JanuaryFebruary 2012

An Update on General Anti-Tax Avoidance Rules in China

By Daniel K.C. Cheung

Introduction
The tax avoidance has been increasing for decades. This phenomenon is no exception in the Chinese tax regime. In January 2008, when launching the new corporate income tax reform, in addition to introducing specic anti-tax avoidance provisions such as controlled foreign corporation rules, cost sharing arrangement, and thin-capitalization rules, China also took the opportunity to introduce a whole new set of General Anti-Tax Avoidance Rules (GAAR) to its corporate income tax regime. Among the other things, the GAAR are aimed to attack those tax-driven scheme and blatant tax devices. Over the past three years, China has experienced a lot of challenge on how to administer the GAAR in terms of application and interpretation with an establishment of case decisions and practice guidelines. All these are extremely relevant to MNCs to better understanding their tax exposures when exercising their investment and exit strategies in the framework of mergers and acquisitions which involve the equity interests of Chinese entities. This article provides an update on the GAAR in China. It will rstly introduce the evolution of the GAAR in the corporate income tax regime in terms of laws and rules. Then, the article will analyze the signicance and application of the related circulars with an illustration to highlight the issue of indirect share transfer of equity interest in China. Detailed case analyses are included for a better understanding of the decision bases and implications. The article is concluded with practical advice.
Daniel K.C. Cheung is Associate Professor and Work-Integrated Education Coordinator at the School of Accounting and Finance at the Hong Kong Polytechnic University.

Evolution of GAAR in China

The GAAR were rstly introduced in the Corporate Income Tax (CIT) Law1 effective from January 1, 2008.

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Article 47 of the CIT Law states: Where an enterprise enters into other arrangements without reasonable business purposes causing a reduction of its taxable gross income or taxable income, the tax authorities shall have the discretion to make adjustments using appropriate methods. In other words, GAAR focus on tax adjustments on transactions without reasonable business purposes. Article 120 of the Implementation Rules of the Corporate Income Tax Law2 (IR) states: Business arrangements without bona de business purposes as cited in Article 47 of the CIT Law refer to arrangements whose primary purpose is to reduce, avoid or defer tax payments. The CIT Law, together with its implementation rules, provides a framework and general principles for an anti-avoidance regime. In addition to the general tax avoidance arrangement, the CIT Law and IR contain various specic anti-tax avoidance provisions concerning transfer pricing, controlled foreign corporations and thin-capitalization, all of which empower the State Administration of Taxation (SAT) to make income tax adjustments and impose interest surcharges on taxpayers. It appears that the SATs main purpose for introducing the GAAR in the CIT Law and IR is to prevent taxpayers from using abusive or illegal mechanisms or structures with the intent to avoid, reduce or defer the timing of paying taxes in China. On January 8, 2009, the SAT issued Circular 23; Chapter 10 of Circular 2 provides the basic framework for implementing GAAR principles. First, Article 92 states that the tax authorities may initiate a GAAR investigation into enterprises with tax-avoidance arrangements, such as schemes to manipulate organizational structures, in abuse of preferential tax treatment, and unjustiable involvement of tax haven companies without reasonable business purposes. Second, Article 93 states that during the anti-tax avoidance investigations, the tax authorities shall evaluate whether an enterprise is involved in a tax-avoidance arrangement based on the principle of substance over form. Finally, Article 94 allows the tax authorities to review and remodel or re-characterize the tax avoidance arrangement of an enterprise according to its genuine economic substance and to nullify the tax benets it has previously obtained from such an arrangement. With the implementation of the above regulations, the Chinese tax authorities are empowered (1) to consider what elements could constitute and justify the interpretation of the term without reasonable business purpose, and (2) to apply the substance over form principle.4 For example, if the SAT considers that the enterprises set up as offshore holding company by the taxpayer lacks business substance, especially those in tax haven countries, it will disregard the existence of such enterprises for corporate income tax purposes. However, the GAAR are new, vaguely drafted and untested, and the most effective defense is the proof of a valid business purposes. Thus, the SAT must review all factors using a holistic approach to decide whether an arrangement is without a reasonable business purposes. The determination of attacking tax-motivated arrangements can be reected in the special seminar of the SAT on March 31, 2009, where it emphasized that (1) transactions involved in general anti-avoidance adjustments should be re-characterized, (2) tax benets that accrue because of tax-avoidance should be annulled, and (3) the existence of tax-avoidance entities (especially shell companies) should be denied. In Guoshuifa [2009] No. 114 (July 27, 2009) Detailed Measures on Further Strengthening Tax Collection and Administration, the SAT also mentioned its focus on investigating the transfer of domestic equity interests between nonresident enterprises to prevent abuse of legal forms, tax havens and tax treaties. This is the foundation of attacking indirect transfer of equity interests in Chinese entities.

Chongqing Case Doubts on Its Legal Basis

In 2008, the Chongqing tax bureau imposed taxes on gains a Singaporean seller derived from the indirect transfer of a Chinese resident company by selling a Singapore intermediary holding company. In the instant case, the Singaporean seller held its wholly owned subsidiary in Singapore, which in turn had an equity interest of 31.6 percent in a Chinese joint venture. Instead of transferring the equity interest in the Chinese joint venture from the intermediary holding company, the parent company sold its whole interest in the intermediary holding company to the buyer which was another company in China. As all transactions were completed outside China, the gains arising from the disposal of the equity capital of the Singaporean intermediary holding company should be regarded as having a source outside of China thus not taxable in China and subject to a withholding tax (WHT) of 10 percent on the gains. It must be noted that this ruling was not based on the new CIT Law, and did not focus on its GAAR because the transaction took place before January 2008. Thus, tax practitioners are doubtful whether there is any

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legal basis to form the decision to tax the gains. Although there was little information about the case, tax practitioners were speculating about whether the Chinese tax authority would formally adopt this position in similar transactions because in 2008 the application of GAAR in the CIT Law was not yet known. But the issuance of Guoshuihan [2009] No. 698 (Circular 698)5 in December 2009 laid such speculation to rest. In the Chongqing case, the taxpayer argued that gain on transfer of shares in a nonresident company should not be subject to corporate income tax in China if it was a genuine and legal transaction. On the other hand, the tax authority was of the view that the related gains should be regarded as sourced from China as there was no documentary evidence to prove that the Singapore intermediary holding company (a special purpose vehicle)s management was located outside Chinathus, the transaction in substance was to transfer interest in a Chinese company. In making such decision, one has to look at the functions of an offshore special purpose vehicle (SPV) in the international tax planning regime. In general, a SPV can be used as intermediate holding company of MNCs and investment funds for income tax, operational or other reasons. From income tax perspective, the offshore SPV could enjoy the applicable tax treaty benets such as reduced rate on dividend, interest and royalty payment or capital gain tax exemption on transfer of shares. Another reason is to facilitate the future exit strategy through transfer of shares in the offshore SPV without triggering any taxes in the country where the investment is located. This is the key point the seller in the Chongqing case wants to rely on. In most cases, the transfer of shares in the offshore SPV will not trigger any taxes in such offshore country. In the Chongqing case (see above), the Chinese local tax bureau disregarded the SPV on the ground that the SPV had no substance and the purpose of interposing and disposing such SPV was solely for China tax avoidance. Though the case concluded with WHT being collected over the equity transfer gains, no strong legal precedence may be taken from the ruling.

Highlights of Circular 698

The major implications of Circular 698 include the following: Where a foreign investor indirectly transfers equity interests in a Chinese resident enterprise by selling the shares in an offshore holding company (namely the SPV), and the latter is located in a country (jurisdiction) where the effective tax burden is less than 12.5 percent or where the offshore income of its residents is not taxable, the foreign investors shall provide the tax authority in charge of that Chinese resident enterprise with the relevant information within 30 days of the share transfer. The requisite documents and information may include the equity transfer contract/agreement, documents showing the relationship, operation of the SPV being transferred, written explanation of the reasonable business purpose of the foreign investor in setting up the SPV being transferred and other information as requested, etc. Where a foreign investor indirectly transfers equity interests in a Chinese resident enterprise through the abuse of form of organization, etc., and there are no reasonable business purposes such that the CIT liability is avoided, the tax authorities shall have the power to re-characterize the nature of the equity transfer in accordance with the substance-over-form principle and deny the existence of the offshore holding company that is used for tax planning purposes. Once the SPV is disregarded, the transfer should be effectively treated as a nonresident enterprise (NTRE) transferring the Chinese investee companys equity, and thus the transfer gain is of China source which should be subject to China WHT of 10 percent (depending on double taxation agreement if applicable). Circular 698 stipulates a very tight timetable to fulll the withholding and compliance requirements as it requires a foreign company to pay the taxes due within seven days from the equity transfer day, or the receipt of the total transfer of

The Signicance and Application of Circular 698

On December 10, 2009, the SAT issued Circular 698, which indicates that overseas investors of an indirect offshore disposal undertaken outside of China may have the reporting requirements to the SAT and may be subject to taxes in China if the SAT considers that such arrangement lacks a reasonable business purpose (i.e., fall within the scope of anti-tax avoidance scenarios mentioned in Circular 2). Circular 698, effective retroactively to January 1, 2008, is to counter and counteract avoidance of China tax gains derived from indirect transfer of Chinese companies equity via disposing the equity of the SPV offshore in China.

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consideration if the withholding agent fails to le and remit the CIT liabilities. The taxing right is back to China and double taxation might occur among the jurisdictions of the NTRE, the SPV and the transferee. Income derived from equity transfers as mentioned in the circular refers to income derived by non-resident enterprises from direct or indirect transfers of equity interests in Chinese resident enterprises, excluding shares in Chinese resident enterprises that are bought and sold openly on stock exchanges. equity capital of the PRC company. It is obvious that the Cayman SPV is not subject to tax in the Cayman Islands. The critical factors that the SAT will look at are: what business activities (e.g., management functions exercised) were carried out in Hong Kong, whether the directors are located in Hong Kong and board meetings were held in Hong Kong, whether directors exercised control and supervision over the investment in China, whether services were outsourced to related companies in Hong Kong, whether there were no employees in Hong Kong as well as whether the HK SPV was appropriately capitalized. If the holistic view of these factors is not in the taxpayers favor, then the gain arising from the disposal of either the BVI SPV or HK SPV might probably attract the attention of the Chinese tax authorities. Following the Circular 698, the tax authorities may ignore the existence of such SPVs and tax the gains from the indirect disposal of the equity interest in the PRC company if the transactions are arranged without reasonable business purpose.

Navigating Indirect Disposals Under Circular 698

As said, Circular 698 deals with indirect offshore share disposals undertaken by investors. Such offshore disposals of Chinese companies may be required to be disclosed to Chinese local in-charge tax authorities (namely reporting of offshore disposals), and may potentially be subject to China taxation where they are considered to be motivated by tax-avoidance purposes (namely substantiation of reasonable business purposes). Regarding these two requirements, the following investors may be affected: Sellers who have previously undertaken an offshore indirect transfer of offshore holding companies after January 1, 2008 Investors who currently hold China investments through offshore holding companies Investors intending to acquire or establish Chinese companies in future Investors in pre-IPO offshore structures Along with Circular 698, the implications of offshore disposals to reportable transactions mean that the local tax authorities can, upon the SATs approval, apply the GAAR provisions to re-characterize offshore indirect disposition as an direct disposition of China companies where it is concluded that the structure has no reasonable business purpose, an abusive use of organizational form or the result of deriving a tax benet as its primary objective. The outcome effectively ignores the existence of offshore holding companies. Therefore, the seller deemed to have derived a China sourced capital gain and subject to taxation accordingly. Indeed what factors the SAT would look through an offshore disposal are critical to an investor. For example, Cayman SPV owns a PRC company in China via two intermediary holding companies, say a BVI SPV (second-tier level) and a HK SPV (rst-tier level), which owns the whole

Illustration of Circular 698

Co. A is an investing group based in the UK. One of its strategic investments is to hold a 75-percent interest in an equitable joint venture (EJV) (a motor vehicle manufacturing company) in Shanghai via its intermediary holding company in the BVI. The structure is shown in Diagram 1. Over the past two years, the automobile industry has been well developed in China, but the technology of the EJV has to be quickly developed and enhanced in order to maintain the keen competitiveness of its products in the ever-growing car market in China. Recently, the management of Co. A was approached by a French company, Co. B, to solicit a sale and purchase deal of the EJV at a very good price. The managing director of Co. A, Raymond Chan, is seeking advices on the following two aspects: 1. Raymond wants to dispose the investing groups 75-percent interest in the EJV between the BVI holding company with Co. B directly. In doing so, though the BVI holding company is a nonresident enterprise, he is afraid that the gain arising from the disposal of the interest will be liable to China corporate income tax. Therefore, he suggests concluding the deal between Co. A and Co. B to transfer of the BVI holding companys shares to Co. B instead of the interest in the EJV. According to this arrangement, the investing groups 75-percent interest in the EJV can be indirectly sold to Co. B. However,

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this time he does not know whether the gain arising from transaction may trigger any exposure to China corporate income tax because the subject shares are related to the nonresident BVI holding company thus, the gains should be sourced outside China. 2. If the indirect disposal of the shares in the BVI holding company is potentially liable to China corporate income tax in (1) above, are there any possible defensive strategies to combat these attacks from the China tax authorities. What are the valid arguments? Under Circular 698, the overseas investors are required to report the transaction to the local tax bureau in-charge if the transaction meets either of the following requirements: If the tax jurisdiction of the holding company (i.e., Offshore SPV) has an effective tax rate of less than 12.5 percent; or If such tax jurisdiction exempts the holding company (i.e., Offshore SPV) from income tax on its income derived from overseas. The above overseas investors are required to report the transactions and submit the following documents within 30 days from the signed date of share transfer agreement: Share transfer agreement or contract Description of relationship between overseas investors and holding company (i.e., Offshore SPV) with regard to capital funding, operations, sales and purchases, etc. Information related to holding company including its operations, employees, bookkeeping and assets, etc. Written explanation of the reasonable business purposes of setting up Offshore SPV as holding company of PRC company Other information requested by the local tax bureau in-charge Based on the information provided, the local tax bureau in-charge will review the transaction based on the principle of substance over form to assess whether the indirect offshore disposal is executed through an abusive arrangement set up by the overseas investors to avoid paying taxes in China. The local tax bureau in-charge is required to report its views to the SAT for verication. If the SAT and the local tax bureau in-charge conclude that the arrangement is set up without reasonable business purposes, they may seek to apply GAAR to challenge the indirect offshore disposal by disregarding the existence of the Offshore SPV, which means that the overseas investors had disposed the shares of the PRC company. If this is the case, the local tax bureau in-charge will treat the realized capital gain arising from the indirect offshore disposal as PRC-sourced income and thus the overseas investors would be subject to 10-percent WHT in China. (Note: Whether the Diagram 1. Transfer of the BVI Holding Companys Shares rate is 10 percent is uncertain from Co. A to Co. B because it is uncertain whether Tr Transfer of SAT accepts reduced rate if the Sh Shares Co. A treaty between China and the Co. B (UK) (France) country where the overseas investor is located provides such benet.) In this Illustration, sal Indirect offshore disposal the tax authorities, pursuant to Circular 698, might challenge BVI holding this structural arrangement company with the BVI interposing SPV. If successful, the gain from the Overseas disposal of the BVI company is subject to tax in China.6 As PRC 75% Chinese partner regards the second question in the Illustration on any possible defensive strategies to combat 25% these attacks from the China EJV tax authorities, it is necessary to look at the issue of business purposes (see below).

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How to Substantiate Business Purposes

To defend the attack from the Circular 698 and the GAAR, taxpayers might consider the following related possible business reasons for SPV structures. For example, rst they may argue that investment funds can source nancing from investors from different countries. A SPV is able to group these investors for specic investment targets. This is particularly popular for nancial investors (compared to industrial companies). Second, they may argue that SPV (single or multiple) structures are there to facilitate the introduction of new partners, pooling investor interests together through a common investor vehicle, different levels of debt/equity nancing/bankruptcy remoteness, etc.thus easy access to funding and less complicated administrative procedure, asset segregation / greater legal protection, and preparing for an initial public offering. Finally, the taxpayer may ensure that funds have substantial operations, but may not reect in a particular SPV. In summary, a good defensive strategy must have the relevant merits for defending the GAAR, such as (1) reasonable business purposes of the offshore company, (2) substance of the offshore company, e.g., its competent management team which may serve the business of the group, and (3) other message delivered from the meeting, e.g., the management function at SPV (e.g., owned by the offshore company) level, management controls and costs. For example, the taxpayers may argue that they are more familiar with the legal system and compliance requirements of such chosen country and such country offers greater protection for their assets, easy access to funding and less complicated administrative procedure. Whether these factors can be accepted by the SAT as a reasonable business purpose is still unknown and in fact each case or transaction will have its own facts and circumstances. Therefore, the likelihood for the SAT to accept the above reasons in the application of Circular 698 and GAAR may vary in practice or in various locations on case by case basis. However, where the offshore holding company is set up in tax haven country and does not have any economic substance, the risk of being challenged by the SAT and chance the SAT will apply GAAR is very high if the overseas investors are unable to provide supports with regards to business reasons.7

doing business in China. For example, the following questions are worth asking. How to determine capital gain where PRC tax authorities apply a look through approach? What is the cost base for capital gains tax purposes? Are there nes / penalties for failing to report to the tax authorities? Will tax authorities apply the Tax Collection and Administration Law of the PRC? Are PRC subsidiaries subject to penalties and tax liabilities of the foreign investor seller? So from foreign investors perspective, what do these new requirements mean for them? Practically speaking, they should consider: increased monitoring on cross-border transactions by PRC tax authorities; greater compliance burden on reporting or disclosures; need to focus on and document business substance and reasonable business purposes when setting up and implementing investment holding structures and on investment exit; need to assess potential exposures and consider how the investment structure can be strengthened to mitigate potential challenges; and signicant uncertainties on how the rules (in particular Circular 698) would be interpreted and enforced in the context of GAAR (see the Chongqing case was before January 1, 2008).

Recent Developments for the Circular 698 and Interpretations and Clarications
On March 28, 2011, the SAT released the Bulletin 248 to clarify Circular 698 and certain other tax issues related to NTREs. Although Bulletin 24 only became effective on April 1, 2011, it is set to have retroactive effect to determine the tax treatment of any transaction that occurred after January 1, 2008, and before April 1, 2011, unless the tax authorities have already ruled on the transaction. If an NTRE directly transfers the shares of a Chinese enterprise and receives payment in installments, the NTRE must recognize the entire amount of the capital gain when the relevant contract becomes effective and the share transfer registration procedures have been completed. Bulletin 24 denes foreign investors (actual controlling party) for indirect transfers of Chinese subsidiaries under the Articles 5, 6, and 8 of Circular 698 to include all the investors that indirectly transfer the shares of the Chinese enterprise Under

Uncertainties of Circular 698

The spirit and the defensive strategies of the Circular 698 may not resolve all uncertainties to investors

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Circular 698, reporting obligations will arise if either of the following conditions is met: (1) The actual tax burden in the jurisdiction of the target company (i.e., the intermediate holding entity to be transferred) is lower than 12.5 percent; or (2) The jurisdiction of the target company does not tax its residents on foreignsourced income. Bulletin 24 has put a new spin on these conditions by further dening the terms actual tax burden and does not tax. Now, after Bulletin 24, the conditions triggering a reporting obligation under Circular 698 should be interpreted to be: the actual tax burden on capital gains in the jurisdiction of the target company (i.e., the intermediate holding entity to be transferred) is lower than 12.5 percent; or the jurisdiction of the target company does not tax its residents on foreign-sourced capital gains. In addition, Bulletin 24 states that when two or more foreign investors indirectly transfer shares of a Chinese enterprise at the same time, they can entrust one of the foreign investors to report the transfer to the competent tax authorities where the transferred Chinese enterprise is located.9 state tax bureau of Jiangdu city (Jiangdu STB) became aware of the intended disposal of the Hong Kong subsidiary by the overseas investor and thus a team of experts was set up to monitor the proposed transaction. On January 14, 2010, the Jiangdu STB, from the buyers website, learnt an announcement that the overseas investor, i.e., the U.S. Group disposed of the PRC equity through an indirect transfer by the offshore intermediate company of 100 percent of the shares of the Hong Kong subsidiary to a U.S. listed group (U.S. investor) at a capital gain of USD254 million (approximately RMB1,730 million). Although the disposal was between two nonresident companies and involved a nonresident company, the Chinese tax authorities imposed tax of RMB173 million on the gain realized by the sellers on the disposal (tax return led on April 29, 2010, and tax duly paid on May 18, 2010). In assessing the transfer to tax under the Circular 698, the tax authority determined that the Hong Kong subsidiary did not have any economic substance, as it had no employees, assets (other than the JV interest), liabilities or operations other than the investment in the JV. After reviewing the transaction, the tax authorities re-characterized the transaction under the GAAR in order to assess the gain on disposal of this indirect share transfer to tax in China. The tax authorities disregarded the existence of the Hong Kong subsidiary and treated the prots on sale as being sourced in China and imposed WHT on the gain. The sellers argument that the transaction took place outside China was apparently not accepted. The Jiangdu case appears to be an inuential precedent case for attacking indirect transfer of shares in China in the tax planning regime. However, it is expected that much of the controversy surrounding the Circular 698 will come from the fact that the broad language of the Circular 698 may give rise lot of room for interpretation. For example, whether the PRC tax authorities will allow access to a relevant treaty once an offshore transaction is recharacterized into an onshore transaction. Another grey area is that the Circular 698 does not dene the meaning of and operation how to re-characterize the transfer of its shares as a direct transfer of the shares of the underlying Chinese company where the foreign investor has avoided taxation in China through the abuse of organizational form and without a reasonable business purpose. Although there are many grey areas under Circular 698 as discussed above, the issue that gives rise to most concerns might be the interpretation of reasonable business purposes.10

Case Development After the Circular 698

Jiangdu Case
The China Taxation News, on June 6, 2010, reported the collection of WHT of RMB173 million by the Jiangsu tax authority on a capital gain arising from an indirect transfer of a 49-percent equity interest in Chinese company (actually a Joint Venture (JV)) in Jiangdu (administratively part of Yangzhou), Jiangsu Province. This is the rst publicly reported case since the SAT announced the Circular 698 involving the look-through of certain intermediary entities considered as being established for tax avoidance purposes and lacked business substance and commercial activities. From the published information, it stated that a company established in an offshore jurisdiction by a U.S. investment group (overseas investor), a private equity fund, holds 49 percent of the equity of a Chinese company in Yangzhou, a city in Jiangsu province, via its wholly-owned subsidiary in Hong Kong. The Hong Kong subsidiary and the offshore intermediate company have no operation/economic substance, i.e., no ofce, staff, assets and liabilities other than the investment in the Chinese company. Actually, at the beginning of January 2009, the local

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Henan Case
In August 2010, the local tax authorities in Henan Province initiated an investigation against a U.S.based investment bank. The investigation also involves capital gains tax relating to transfers of shares in nonresident companies that in turn held, directly or indirectly, shares of a Chinese publicly listed company. Compared with the Jiangdu case, the factual background and holding structure of the Henan case is far more complicated. Moreover, a greater number of parties are involved at different layers of the holding structure, and the potential tax exposure may be even higher than in the Jiangdu case. The indirect transfer of equity of the Chinese company was achieved by a series of offshore restructuring and transfers, some of which occurred before January 1, 2008, i.e., before the new CIT Law and its anti-avoidance rules took effect [Circular 698 also took effect retrospectively on January 1, 2008]. Therefore, the timing of the transfers also adds to the uncertainty about the outcome of this investigation. The Henan case is still under investigation and the tax authorities have not issued any decision. Tax practitioners are paying attention to the outcome of the nal ruling.

Circular 698, the offshore transfer of BVI Subsidiary (second tier) should be deemed as a direct transfer of Shantou Company. Therefore, the offshore transfer should be subject to PRC capital gains tax. The result was that BVI Seller paid a capital gain tax of RMB7.2 million (approximately USD1.1 million) to the SMSTB at the end of March 2011. Substantively, however, the Shantou case adds little to the understanding of Circular 698 because the facts of the case were indisputable that all the intermediate holding companies were SPVs with presumably little reasonable business purpose outside of avoiding tax on the capital gains.11 It is generally agreed that this case provides little insight into the more difcult questions raised by Circular 698, such as what constitutes a reasonable business purpose and what is the relationship between reasonable business purpose and economic substance. It is also observed that as the Shantou case was decided before Bulletin 24, it is of no help in interpreting its effect on the reporting obligations under Circular 698 that have been repeatedly addressed. Finally, this case is particularly interesting because the foreign seller was four tiers above the Chinese subsidiary and yet, was still caught by the Chinese tax authorities.

Shantou Case
In November 2010, the Shantou Municipal State Tax Bureau (SMSTB) started an investigation of a suspected Circular 698 case. Based on publicly available information from the Internet describing an offshore transaction involving a Shantou operating company, the tax authorities were committed to attack this avoidance scheme. According to unofcial information, it disclosed that the investigation revealed that a BVI company being a seller, sold a wholly owned BVI subsidiary which in turn also held another lower tier BVI subsidiary and a Hong Kong company which then owned a Shantou company, to another BVI company being a buyer. The ownership structure showed the following chain: namely Seller in BVI BVI Subsidiary (second tier) BVI Subsidiary (rst tier) HK Co. Shantou Company. In the case, the BVI Seller made the transfer of shares in BVI Subsidiary (second tier) to the BVI Buyer. It was also known that the BVI Buyer is owned by a Hong Kong listing company. Indeed all companies are within the same group. In its ruling, the SMSTB concluded that the existence and use of all of BVI subsidiaries and the Hong Kong company absolutely lacked a reasonable business purpose and by virtue of the GAAR and the

Guizhou Case
Following Circular 698, in August 2011, the Guizhou Provincial State Tax Bureau (GPSTB) collected RMB31.5 million of CIT on the transfer of a BVI company indirectly holding an equity interest in a company established in Guiyang City, Guizhou Province. The BVI company had a business registration in Hong Kong and had claimed that it was a tax resident of Hong Kong in order to obtain the vepercent reduced WHT rate on dividends from the Guiyang company under the double tax arrangement between Hong Kong and the Mainland of China. This was done on the basis that its place of effective management was in Hong Kong. The ownership chain is: Hong Kong parent owns another Hong Kong company which in turn owns the BVI company, the subject shares of which were transferred in this case. Correspondingly the BVI company owns 80 percent of equity capital of the Guiyang company. In the course of a tax assessment against the Guiyang company in late 2010, the tax ofcials discovered that the BVI company was transferred in the early part of 2010 at a price of about RMB800 million with a capital gain of about RMB300 million. After investigation, the GPSTB determined that the BVI company had no

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economic substance in the BVIthe jurisdiction of incorporation (but not in Hong Kong)thus it was a shell company. It levied CIT of RMB31.5 million on the indirect transfer of the equity interest in the Guiyang company pursuant to Circular 698. In this case, it is unclear from the report whether the BVI company had economic substance in Hong Kong. If the BVI company had sufcient economic substance in Hong Kong to be treated as the benecial owner of the dividend income, it is unclear why the tax bureau chose to ignore the companys presence and substance in Hong Kong in the context of the Circular 698 case.12 ferring the timing of paying taxes in China. Therefore, if the taxpayers would like to demonstrate that the structures are established with reasonable business purposes in accordance to the anti-tax avoidance provision under CIT Law and IR, they must at least prove to the SAT that the primary reason for setting up the offshore structures is commercial or business related, instead of tax-driven.13 The key is business substance, and actions are always better words. The business and structural reasons behind the indirect equity transfer must be substantiated and justied to the Chinese tax authorities as reasonable business purposes of the transfer. Despite the case decisions on the application of the Circular 698, there are still many uncertainties from a practical perspective; for example, whether capital gains arising from the indirect share transfer of a Chinese entity by a nonresident individual shall be subject to individual income tax in the domain of GAAR.14 Even at the corporate level, it is questionable if both gains and losses on the indirect share transfers of different equity interests for a whole investment project can be set off. Another uncertainty comes from the application for special reorganization of mergers and acquisitionsthat is whether the Circular 698 can override the agreed special tax treatment as laid down in Caishui [2009] No. 5915 and attack the at cost transactions. Anti-tax avoidance works are like a cat and a mouse game. The extent of greed of a taxpayer must be inversely commensurate with the level of efforts and resources the SAT has put. It is hoped that more objective bases and grounds of applying the Circular 698 can be publicly disclosed so that investors may have a better understanding of their tax position in structuring their transactions involving the interests of Chinese entities.

Concluding Remarks
Based on the above discussion, MNCs when making investments in China, must be alert of the potential attack on taxing the gain on disposal of indirect transfer of equity interests in overall merger and acquisition strategies. Chinese tax authorities are taking an active approach rather than merely relying on NTRE investors to voluntary report the case. Taxpayers must understand that not reporting does not mean no GAAR. Based on the interpretation of Circular 2 and Circular 698, one of the key factors the SAT will apply GAAR is based on whether the taxpayers can demonstrate the reasonable business purposes for setting up the offshore structures. However, the SAT has not issued further guidance or interpretation notes to elaborate the denition of reasonable business purposes and it makes the assessment on each case becomes subjective. On the other hand, transaction without reasonable business purposes has been dened in the CIT Law and IR as transactions which have the primary purpose of reducing, avoiding or de-

ENDNOTES
1

China Corporate Income Tax Law was passed at the 5th Session of the 10th NPC on March 16, 2007, and took effect on January 1, 2008. The Implementation Rules of the China Corporate Income Tax Law was issued through the State Councils Decree No. 512 in 2007, and took effect on January 1, 2008. Guoshuifa [2009] No. 2 Implementation Measures for Special Tax Adjustments (Trial), Jan. 8, 2009, released by SAT on January 9, 2009, with retrospective effect from January 1, 2008. Danny Po, et. al., The Tax Implications of Mergers and Acquisitions and Corporate Restructuring in China, ASIA-PACIFIC J. TAXN,

7 8

Spring-Summer 2010, at 43-54. Guoshuihan [2009] No. 698 (Dec. 10, 2009) Strengthening of Administration of Corporate Income Tax Liability on Income of Non-resident Enterprises from Transfer of Equity Interests. Karmen Yeung, et. al., Recent Development in the General Anti-tax Avoidance Rules in China and Future Impacts on and Challenges for Offshore Investment Structuring, ASIA-PACIFIC J. TAXN, Spring-Summer 2010, at 55-61. See note 6. SAT Bulletin [2011] No. 24 Concerning Certain Issues Related to Taxation of Non-resident Enterprises (Mar. 28, 2011). The full text

10

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of Bulletin 24 is available at www.gzds.gov. cn/xwzx/zxfg/201104/t20110414_808178. htm (in Chinese). Baker & McKenzie, Recent Developments for Notice 698, CHINA TAX MONTHLY, Apr. 2011, at 1-3. Baker & McKenzie, Tax Disputes Gradually Becoming a Reality in China, CLIENT ALERT, Apr. 2011, at 5-6. See note 9. Baker & McKenzie, Recent Developments for Notice 698, CHINA TAX MONTHLY, Apr. 2011, at 3-5. According to the news report in the China Taxation News (Reported on China Taxation News on May 11, 2011 (www.ctaxnews.net.cn/ html/2011-05/11/nbs.D340100zgswb_01.

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An Update on General Anti-Tax Avoidance Rules in China ENDNOTES

htm)), the SMSTB relied on the following key factors for imposing tax on the offshore transfer: (1) neither BVI nor Hong Kong taxes its residents on foreign-sourced income; (2) all BVI subsidiaries and Hong Kong company are all SPVs that do not have any other business or investments except the investment in Shantou company; and (3) the two BVI subsidiaries were both newly established in July 2009 and could not provide any evidence to show a reasonable business purpose. Baker & McKenzie, Guizhou Case on Taxation of Indirect Equity Transfer, CHINA TAX MONTHLY, Aug. & Sept. 2011, at 1-2.
13 14

12

See note 6. Baker & McKenzie, Individual Income Tax: Capital Gain from Indirect Share Transfer, CHINA TAX MONTHLY, June 2011, at 4-5. In June 2011, the rst case in which a local tax bureau imposed individual income tax (IIT) on capital gains derived by a Hong Kong individual from the indirect share transfer of a Chinese entity became publicly available. A local tax bureau in Shenzhen successfully attacked an indirect share transfer of a Chinese entity carried out by a Hong Kong individual transferor and collected IIT in an amount of RMB13.68 million. The Hong Kong indi-

15

vidual had transferred his shares in a Hong Kong company which in turn was the sole shareholder of a Shenzhen logistics company, a wholly foreign owned enterprise, to a Singapore company in return for more than RMB200 million. On April 30, 2009, the Ministry of Finance and the SAT promulgated Caishui [2009] No. 59 Circular on Several Issues on Corporate Income Tax Treatment for Corporate Restructuring Transactions, retroactive effect from January 1, 2008. See Daniel Cheung, Tax Implications of Recent Merger and Acquisition Rules in China, INTL TAX J., MayJune 2011, at 43-51.

Sovereign Wealth Funds

Continued from page 8

provide an independent, wholesale exemption for the disposition of partnership interests,33 they treat the ownership of an interest in a partnership that qualies for the trading exception as not commercial in nature, suggesting a look-through approach. A consistent (and logical) approach would treat the gain on the sale of a partnership interest as exempt under Code Sec. 892 to the extent that a sale of the exempt partners portion of the assets (if held directly by the foreign government) would be exempt. Additionally, because there is ambiguity under Code Sec. 897(g) as to when a partnership interest is itself considered a USRPI, Treasury shouldat the very leastclarify the common sense conclusion in the example above that the sale of an interest in a partnership that holds only noncontrolled USRPHC stock (determined by looking to the portion indirectly owned by a foreign government) would be exempt under Code Sec. 892.34

Deemed CCE Rule

As discussed above, the Deemed CCE Rule treats a controlled en-

tity as a CCE if the entity would be considered a USRPHC if it were a U.S. corporation. 35 The Deemed CCE Rule thus treats a foreign controlled entity that holds USRPIs (including stock in USRPHCs) as a CCE if the USRPIs constitute more than 50 percent of the entitys assets.36 The Deemed CCE Rule, which would prevent any of the controlled entitys income from being exempt under Code Sec. 892, is inconsistent with the general treatment of foreign governments ownership of USRPIs under Code Sec. 892. In particular, under the Deemed CCE Rule, a controlled entity that owns less than 50 percent of the stock of a USRPHC and does not have enough other good assets to offset the USPRHC stock would not be eligible for exemption under Code Sec. 892, regardless of how much actual U.S. real property it actually holds. However, if the foreign government held the USPRHC stock directly, through an integral part, or through a noncontrolled entity, the foreign government would not be subject to gain on the sale of USPRHC stock.37 Additionally, the Proposed Regulations clarify that a controlled entity is not considered engaged in commercial

activities by virtue of disposing of USRPIs, 38 so it makes little sense that a controlled entity may dispose of USRPIs without being engaged in commercial activities, but it cannot also hold USRPIs without fear of triggering the Deemed CCE Rule. Furthermore, this rule is relatively easy to avoid by internal re-structuring, so it only becomes a nuisance or, worse, a trap for the unwary. Not only is the Deemed CCE Rule confusing and inconsistent with the other provisions in the Temporary and Proposed Regulations, it can also lead to inefficient structuring mechanisms to avoid its application.

Conclusions
The Proposed Regulations offer some comfort to foreign governments and their 100-percent controlled entities, and it is hoped that these clarications and modications are ultimately incorporated into the nal regulations. But the job of providing guidance under Code Sec. 892, and further clarifying or removing some of the strict, confusing, and arbitrary rules still lurking in the Temporary Regulations, should continue.

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