Circular 698. Or How China's Tax Authorities Are Plotting To Take Over The World.
Shanghaiist just posted my list of "China’s top 5 business law trends of 2010," which list included China stepping up its tax collection efforts. Drastically.
Speaking of drastically, I just read a really excellent article by a swarm of O'Melveny & Myers lawyers, entitled, "China Adopts Controversial Vodafone-style Extraterritorial Tax and Disclosure Rule," discussing China's just circulated Circular 698. The O'Melveny article summarizes an "amazing" part of that circular as follows:
However, Article 5 of Circular 698 then takes an amazing leap. It [Article 5 of Circular 698] states that foreign entities are required to disclose all indirect transfers of PRC resident enterprises to the PRC tax authorities in cases where an intermediate holding company through which such transfers are made are located in a low tax jurisdiction or such jurisdiction exempts income tax on foreign-sourced income. In this case, the foreign enterprise making the indirect transfer must disclose the following documentation to the PRC tax authority in the location of the PRC resident enterprise within 30 days of executing the transfer contract:i. Equity transfer agreement/contract;
ii. Representations regarding the relationship between the foreign entity and holding company being transferred in terms of “capital, operation, sales and purchase etc.”;
iii. Representation regarding the operation, employees, bookkeeping, and assets of the holding company being transferred by the ultimate foreign entity;
iv. Representations regarding the relationship between the holding company being transferred by the ultimate foreign entity and the PRC resident enterprise, in terms of “capital, operation, sales and purchases;”
v. Representations regarding the reasonable business purpose with respect to the transfer of the holding company; and
vi. Other materials requested by the tax authority.
The article then very nicely lays out some truly extreme examples of where foreign companies may be required to report to China on their foreign M&A activity and then asks the following series of questions relating to whether the circular is "even legal:"
(1) Is there a legal basis under any validly promulgated PRC law or administrative regulation which imposes information reporting obligations and tax with respect to such indirect transferors? How does an interpretive circular like 698 derive its PRC legal authority?(2) Does the PRC general anti-abuse rule (“GAAR”) in the EIT grant virtually unlimited power to the PRC tax authorities concerning transactions, including matters of extraterritorial jurisdiction? How does one sentence in a quasi-civil law statute encapsulate an entire doctrine?
(3) Is there a colorable theory under international legal principles to assert extraterritorial jurisdiction over the numerous parties potentially described in Circular 698?
(4) Will the enormous administrative complexities and burdens created by the disclosure mean erratic compliance and result in grossly unfair application of the rule? Can most foreign entities comply?
(5) Will local PRC tax bureaus be staffed with the resources, training, and other administrative infrastructure to deal with those disclosure actually submitted?
This circular is so far out of the norm and so likely to cause an uproar I suspect much of it will never come to pass. No matter what though, it is a great indicator of China's strong desire to increase its taxing powers, especially with respect to foreign companies.
For more on Circular 698, check out the following:
-- Detailed Analysis of of Circular 698, on the China Tax Insights Blog.
-- "China Reinforces Tax Administration of Share Transfers by Non-resident Enterprises," by the Mayer Brown law firm.
-- Tax Alerts by PriceWaterhouse and Deloitte.
UPDATE: China Tax Insight just did a new post on Circular 698, entitled, "One Last Post on Circular 698," taking Deloitte to task for saying "Circular 698 creates some legal questions as to whether the Chinese government has the right to tax foreign companies."
Comments (10)
Read through and enter the discussion by using the form at the endMatthew - December 31, 2009 2:53 AM
Dan,
Its a well written article by the OMM crew. Although, I think some of their pronuncements are slightly strong. The scenarios they pose may require documentation disclosure (which is a pain in itself) but it is doubtful that they would lead to a tax liability as there would seem to be a reasonable business purpose for the arrangements.
Im not sure I agree that the SAT will back down on this issue, although I do think it will be primarily targeted at higher-end deals.
bob - January 1, 2010 10:04 AM
it seems like an example of a law devised never to be implemented except in certain convenient circumstances.
Do business with china at your own risk
Matthew - January 2, 2010 6:52 PM
Bob,
In all fairness, all GAAR are enforced in such a way. It is impossible, given limited resourced and limited access to information, for tax authorities to catch all arrangements that avoid tax.
Further, I think a better statement is "avoid tax at your own risk".
Twofish - January 2, 2010 7:38 PM
The authority for the Circular 698 comes from Article 25 on the Law on Tax Administration which says:
Taxpayers shall file tax returns truthfully and present accounting statements and other information related to tax payment required by the tax authorities in the light of the circumstances in accordance with the law, administrative regulations and the time limit and content for filing tax returns prescribed by the tax authorities in accordance with the law or administrative regulations.
So the SAT has the authority to require anyone to turn over information that is needed to calculated taxes. Note that as far as I'm aware, this is a reporting requirement and not a tax requirement, and I don't know of any change the the calculation of taxes.
Also, I don't really see how this is out of line with what pretty much every other country is doing right now in response to the global recession. China just copied India's practice, and this follows a very loud and well publicized effort by the United States to make banks and individuals disclose off-shore accounts.
As this is a reporting requirement rather than a tax liability requirement, it looks to me that the main focus is to avoid people moving funds from the PRC offshore.
I think the reason that this is big news is not so much because of the tax implications than with the corporate structure implications. Over the last several years, people have used extremely clever legal structures to do things that would be difficult to do in China, and the issue now is that there is now a legal obligation to report those structures to the Chinese government, which will give the government a lot more influence over what structures are allows and what ones aren't.
Twofish - January 3, 2010 8:06 AM
The way that taxes and a lot of economic legislation works is that they are extremely vague and broad. The legislative part of US securities and anti-trust law can summed up in one paragraph.
What happens in these situations is that the legislature passes extremely broad and vague legislation, and then the courts and the administrative agencies then issue very detailed rulings that add certainty and consistency to the legislation. Much of what constitutes a "legitimate business purpose" in both the US and China tends up being decided by the administrative agencies. The legislature rarely get involved, and you can theoretically appeal to the courts, but that tends to happen under only the most extraordinary conditions (simply because the cost of appealing to the courts are often much, much higher than the matter under dispute).
I think that this sort of hysteria says more about fears of a rising China than anything that China has actually done. What China is doing in this situation (and it pretty much every other economic situation) isn't that different from what any other nation tends to do. What's happening is that what China does is starting to matter more and more because the world is shrinking, and whereas someone in Peoria could ignore China twenty years ago, you can't now. On the other hand, that's not too much different from the fact that people outside of the US or UK can't ignore what they do either.
Bank CD Rates - January 3, 2010 10:20 AM
You've just earned yourself a new reader. Just subscribed to your RSS and looking forward to more posts.
Matthew - January 4, 2010 1:47 AM
Twofish,
Insightful comments in respect of the nature of such laws. I dont necessarily agree that such laws are not reviewable (although in China this is extremely difficult). In an Australian context, the previous GAAR was read down so much by the court that it was rendered useless, hence the need for the current GAAR.
In respect of your above comment, I am not certain that the Law on Tax Administration can truly be a source for the documentation requirements in 698. Article 25 is with respect to tax filings whereas Circular 698 is for the purpose of determining whether there is any tax liability.
Twofish - January 4, 2010 4:18 PM
Matthew: I dont necessarily agree that such laws are not reviewable (although in China this is extremely difficult). In an Australian context, the previous GAAR was read down so much by the court that it was rendered useless, hence the need for the current GAAR.
For most companies especially small and medium enterprises, tax issues are effectively not reviewable because the cost of litigation is more than the amount of tax. For large companies, the cost benefit changes dramatically.
As far as the legality of Circular 698, Article 25 allows the tax authorities to demand "accounting statements and other information related to tax payment required by the tax authorities". I don't see why the information that is requested by 698 isn't considered material supplemental to tax payment.
Matthew - January 4, 2010 7:59 PM
Twofish,
In respect of costs outweighing the financial benefits in challenging it depends upon the jurisdiction - in Australia the winners costs (or about 70%) are generally payable by the losing party. Regardless, a significant amount of tax litigation is funded by syndicates of business or organisations that have an interest in challenging the prevailing view.
I think Article 25 is arguable but in my view for it to be operable there must be a "taxpayer". In contrast, Circular 698 effectively operates before it is has been determined there is a requisite "taxpayer". I dont think, on a reasonable argument, the powers indicated in Article 25 can be extended beyond the situation of regular tax filings as that is the context in which the Article is referring too.
Ultimately, these are just legalistic (and completely hypothetical) arguments that will carry absolutely no weight in China. For practical purposes, Circular 698 (as with all Circulars issued by the SAT) has the same effect as if it was promulgated by the NPC. Criticisms to the contrary are just murmurings in the wind.
Rockli - July 15, 2010 11:02 PM
Regarding the circular 698, as far as I nknow, it responses to Chongqing case: indirect share transfer – November 2008. Basing on the so-called "subtances over form", the offshore share transfer is requried to be filed and documented. Although the tax liability is not mentioned clearly for Circular 698, it is easy for us to image that further regulations will be followed accordingly. Due to the Circular 698, some investors are concerning the risk of listing abroad which are possiblely be taxed. If yes, then, how terrible it is! Maybe, that is why the detailed regulations are still under draft. Looking forward to the further info...........