China’s Anti-tax Avoidance Rules

The general anti-avoidance rule was first introduced in China under the 2008 CIT Law. It empowers Chinese tax authorities to make reasonable adjustments where an enterprise implements an arrangement without reasonable business purposes in order to reduce its taxable income or profit. According to the CIT Law’s Implementation Guidelines, “an arrangement without reasonable business purpose” refers to an arrangement which has the main purpose of obtaining tax benefits such as the reduction, elimination, or deferral of tax payments.

Prior to 2008, a special purpose vehicle (SPV) was the most common structure used by foreign companies to hold investments in China. A SPV refers to a holding company set up outside of China – usually in Hong Kong or other locations that boast notable tax advantages and favorable tax treaties with China – for the special purpose of holding equity interest in an onshore FIE.

When the foreign investor disposes of its investment in China by transferring equity in the SPV instead of directly selling the Chinese company’s shares, the transfer is technically exempt from capital gains tax in China since both the seller and subject entity are located offshore. The shares of the Chinese company didn’t change owners – it continues to be owned by the holding company – so the investor would not have to pay Chinese capital gains tax. The offshore company in such a transaction would often be in a country that imposes a low, or even zero, capital gains tax on income from equity transfers, which enables further tax benefits for the investors.

However, in recent years, offshore equity transactions have been increasingly subject to heightened scrutiny by the Chinese tax authorities as the country strives to protect its tax revenue.

On January 9, 2009, the SAT issued the Implementation Measures for Special Tax Adjustments (for Trial Implementation) (Guo Shui Fa [2009] No.2), among other measures, provided a stronger regulatory basis for disregarding an SPV that lacks economic substance. The areas specified for anti-avoidance investigation include:

• Abusing tax treaties;
• Avoiding tax via tax havens;
• Abusing corporate organizational structures; and
• Other arrangements without reasonable business purposes.

Guo Shui Fa [2009] No.2 empowers the tax authorities to disregard the existence of an enterprise that has no economic substance and to annul the tax benefits obtained by such an enterprise – specifically, enterprises established in tax havens that allow their related parties or non-related parties to avoid taxes.

At the end of 2009, China’s tax authorities further emphasized their intention to scrutinize offshore indirect transfers of Chinese equity interests by non-resident enterprises via the promulgation of Guo Shui Han [2009] No.698. It was further amended by SAT Announcement [2015] No.7 in 2015.

Accordingly, where an offshore controlling shareholder indirectly transfers equity in a Chinese resident enterprise, the parties to the transaction and the Chinese resident enterprise whose equity is transferred indirectly should subject relevant materials to the tax authorities voluntarily or upon request. By submitting relevant materials voluntarily within 30 days from execution of the equity transfer contract or agreement, the future tax penalty may be reduced or waived if they are not qualified for the tax breaks.

Guo Shui Han [2009] No.698 and SAT Announcement [2015] No.7 also clarify the tax policies for the indirect transfer of Chinese assets/equity. Where an offshore equity transfer has no reasonable commercial purpose, the indirect transfer shall be redefined as direct transfer of equity of Chinese resident enterprises and Chinese tax shall be imposed on the transfer.

Importantly, SAT Announcement [2015] No.7 clarifies what is considered a reasonable commercial purpose. Instead of having a single defining factor, SAT Announcement [2015] No.7 lists a number of elements that may contribute to the transaction having a reasonable commercial purpose. The official explanation emphasizes that more than one factor needs to have been met. Single or partial factors will not suffice. These factors are:

• Whether the main value of equity in the foreign entity is made up of taxable assets in China;
• Whether the assets of the foreign entity are mainly comprised of investments in China, or whether its income is mainly sourced from China;
• Whether the corporate structure has economic substance, from the point of the functions the foreign company is performing, and the risk it is bearing. This is commonly assessed by looking at the related companies’ equity structure, assets, staff arrangements, income, and other operational information;
• The length of time the foreign company’s business model, shareholders, and organizational structure have been in existence. The official explanation reveals that the tax authority will look for ‘traces of a plan’ to avoid tax by indirect transfer. It gives the example of an intermediary company being set up shortly before the indirect transfer. This would be a clear red flag that the investor is trying to evade tax by use of foreign corporate structures;
• Whether foreign tax is being paid on the transaction. The tax authorities will assess whether the transaction is resulting in a cross-border tax advantage, looking at both the party transferring
  and the one receiving the shares. If the tax burden is less than what would have been paid in China, this would flag the tax authorities;
• Whether the transaction could have been substituted by a direct transfer. The tax authorities will consider a variety of matters to determine whether not transferring assets directly serves a reasonable business purpose, such as market access, the need for a review of the transaction, compliance requirements for the transaction, and the goal of the transaction;
• Whether China has a Double Taxation Avoidance Agreement with the states in question, or other tax reducing arrangements relevant to the case; and
• Other matters deemed relevant.

Certain transactions are automatically deemed to not have a reasonable commercial purpose if:

• 75 percent or more of the foreign entity’s income is derived from taxable assets in China;
• If at any time in the year before the transaction, 90 percent or more of the foreign entity’s asset value (excluding cash) is comprised of assets in China;
• The foreign company performs only limited functions and bears only limited risk, and while being fully incorporated according to the jurisdiction’s laws, does not have economic substance. This clause is a clear targeting of shell companies and similar arrangements; and
• The overseas tax burden on the transaction is less than what it would have been with a direct transfer.

However, an indirect transfer shall not be flagged in following circumstances:

• The trading of listed shares on a public exchange;
• When the income would be exempt from Chinese tax under an applicable tax treaty or arrangement had the transaction been direct;
• Where all of the following conditions are satisfied in the transaction:

The two parties of the indirect transfer are in a corporate group, where transferring company owns over 80 percent of the shares of the receiving company; or where the receiving company owns over 80 percent of the shares of the transferring company; or where a third company owns over 80 percent of the shares in both the transferring and receiving company;

The transfer would not result in a lower tax burden in China; and

The receiving company fully pays for the transfer with its own equity.