China's State Administration of Taxation held an on-line Q&A session on anti-avoidance administration in June

Jun 2009
On 2 June 2009, China's State Administration of Taxation (the "SAT") held a half-day on-line Q&A session to answer questions regarding China's latest rules on special tax adjustments (e.g., Guo Shui Fa [2009] No. 2 - Implementation Measures of Special Tax Adjustments (Trial) and Cai Shui [2008] No. 121) and taxation administration on non tax-resident enterprises (e.g., Guo Shui Fa [2009] No. 3 and Guo Jia Shui Wu Zong Ju Ling [2009] No. 19). The SAT host was Mr. Liao Ti Zhong, the Deputy Director of the International Taxation Department of the SAT. This news alert summarizes some of the key points made by the SAT relating to special tax adjustments. Reimbursements regarded as related party transactions In response to questions regarding reimbursements between related parties, the official said that reimbursements should be regarded as related party transactions. Therefore, the related party reimbursement amounts would be treated as an "other related party transaction" and included in determining whether or not the enterprise is subject to China's contemporaneous documentation requirements. (If the enterprise does not meet one of the three exemption criteria under Article 15 of Guo Shui Fa [2009] No. 2), then it is required to prepare contemporaneous documentation to justify the arms' length nature of its related party transactions. Transfer pricing investigations on domestic related party transactions The official reiterated the SAT's position on domestic related party transaction adjustments as below: In principal, no transfer pricing investigation or adjustment will be made if the effective tax rate of the taxpayer is no higher than that of its related parties, assuming there is no additional corporate income tax ("CIT") to be levied after the transfer pricing corresponding adjustment. If the effective tax rate of the taxpayer under transfer pricing investigation is higher, the taxpayer should pay additional CIT (and a special interest levy) in accordance with the effective tax rate difference, based on the income tax adjustment amount (i.e. corresponding adjustment will be automatically calculated by the Chinese tax authorities in different jurisdictions). For this purpose, the effective tax rate should be defined as: actual CIT paid (i.e. taking into consideration any tax preference treatment, accumulated losses and government subsidies) divided by taxable income. Excessive interest expense paid to third party bank but guaranteed by related party may not be deductable In response to a question about the deductibility of interest expense paid to a third party bank but guaranteed by the taxpayers' related parties, the SAT official explained that (as per Article 119 of the Implementation Regulations of the Corporate Income Tax Law) debt investment provided by a third party that is guaranteed by a related party should be regarded as related party debt investment. Therefore, the excessive interest expense paid to the third party bank is not deductible for CIT purposes, except in situations where an enterprise can prepare and provide (upon the request of tax authorities) contemporaneous documentation to support the arm's length nature of intercompany financing arrangements (e.g. debt/equity ratio); or if the effective tax rate of the borrowing enterprise is not higher than that of the domestic lending enterprise, according to Cai Shui [2008] No. 121. No safe harbor rules for related party transactions The official reiterated that in determining whether related party transactions complied with the arm's length principle, there are no safe harbor rules under China's CIT regime. The Chinese tax authorities prefer a case by case analysis (i.e., by performing function and risk analysis and comparability analysis) to determine appropriate transfer pricing methods. Special interest levy vs. tax surcharge One of the most significant impacts of the CIT Law on transfer pricing is the imposition of a special interest levy on anti-avoidance tax adjustments proposed by tax authorities. In the context of transfer pricing adjustments, the taxpayer will be subject to a special interest levy where a transfer pricing adjustment is imposed. A daily surcharge of 0.05% will be levied if the taxpayer fails to pay the tax assessment within the time limit set by the tax authorities in the Final Transfer Pricing Adjustment Notice. According to the literal meaning of Article 107 of Guo Shui Fa [2009] No. 2, it is possible for the tax authorities to impose both surcharge and special interest levy on the late tax payment in relation to a transfer pricing adjustment for the period from the deadline set by the tax authorities to the day the underpaid tax is settled. In response to a concern raised by taxpayers regarding the imposition of the surcharge and special interest levy on the same tax adjustment amount, the official indicated that the SAT's position is that only surcharges would be imposed in this case. He said the SAT would issue a further notice to clarify this matter in the near future. Due date for the preparation of 2008 contemporaneous documentation for cost sharing arrangements and for thin-capitalization According to the official, the due day for the preparation of 2008 contemporaneous documentation for cost sharing arrangements (i.e., pursuant to Article 74 of Guo Shui Fa [2009] No. 2) and for thin-capitalization situations (i.e., pursuant to Article 89 of Guo Shui Fa [2009] No. 2) can also be extended to 31 December 2009. Transfer pricing adjustments on business tax During the Q&A session, the official confirmed that the local tax authorities have the authority to make transfer pricing adjustments on Chinese Business Tax, based on the relevant provisions in China's Tax Collection and Administration Law and its Detailed Implementation Regulations. Furthermore, the provisions of transfer pricing administration in Guo Shui Fa [2009] No. 2 shall also apply in the matter of business tax administration. Observations Through the on-line Q&A session, the SAT official clarified some of the ambiguous tax and transfer pricing issues in respect of special tax adjustments. However, since Guo Shui Fa [2009] No. 2, which introduced various new anti-avoidance concepts, is a trial version, there are still some uncertainties to be clarified and tax officials may hold different views and interpretations on specific articles of Guo Shui Fa [2009] No. 2. For instance, we noticed that as per Art 85 of Guo Shui Fa [2009] No. 2, the excessive non-deductible interest expense from taxable income, as stated in Article 46 of the CIT Law, is limited to "annual actual total interest paid to related parties" (interest expense here include interests, guarantee fess, mortgage fees and other forms of expenses in the nature of interest). However, some tax officials are of the opinion that the excessive interest expense paid to a third party bank cannot be deducted as well if the loan is guaranteed by a related party and the ratio of debt investment to equity investment from related party exceeds the prescribed debt/equity ratio in Cai Shui [2008] No. 121. We will continue to closely monitor the relevant development and provide you with our commentary when there is further clarification from the SAT on this issue. We understand that the SAT will issue additional tax notices to clarify some commonly-raised questions regarding Guo Shui Fa [2009] No. 2. In the long-run, it is believed that the SAT will promulgate a new circular to combine all the necessary revisions and supersede Guo Shui Fa [2009] No. 2, just as under the old foreign enterprise income tax regime, Guo Shui Fa [1998] No. 59 (i.e., the Chinese transfer pricing foundation rules) was released by the SAT in 1998 as a trial version and then superseded by Guo Shui Fa [2004] No. 143 in 2004.