enterprises whose profit levels obviously do not match the functions performed and risks assumed;

-

enterprises which have transactions with associated parties registered in a tax haven; and

-

enterprises which fail to file their related party transactions or prepare contemporaneous documentation.

As noted, the Chinese tax authorities are not yet at the level of sophistication of having individual tax risk ratings for taxpayers, based on a wide selection of information including an assessment of internal control systems, as in Australia, though such a system is under development.

It should be noted that self-examination by large taxpayers (already referred to in section 2. on TP self-adjustments) is a preferred method of tax investigation for Chinese tax authorities given its costeffectiveness for the tax authorities (though not for taxpayers as fulfilling and documenting these Š Copyright 2015 Tracy Zhang,, Conrad Turley,. All rights reserved. Š Copyright 2015 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information.

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procedural requirements, to prove compliance to the tax authorities, can be time-consuming and onerous).

Clearly then, enterprises should try to understand the mechanism of tax audits and review their operations to determine whether they fall into any high-risk categories which may likely be targeted for audits. Taxpayers should review their operations periodically to identify any tax non-compliance areas and should establish monitoring systems to ensure proper compliance. Taxpayers should also keep proper accounting records and ensure that documentation is kept in order.

Conduct of audits One important point to note is that, unlike tax audits in many other countries which often are adversarial proceedings, taxpayers involved in an audit in China should try to cooperate with the tax authorities as much as possible. An uncooperative attitude is likely to antagonize local officials, leading to a less satisfactory result. Because the outcome of an administrative appeal is often uncertain, it is important to attempt to work out the best settlement at the local level, rather than to prepare for an administrative appeal or for a court action.

In conducting tax inspections, tax officials must present their tax inspection identification card and a tax inspection notice to the taxpayer. Tax officials are required to maintain the confidentiality of any taxpayer information revealed and taxpayers have the right to comment on decisions made by tax bureaus and may resort to administrative appeals or court proceedings. Under certain circumstances, if there is obvious evidence that a taxpayer will transfer assets in order to avoid paying taxes, tax authorities may require a guarantee of tax payment. If the taxpayer fails to provide the guarantee, the tax authorities may issue a written notice to the taxpayer’s bank to freeze an amount equal to the amount of the tax payable or seize or withhold the taxpayer’s property in a value equal to the amount of the tax payable.

Claims for back taxes and penalties are limited by the statute of limitations and different time frames apply to different circumstances.

-

If the tax non-payment or underpayment was caused by the tax authorities, such as the improper application of tax laws or regulations, or the illegal enforcement of the laws or regulations, then the statute of limitations is 3 years for the tax authorities to demand repayment in arrears for taxes owed or underpaid. In such cases, no late payment penalty applies

-

If the tax non-payment or underpayment was caused by the taxpayer due to its unintentional mistake, such as making an erroneous calculation, the statute of limitations shall be three years for the tax authorities to collect the taxes in arrears and also the late payment penalty. However, for enterprises of any size, the relevant time limit is likely 5 years as this timeframe applies where taxes unpaid or underpaid reach or exceed RMB 100,000.

-

If a taxpayer engages in tax evasion, refuses to pay taxes or commits fraud, then the tax authorities are not subject to the time limitation, that is, they can pursue the collection of the taxes unpaid and underpaid, as well as the late payment penalty, for an indefinite period.

-

In transfer pricing cases, the statute of limitations is 10 years.

It should be noted that the exact application of the statute of limitations is unclear. The clock starts ticking when a “mistake” has been made, but the meaning of mistake is unclear. It is widely debated as to whether failure to withhold tax is a mistake such that within 5 years of the WHT obligation crystallizing the statute of limitations expires. Some have argued that such failure is not a mistake and that in fact © Copyright 2015 Tracy Zhang,, Conrad Turley,. All rights reserved. © Copyright 2015 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. Disclaimer: IBFD will not be liable for any damages arising from the use of this information.

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the clock would only start ticking when the tax authority makes a formal demand for payment of the nonwithheld WHT. This has been, for example, a key tax risk management issue in relation to the settlement of historic taxes in relation to qualified foreign institutional investors in Chinese listed securities markets.

It might be noted that the upcoming new Tax Administration and Collection Law will move the statute of limitations in most situations to 5 years. The “mistake” ambiguity is to be resolved, as for taxpayers who fail to perform tax registration and tax filings or are subject to investigations, the period of pursuing collection of taxes is revised from an indefinite period to 15 years. The limitation period for pursuing collection of taxes in arrears is revised from an indefinite period to 20 years.

Penalties for discovered non-compliance can be stiff. The interest surcharge for late payment of taxes is 0.05% of the overdue tax amount per day, commencing on the first day the tax payment is in default.

Moreover, the tax authorities may impose a penalty of 50%-500% of the amount of tax unpaid or underpaid. If a withholding agent fails to withhold taxes, a penalty of 50%-300% of the amount of tax overdue applies. In the case of fraudulent claims for export tax refunds, tax authorities may demand repayment of the refund amount in addition to a fine of one to five times the refund amount. Taxpayers will be prosecuted if the activities constitute a criminal offence.

The new Tax Administration and Collection Law will, however, adjust these penalties and provide that taxpayers and withholding agents who fail to pay tax or underpay tax due to negligence would bear lesser legal liabilities than those who evade tax payment, so linking the level of penalties to the nefariousness of intent, as is the case in other countries. The new law also gives greater clarity on when penalty mitigation applies so as to reduce the discretion of local tax authorities.

5. Approach of Tax Authorities Section 4. on the ‘Tax Control Framework in Practice’ explained how taxpayers seek to control the main China tax risks and deal with the Chinese tax authorities on the basis of their existing enforcement practices.

This section deals with the emergent ‘Approach of the Tax Authorities’ with new initiatives directed at both detecting tax non-compliance and deterring aggressive tax planning, and at working closer with taxpayers to generate a more compliant tax culture. As in other countries the SAT intends for the two approaches to complement each other as ‘stick’ and ‘carrot’. The unique characteristics of China’s tax system, as outlined in section 2., do of course impact the real effect, in practice, of such initiatives.

Greater information collection and analysis capacity, and greater reporting requirements to catch evasion and deter aggressive tax planning The Chinese tax authorities are currently in the process of building information platforms to integrate various tax filing information, information from business databases and information from other government departments including customs offices, commerce administrations and AICs. This builds on existing efforts; as facilitated by SAT Circular 126 [2011] the tax authorities and the AIC branches have already since 2012 been exchanging information on transfers of listed and non-listed equity interests every month. The forthcoming Tax Administration and Collection Law also contains provisions calling for the formalization of tax authority information pooling arrangements.

Using these pooled information resources, the Chinese tax authorities plan to utilize data warehousing technology to determine risk indicators and categorize risks, and use this information to undertake

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risk screening processes and identify key targets for further review and investigation. As such, the Chinese tax authorities will in time see a convergence in terms of sophistication with tax authorities which already use advanced data processing for risk rating and targeting of taxpayers, such as the Australian Tax Office (ATO), whose systems reportedly have the ability to receive and match over half a billion transactions per year.

Progress in this regard has been especially swift in the TP field and the TP comprehensive indicator system has been developed to improve the efficiency of evaluating transfer pricing risks, encourage internal information sharing and improve the quality of information in their internal database. The system was developed based on the internal database collected by the SAT over the past several years and can be applied not only to benchmarking studies across different industries, fiscal years and countries, but also to anti-avoidance models of specific industries to help strengthen transfer pricing management.

During 2013, over 1,000 taxpayers were prompted to change their transfer pricing mechanism or policy after review by the tax authorities, with over RMB 1 billion in additional tax revenue collected by local tax bureaus.

Deployment of such technology will allow for better use of the information already held by the various Chinese public authorities. The Chinese authorities are in addition adding new sources of information and obligations for enterprises in China to report to the Chinese tax authorities have been significantly expanded in recent years.

Some of the additional reporting requirements, noted above, relate largely to domestic transactions and activities, such as the introduction in Beijing of a separate annual tax audit report, and initiatives such as the periodic tax authority requests, in larger cities such as Beijing, for companies to do self-reviews on overlooked historic incorrect tax treatments and report these to the authorities. However, a truly seismic change is due to be made with the introduction of a taxpayer identification number (TIN) system as both individuals and enterprises will be obliged to use their TINs when signing contracts/agreements, paying social insurance premiums, registering real estate and handling tax matters. Banks and other financial institutions shall record TINs in the bank accounts of taxpayers engaging in production and business operations and it is provided that where a unit or individual engaging in production and business operations makes payments of over RMB 5,000 to another unit or individual during a tax year, the TIN of the payee shall be provided to the tax authorities. Where single cash payment exceeds RMB 50,000, the TIN of the payee shall be provided to tax authorities within 5 days.

As such, the TIN system would give ample information to the tax authorities, presuming the data can be effectively processed and matched, and enhance the credibility of enforcement of given taxes. It is also seen to provide an important underpinning for a general Real Estate Tax Law and revisions to the IIT Law. So much for the future, but more recently, the greater number of the new reporting requirements relate to cross-border activities. This would appear to be in line with the fact that most of the new tax rulemaking activity at SAT level has been squarely focussed on cross-border transactions and structures.

In addition to the cross-border related party payments reporting, notable recent and upcoming additions to the unilateral reporting are China FATCA (SAFE Circular 642 – January 2014), under which Chinese residents are required to report their foreign financial assets and liabilities and all cross-border transactions, the enhanced CFC reporting (SAT Announcement 38 – July 2014) and, of course, the country-by-country reporting for TP purposes, which follows the BEPS Action 13 Sept. 2014 Report

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and which is set to be put into domestic effect by the revised SAT Circular 2 later in 2015. This is complemented by China’s extensive additions to its mechanisms for cross-border information exchange (as detailed further in section 6.).

While China has expanded its sources of information, both through additional reporting requirements, information exchange and other government department information, and sets to use this information more effectively with greater data analytics, China still does not have in place arrangements comparable to Australia’s “reportable tax position” filing requirements. Such reporting covers transactions and arrangements involving substantial tax technical uncertainty or in relation to matters for which there may be a higher risk of tax revenue loss.

Further, China does not, unlike other countries, currently have legislation and mechanisms in place for the automatic bulk reporting of taxpayer information stored with banks and other financial institutions.

In terms of the public tax disclosures, which parallel tax authority reporting, while for listed companies tax disclosure requirements have been increased in recent years, Chinese company law does not require the same level of financial statement disclosure on tax risk areas as, say, Australian company law. In any case, even for the listed companies, and unlike in other jurisdictions, no external audit opinion on the effectiveness of the controls is required.

All this being said: -

The upcoming Tax Administration and Collection Law will provide that banks and other financial institutions must provide tax authorities with the accounts, account numbers and investment income of bank account holders as well as total interest and ending balance. For a single fund transfer of over RMB 50,000 by a bank account holder or cash withdrawal of over RMB 50,000 within a day, banks and other financial institutions should provide relevant information for tax authorities.

-

As noted in section 3., China may well introduce a mandatory disclosure reporting regime in line with its commitment to the BEPS initiative.

-

In the vanguard of tax authorities globally, with the Tax Administration and Collection Law, the SAT is introducing provisions for reporting on e-commerce businesses. Online trading platform operators will need to provide tax authorities with registration information of e-commerce traders operating on their platform and tax authorities will be entitled to audit the trading status and payment history in relation to the traders on the platform.

This will affect both Chinese resident traders who have not reported income and foreign based traders who may have incidental tax nexus to China. Apparently the tax law is also to be upgraded to catch such foreign traders within Chinese tax nexus.

Establishment of the Large Enterprise Department In section 4. it was noted that the issuance of SAT Circular 90 [2009] urging large enterprises to set up comprehensive tax risk management systems overseen by the board was allied to the establishment of the Large Enterprise Department within the SAT in 2008 with SAT Measure 87 [2008].[30] The main

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Notice of the Principal Responsibilities and Personnel Allocation of the State Administration of Taxation (Guobanfa [2008] No. 87), enacted by the General Office of the State Council on 10 July 2008.

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objective of establishing the Large Enterprise Department is to facilitate the raising of tax compliance levels amongst these large enterprises.

While the Department of International Taxation has retained responsibility for the formulation and implementation of transfer pricing regulations, bilateral APAs and MAPs, the Large Enterprise Department takes responsibilities in the following matters: drafting documents regarding comprehensive tax collection and administration; administration of tax invoices and certificates; provision of assistance and services to large enterprises; tax assessment; anti-avoidance tax investigation and audit; and the provision of guidance to the tax administration for offshore oil and gas exploration and development.

To facilitate the raising of compliance levels, the Large Enterprise Department has established a management information platform to connect selected large enterprises with the department, referred to in Circular 90 as a “one-stop” communication platform. Through this, customized services are to be provided to the selected large enterprises which should help them towards tax compliant outcomes.

The department will help these enterprises to resolve tax issues arising from inconsistency in the implementation of tax policies by local tax departments and thus may be of particular use to crossregional large enterprises, as is clear from section 2. The department also indicates that it can help clarify matters in relation to cross-border transactions.

SAT Measures 87 [2008] also encourages the establishment of similar communication protocols at the local level between provincial tax authorities and enterprises.

At the same time, the Large Enterprise Department selects certain large enterprises that will be required to engage in “self-review” as outlined in section 4.

As such, the Large Enterprise Department applies both the carrot and stick to ensure greater taxpayer engagement and foster greater compliance.

Tax authority roll-out of tax compliance agreements SAT Circular 90 [2009]’s encouragement of the establishment of comprehensive tax risk management systems and SAT Measures 87 [2008] establishment of the Large Enterprise Department are intended to dovetail with the roll-out of the SAT’s ‘Tax Compliance Agreement’ programme, which is a cooperative compliance programme along the lines of those seen in other countries.

Large enterprises with comprehensive tax risk management systems in place would be suitable candidates for signing up to Tax Compliance Agreements (TCAs) for closer cooperation with the Large Enterprise Department[31] and the TCAs can also be rolled out at lower levels of the tax administration; from 2012 onwards, a number of local provincial level tax authorities has been entering into TCAs with taxpayers with a good track record of high compliance.

Feedback on the initial scheme appears to be that TCAs need to become firmer on specifics to be more appealing to taxpayers (e.g. if a taxpayer reports that its tax control system works adequately and meets the other reporting requirements set by the TCA, such as on planned future transactions, over what period can tax inspections be waived?). The inevitable question resulting from China’s many layers of tax authority – how can a TCA be applied to a company with operations in many tax districts?

– also needs to be resolved.

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According to a report posted on the SAT’s official website, the first batch of enterprises ruled eligible includes 31 state owned enterprises, 4 privateowned enterprises and 10 foreign-owned enterprises.

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Effectiveness of tax authority “carrot and stick” approach to increasing taxpayer compliance China is clearly pursuing the adoption of global best practices in tax enforcement from countries such as Australia, whereby the ATO will seek to reduce the reliance on tax avoidance arrangements by extensive tax reporting to the tax authority by the enterprises, as well as by offering certainty through rulings. It also induces adoption of good tax risk control systems, which in any case are demanded by a range of separate regulations, by the use of risk ratings which take the presence and the good functioning of these systems into account. The ATO can also leverage the decreasing appetite for tax risk amongst investors to discourage aggressive tax planning, with the tax risk created by aggressive tax planning highlighted for investors by the extensive public disclosures on tax risk required by company law and accounting standards, and on the increasing sensitivity of large businesses to public sentiment and reputational risk.

China’s advance rulings mechanism is due to come into effect with the new Tax Administration and Collection Law. This will allow taxpayers to apply (to tax authorities above provincial level) for a ruling for “complicated tax matters which are predictable and involving significant economic interests”. This formal system supplants the informal arrangements under which the Large Enterprise Department was already issuing written rulings to the limited number of enterprises covered under the Tax Compliance Agreement programme and the pilot scheme provided under Shui Zong Fa [2013] No. 145.

Clearly, the uncertainty inherent to Chinese tax law due to the manner in which it is created, as well as the fact that local authorities can apply the law in deviant and inconsistent ways, may well make SAT rulings, binding on lower level tax authorities, of great appeal. The risk might be, though, that the system becomes gummed up with requests, given the many areas of uncertainty in the law, and that a backlog arises. This has already been the case for APAs for which limited resources are available.

The platforms for pooling information across government authorities, together with the new streams of information from new reporting requirements and from information exchange, could indeed have a significant effect in detecting and deterring evasion and aggressive tax planning. However, the technical challenges are sizeable and it remains to be seen over what timeframe such a system can be put in place.

As to the inducement of enterprises to adopt highly comprehensive tax risk management systems, many internationally active companies are already doing so, given the heightened risk from the particular SAT focus on cross-border transactions. Whether the bulk of large Chinese companies can be induced to do so may well turn on how effective the SAT’s program of linking bad compliance system reviews to more intensive and frequent audits works. The ATO conducts rolling risk reviews of enterprises (separate from tax audits) which provide the information necessary for the risk rating system and for the targeting of tax audits. As with all the new SAT initiatives, the success of the SAT’s programme will likely turn on the skilled resources the tax authorities can bring to bear; an issue which is already proving a bottleneck for many tax authority initiatives.

6. Tax Risk Management in the Global Environment It should be clear from the previous sections that to the extent that tax risk management practices and systems need to contend with true tax technical complexity, given that complex tax structuring and tax

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shelters are not a feature of purely domestic transactions, this happens largely in the international tax space.

Ongoing overhaul of Chinese international tax rules The Chinese tax authorities have been committing significant efforts and resources to an overhaul of the international tax provisions in the domestic tax law. As a measure of the seriousness with which the Chinese government is taking the G20/OECD BEPS global tax reform initiative, China’s President Xi Jinping addressed the November 2014 G20 Leaders' Summit on international taxation, indicating China’s support for efforts to enhance global cooperation in collecting tax and crack down on international tax evasion. This was notably the first time in history that a president of China specifically commented on tax matters at the G20. This has led to an acceleration of international tax enforcement initiatives by China, with a comprehensive SAT 2013-2016 international tax work programme being rolled out.

China’s influence on the BEPS process is particularly noticeable in the area of transfer pricing, with greater weight being given to functions and a downplaying of contractual risk and of the financing and legal ownership of IP in allocating profits, and with recognition being given to local market characteristics (e.g. cost savings) as comparability adjustments. As such, by ensuring that practices already being put into effect in Chinese TP practice are recognized within the global standards, this further secures the ability of the Chinese tax authorities to deploy these TP approaches going forward. China is also eager to adopt the CbCr and is gearing up to do so.

China’s willingness to adopt the BEPS deliverables may be set to see a number of significant changes to the CIT Law outside of the TP space, including CFC rules, anti-hybrid rules, interest deduction and limitation rules and mandatory reporting requirements.

As in other countries, the Chinese tax authorities are referencing the BEPS reforms as a pretext for supporting and accelerating international anti-avoidance efforts already underway. The most significant of these, including the use of the GAAR against indirect offshore disposals and treaty shopping, and the move to start deploying the existing CFC rules, have been outlined in section 2.

The SAT has also set out, in September 2014, 15 “unacceptable” tax practices (all in the international tax space) on which tax audit attention will be focussed: 1.

Base Erosion and Profit Shifting (BEPS);

2.

double or multiple non-taxation;

3.

aggressive tax planning;

4.

opaque tax regimes and arrangements;

5.

legal arrangements without economic substance;

6.

deduction of expenses not in line with substance;

7.

loss in single-function subsidiaries for foreign parents;

8.

treaty abuse;

9.

disproportionate pricing of intangibles;

10.

remuneration incompatible with functions and value contribution;

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11.

low remuneration for “hi-tech” entities;

12.

disrespect of local market characteristics;

13.

parent losses shifting to Chinese subsidiaries;

14.

refusal of information disclosure; and

15.

hybrid mismatch to avoid tax.

International exchange of information The SAT foresees a full-hearted cooperation in information exchange and tax collection with other tax administrations.

At a multilateral level, China has indicated that it will undertake its first exchange of information under the OECD’s Common Reporting Standard system starting in 2018. The legal basis for this and for other multilateral initiatives, such as joint audit and assistance in tax collections, is China’s adherence, on 27 August 2013, to the Multilateral Convention on Mutual Administrative Assistance.

China is also involved in multilateral exchange of intelligence on aggressive tax planning strategies in use and cooperation through the OECD Forum of Tax Administration (FTA) and the Joint International Tax Shelter Information Centre (JITSIC). The SAT has indicated that it intends to work more closely with the JITSIC members in audits on cross-border structures and financial arrangements and the focus of the JITSIC taskforce on high wealth individuals, losses, hybrid structures and transfer pricing interfaces well with Chinese efforts.

At a bilateral level China has reached an “agreement in substance” on 26 June 2014 for a Foreign Account Tax Compliance Act (FATCA) Model 1 Intergovernmental Agreement (IGA) with the United States under which China was to make its first reporting to the United States from March 2015. China has been steadily updating its 105 existing double taxation agreements with the latest (2005) version of the OECD MTC EoI article and has Tax Information Exchange Agreements (TIEAs)[32] with the ten major tax haven jurisdictions.

7. Future Developments and Expected Implications Related to Changed Approach to Tax Risk Management The discussion in the preceding sections, in addition to sketching out the current state of tax risk management in China from a taxpayer and tax authority perspective, has given some indication on the emerging new rules and the trends for the future. To briefly recap: -

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Consistency of the law: the SAT is taking a tighter rein over the tax law making process in China to ensure greater consistency. Prohibiting local tax authorities making rules at odds with existing SAT rules, programmes to “clean up” and abolish existing local incentives, and requirements for approval of new incentives are accompanied by procedures through which taxpayers can initiate SAT review of local rules at odds with national rules. Such tightened control over rule-making is expected to continue in the future and should bring greater certainty for taxpayers.

BVI 2009, Bahamas 2009, Jersey 2010, Isle of Man 2010, Guernsey 2010, Bermuda 2010, Argentina 2010, Cayman Islands 2011, San Marino 2012, Liechtenstein 2014.

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-

Consistency of enforcement: equally important are the allied measures by the SAT to ensure consistency not just in the rules themselves, but in the enforcement of these rules. SAT measures allow taxpayers to appeal their individual cases up from the local tax authorities to higher level authorities (including up to the SAT). Approvals for tax adjustments in individual tax cases from higher level authorities (including from the SAT in GAAR cases and large TP cases) should limit arbitrary exercise of discretion by local authorities, while publication of such decisions should help to guide taxpayers and their advisors in their discussions with the tax authorities. The Tax Administration and Collection Law appears set to settle down these arrangements more formally going forward.

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Sharper and more joined-up anti-avoidance rules: the alignment of the newly clarified GAAR with the revised indirect offshore rules and the treaty shopping provisions is only the start of a range of new anti-avoidance provisions set to come online in 2016.

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Information: an exponential expansion of the sources of information at the tax authorities’ disposal is underway, from pooling information with other tax authorities, accessing information held by other domestic public authorities, increasing domestic reporting requirements (most notable with the TIN scheme), conducting taxpayer risk control system reviews (including selfassessments) and international information exchange. Whether the tax authorities will be in a position to properly analyse and utilize all of these sources of information remains to be seen.

-

Closer taxpayer-tax authority cooperation: the Large Enterprise Department is facilitating the rollout of TCAs and may well be the channel for many of the new private rulings provided for under the Tax Administration and Collection Law, given that these are limited to significant economic transactions. Focus by the SAT on more proactively targeting tax risk areas, in cooperation with taxpayers, will likely be facilitated by the planned joint establishment, by the SAT and provincial level tax authorities, of a national “Risk Management Office”, which will be responsible for identifying the major tax risks of different industries, and by the planned establishment by the SAT of a working group on tax risk management with industry representatives, which would come up with relevant regulatory guidance.

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