2009 was an extremely eventful year for Chinese cross-border taxation, when substantial developments took place both in the indirect tax and income tax spheres.Unfortunately, for inbound investments into China, the year will probably
be remembered for a number of government announcements that not only were
unfavorable to foreign investors, but also so unsettled the legal order that,
in the areas they touch on, everything now seems possible. Perhaps most representative
of these problematic announcements is the Notice on Strengthening the Management
of Enterprise Income Tax Collection on Proceeds from Equity Transfers by
Non-resident Enterprises (“Circular 698”), issued by the State
Administration of Taxation (SAT).1 In this notice, the SAT imposed a requirement on foreign
entities to disclose, in certain circumstances, indirect transfers (i.e. through
the use of intermediate holding companies) of equity interests in Chinese resident
enterprises to Chinese tax authorities.2 In addition, Circular
698 empowers tax authorities to disregard intermediate holding companies if
it is determined that the latter are used without a reasonable business purpose
and to avoid Chinese tax.3
Gain
derived from the transfer of equity interest of Chinese companies by foreign
entities is generally taxable under the enterprise income tax (EIT).4 Tax authorities in practice refrain from collecting this tax on gain from the
trading of shares of Chinese companies on Chinese and foreign stock exchanges,
presumably because it is administratively unmanageable, although no regulation
sets out an explicit exemption for foreigners in such circumstances.5 As in other countries that attempt to tax equity transfers by foreigners, Chinese
tax authorities must also confront the fact that foreigners may try to avoid
this tax, when non-tax considerations permit, by transferring not the equity
interest in a domestic company directly but the equity of an offshore holding
company that holds (directly or indirectly) the domestic company’s shares.
On its face, Circular 698 is an attempt to identify such arrangements by requiring
the disclosure of indirect transfers where the holding company transferred is
located in a low tax jurisdiction (or a jurisdiction that exempts income tax
on foreign-sourced income). It provides that offshore holding companies will
be disregarded if their use lacks economic substance. Should one see this, then,
as a laudable attempt by the Chinese tax authorities to strengthen tax enforcement
against international tax avoidance?
The
inconvenient truth is that these provisions of Circular 698 have no legal
foundation. China has a hierarchical, civil-law-like system where government
regulations are enacted to implement legislation. The highest form of legal
authority, other than the Constitution, are statutes (“Laws”)
adopted by the Parliament. Laws typically delegate powers of interpretation
and implementation to the executive branch, which is headed by the State
Council. Regulations issued by the State Council - labeled “Administrative
Regulations” - need to be consistent
with Laws; regulations adopted by national ministries in turn have to be consistent
with Laws and Administrative Regulations; and government agencies’ interpretive
documents need to be consistent with higher Laws and regulations.6 Where
government documents are inconsistent with higher law, they may be disregarded
during administrative and judicial review.7 Circular
698, which takes the form of a notice issued by the SAT, is an interpretive
document and has no independent legal effect. Moreover, it is patently
in conflict with the EIT Law, as that is interpreted by the State Council’s
EIT Law Implementation Regulations.
Under
the EIT Law, only two types of entities are subject to the EIT: the first are
enterprises that have tax residence in China; the second are enterprises that
are not tax residents of China but have either an “establishment or site”
in China or have Chinese-source income. A foreign entity that neither is a resident
enterprise nor has a Chinese establishment or Chinese-source income would fall
outside the jurisdiction of the EIT Law. It would not be a taxpayer within the
EIT system.8 And under existing rules determining what income
has a Chinese source - rules that are contained in the EIT Law Implementation
Regulations - gain on the transfer of equity interests is Chinese-source only
if the enterprise the equity of which is transferred is located in China.9 Thus the transfer by a foreign entity (i.e. one that is not a Chinese resident
enterprise) of equity interests in another foreign entity simply falls outside
the jurisdiction of the EIT regime.
It
would be mistaken to suppose that Circular 698’s approach to indirect
equity transfers can be justified by the general anti-avoidance provision in
Article 47 of the EIT Law. That provision states that “where an enterprise
adopts an arrangement with no reasonable business purpose to reduce the amount
of its taxable income, the tax authority shall have the right to make adjustments
through reasonable means”. However, the government would face serious
legal obstacles in appealing to Article 47 to defend Circular 698. Under the
most natural interpretation of that article, a precondition of its application
is that the enterprise whose tax liability is subject to adjustment must be
a taxpayer falling within the jurisdiction of the EIT in the first place. In
claiming jurisdiction over foreign entities that engage in indirect transfers
of Chinese equity (by requiring such entities to disclose such transfers to
Chinese tax authorities), Circular 698 already systematically disregards the
form of such transactions, and does so on no more ground than the possibility
of abuse. Article 47 cannot be read as granting tax agencies unfettered discretion
in this fashion.
Ironically,
precisely because Circular 698’s provisions on indirect equity transfers
have insufficient basis in higher law, non-compliance with these provisions
arguably also cannot legally attract any penalty. According to the Law on the
Administration of Tax Collection,10 which is where penalties
for non-compliance with tax law are generally laid out, taxpayers are entities
or individuals obligated to pay taxes prescribed in Chinese Laws or Administrative
Regulations.11 Although taxpayers are generally required to
truthfully file tax returns, and submit relevant information required by the
tax authorities, such requirements must be imposed to implement Laws and Administrative
Regulations, and in any case can only be imposed on taxpayers. This implies
that foreign entities engaging in indirect transfers of Chinese equity could
adopt the legal position that failing to heed Circular 698’s disclosure
requirements should have no adverse consequences, since the Law on the Administration
of Tax Collection does not apply to them. The risk of taking this position would
seem to be particularly low if the foreign entities believe that their use of
intermediate holding companies does possess “economic substance”:
although that term is nowhere defined in Chinese tax law, the onus of proof
of lack of economic substance should be on the government.
Of course, even if Circular 698’s provisions on indirect equity transfers
were legally valid, one would expect that Chinese tax authorities could enforce
them very unevenly at best. As other commentators on the circular have pointed
out,12 the scope of application of the disclosure requirement
is so broad as to encompass many types of transactions that arguably pose no
threat to China’s tax base. For example, if an M&A transaction among
multinationals involved a small Chinese subsidiary in the package, Circular
698 would require the submission of information regarding the entire transaction
to a local Chinese tax authority. The impracticality of this requirement is
transparent. Widespread compliance with it would be surprising.
So
how can the requirement be made more palatable so as to elicit compliance? For
the moment, many Chinese tax practitioners seem to be relying on a basic tool
of their trade, which is talking to whichever tax officials at the SAT or in
local tax bureaus that are willing to discuss this matter and getting the latter’s
informal opinions. One should query what assurance could be obtained from such
informal conversations about an ultra vires interpretive document. Moreover,
the question could be raised as to why tax advisors are acquiescing in such
an ill-considered - and illegal - government directive. Shouldn’t they,
as professionals, be openly objecting to the directive and preparing to offer
taxpayers assistance should the latter decide to challenge Circular 698?
Most Chinese tax advisors would dismiss this last suggestion. They subscribe
to the view - and advise clients accordingly - that Chinese tax officials are
all-powerful, and that in their experience few taxpayers are willing to enter
into dispute with a tax agency. Administrative or judicial appeals are simply
too costly and the outcome too uncertain. Moreover, given the general unwillingness
to challenge tax authorities, anyone daring to initiate such challenge risks
retaliation. While there is some truth to this view, it is not hard to see that
the view also has a flip side. It is in no small part because few people challenge
tax officials that the latter feel all-powerful. The SAT’s failure of
restraint in issuing Circular 698 is at least partly because the agency has
rarely had to face formal questioning as to the legality of its actions. Moreover,
many members of the Chinese tax profession - comprising both local firms and
international service providers - have devoted significant resources to cultivating
connections with tax officials. On the one hand, this is understandable, given
the often incomplete, arbitrary, and inconsistent character of Chinese tax
rules. On the other hand, in such an environment, service providers are competing
against one another on access to government officials, and advising and helping
clients to dispute the government’s positions would at best
be a different game, and at worst undermine one’s efforts in the competition
for access. In short, when the design of tax rules is removed from the realm
of law, service providers may survive; it is taxpayers who are stuck with recklessness
in government rulemaking, which, for the moment, seems to be spiraling out of
control.
1.
Guoshuihan [2009] 698 (State Administration of Taxation, Dec. 10, 2009, retroactively
effective Jan. 1, 2008).
2. Id., Art. 5.
3.
Id., Art. 6.
4.
See Enterprise Income Tax Law (10th Nat’l People’s Cong., Mar. 16,
2007, effective Jan. 1, 2008) [hereinafter EIT Law], Art. 3-4; Enterprise Income
Tax Law Implementation Regulations (promulgated by the State Council, Decree
No. 512, Dec. 6, 2007, effective Jan. 1, 2008) [hereinafter EITLIR], Art. 7(3)
and 91(1).
5.
This silence appears to be deliberate. The SAT has explicitly required withholding
of tax on dividends and interest paid to foreign holders of publicly traded
securities of Chinese companies. See, e.g. Guoshuihan [2009] 47 [Notice Regarding
the Withholding of Enterprise Income Tax with Respect to Dividends and Interest
Paid to QFII by Chinese Resident Enterprises] (SAT, Jan. 23, 2009).
6. See generally Law on Legislation (9th Nat’l People’s Cong., Mar.
15, 2000, effective Jul. 1, 2000).
7.
See Administrative Reconsideration Law (9th Nat’l People’s Cong.,
Apr. 29, 1999, effective Oct. 1, 1999), Art. 7; Fa [2004] 96 (Meeting Minutes
Regarding the Application of Legal Norms in Reviewing Administrative Cases(
Supreme People’s Court, May 18, 2004), Sections 1 and 2.
8.
EIT Law, Art. 2.
9.
EITLIR, Art. 7(3).
10.
Law on the Administration of Tax Collection (7th Nat’l People’s
Cong., Sep. 4, 1992, effective as amended May 1, 2001).
11. Id., Art. 4.
12.
See, e.g., Lawrence Sussman et al, “China's Controversial New Disclosure
Rule,” World Tax Daily, Dec. 18, 2009 (2009 WTD 241-1).
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