The Chinese laws and regulations in the cross-border context are intricate and in constant flux. Foreign companies must grapple with a multitude of tax issues in various phases of the investment cycle, and sometimes struggle for the answers. The complex nature of these issues requires specialised expertise to handle them effectively. Below are some of the Chinese tax challenges that MNCs commonly face.
Beneficial ownership
China has income tax treaties with close to 100 foreign countries and jurisdictions, providing substantial benefits by reducing the 10 percent withholding tax on China sourced passive income. To combat potential abuse of the treaty system, Chinese tax authorities have limited the extension of treaty benefits related to certain passive types of income to residents of a treaty jurisdiction that meet the beneficial ownership test. To access lower withholding rates under a treaty, a foreign recipient needs to demonstrate that it conducts substantive business activities in the residence treaty jurisdiction and possesses dominion control over the China-sourced passive incomes. In reality, the criteria for beneficial ownership are vague. The answers on treaty qualification are often painfully elusive.
Permanent establishment
A foreign person’s business profits can only be taxed in China to the extent that its activities in China rise to the level of a permanent establishment (PE) in the treaty context. The Chinese criteria of PE are expansive. Some examples of how a PE can arise in China include a fixed place of business, a construction site, a continuous presence of foreign personnel, or a dependent agent with contract execution authority on behalf of a non-resident. In recent years, Chinese tax authorities have intensified efforts to monitor activities of non-residents in China that may lead to PE creation, and have followed a substance-over-form doctrine in the examination. MNCs doing business in China need to be vigilant to avoid unintentionally creating taxable presence in China and subjecting offshore profits to PRC taxation.
Indirect transfer
China has a fairly singular indirect transfer rule. When a MNC disposes of a Chinese subsidiary by indirectly transferring the shares of a non-resident special purpose vehicle (SPV) that holds the ownership interest in the Chinese subsidiary, the MNC generally needs to report the indirect transfer to the local PRC in-charge tax bureau. If the local tax bureau decides that the interposition of the SPV lacks a legitimate business purpose, it could re-characterise the indirect transfer as a direct transfer of the Chinese subsidiary, and impose a 10 percent Chinese withholding tax on gains from the transaction. The Chinese tax authorities have regularly invoked the indirect transfer rules in cross-border tax enforcement. How to convince the Chinese tax bureaus that a certain offshore holding structure should be respected for tax purposes represents a major challenge for many MNCs.
Re-organisation
The Chinese tax re-organisation rule prescribes complete or partial tax deferral on gains realised in a tax re-organisation transaction that meets prescribed conditions. Tax re-organisations by MNCs usually face more stringent restrictions. Only three types of cross-border transactions are eligible for tax deferral treatment. In addition, the Chinese tax re-organisation rules just spell out the general taxation principle while leaving a number of operating details unaddressed. In most cases, government authorities other than tax bureaus need to be engaged to complete a restructuring transaction. MNCs often find little official guidance to facilitate the cooperation of the various government branches in different locations. As a result, significant hurdles exist for MNCs to carry out re-organisation and secure the desired tax deferral treatment in China.
Anti-avoidance
China has a general anti-avoidance rule (GAAR) that emphasises business purpose in recognising tax outcomes. A commercial arrangement must not have the elimination, reduction, or deferral of Chinese corporate income tax (CIT) as its main objective. Otherwise, the arrangement may be re-characterised for Chinese CIT purposes, and the intended tax result may be denied. The Chinese GAAR is loosely defined, and offers little explanation as to what a business purpose is. Due to its flexibility of interpretation, the GAAR has become a weapon of choice for Chinese tax authorities in tackling perceived tax abuses, especially in the international tax arena. This wide reach of the GAAR has generated a great deal of uncertainties on MNCs’ cross-border tax planning in China.
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