Tax compliance issues for outbound investment

By Xiao Bo and Shaji Ravendran, AllBright Law Offices
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Since the implementation of the Belt and Road Initiative, Chinese foreign investment has grown rapidly. When designing the structure of outbound investment, companies will often establish or acquire an operating company in a particular jurisdiction, normally where it plans to conduct the bulk of its sales or services, and then set up an intermediate holding company in a low-tax jurisdiction. However, with changes in the global tax environment, this structure faces higher compliance risks than before. This article analyses some of the more important and prevalent issues.

肖波, Xiao Bo, Senior partner, AllBright Law Offices
Xiao Bo
Senior partner
AllBright Law Offices

Overseas companies may be deemed to be tax resident in China

In 2009, the State Administration of Taxation created a new rule stating that any company registered outside mainland China would nevertheless be subject to corporate income tax in China on its worldwide income, if its place of effective management was located in China.

The place of effective management was defined as the place where implementing substantive and comprehensive management decisions, control over production and business operations, staff, accounts and property etc., of an enterprise takes place. Consequently, if the decision makers undertake these key tasks within China, then the foreign-registered company will be deemed to be resident in China for tax purposes.

The same approach is used to assess corporate residence in many of the Double Tax Agreements between China and other countries, i.e., the company is regarded as resident in the country where its place of effective management is located.

Companies that place key decision makers in China should be aware of these rules, given that in such cases, where the place of effective management is regarded as China, the company will be subject to compulsory financial reporting rules, both in respect of the corporate entity itself, and also, potentially, the individual decision makers. A failure to correctly file financial returns in such cases could result in penalties and sanctions being applied to both the company and the individuals.

Shaji Ravendran, Legal consultant, AllBright Law Offices
Shaji Ravendran
Legal consultant
AllBright Law Offices

Controlled foreign corporations

The Chinese controlled foreign corporations (CFC) regime was introduced in 2008. Under Chinese law, a CFC is a non-Chinese company that: (1) is owned by one or more China tax residents that either hold, directly or indirectly, shareholdings at least of 50% of the company, including at least 10% or more of the voting shares of the company; or (2) be effectively controlled by one or more Chinese residents by ownership, capital, business operations, or authority over purchase and sales-related matters.

A Chinese resident shareholder (individual or enterprise) is subject to tax on undeclared profits, kept without reasonable business reasons, by any foreign company established in a jurisdiction with an effective tax rate 50% lower than the Chinese rate. Chinese resident shareholders of companies registered in the following jurisdictions are exempt from CFC rules: Australia, Canada, France, Germany, India, Italy, Japan, New Zealand, Norway, South Africa, the UK, and the US.

Risks related to tax treaties

  1. Consider whether a relevant tax treaty exists. For example, no treaty exists between Germany and Hong Kong, and so the standard German withholding tax rates of 26% or 16% may apply to dividends;
  2. Whether the presence of employees, or agents of the parent company, will create a permanent establishment in that country causing profits to be taxed there;
  3. Identify the correct tax treaty. There are occasions when a company may be disregarded for treaty purposes, in which case identifying the correct countries and treaties becomes more complex;
  4. Some treaties contain a limitation on benefits (LOB) clause, limiting the types of companies and other entities that can claim benefits under the treaty, such as a company with no commercial substance;
  5. Some treaties contain a principal purpose test (PPT), where a country can disapply the benefits available under the treaty in certain cases where the transaction in question was undertaken for the principle purpose of obtaining a tax benefit;
  6. The definition of dividends, interest, royalty payments etc., is left to the domestic laws of the signatory countries. Each type of payment will be covered by different articles of the treaty, and so conflicts may arise between jurisdictions; and
  7. More countries are introducing hybrid mismatch rules that disapply treaty benefits in cases involving multiple deductions, or income that is not taxed anywhere.

Risks should be considered by domestic Chinese enterprises. When calculating the tax credit in China for taxed overseas income:

(1) All income from overseas branches, even if that income has not yet been remitted back to China, shall be included in the enterprise’s overseas taxable income for the tax year. Domestic companies should be careful to record both remitted and unremitted overseas income;

(2) Overseas losses should not be offset against domestic taxable income; and

(3) Any overseas tax paid or collected wrongly, together with the additional interest and any fines imposed by the overseas tax authorities, should not be included in the deductible overseas income tax.

Identify relevant domestic laws of the relevant countries (regions) and identify relevant tax risks, such as:

(1) Certain jurisdictions, such as the British Virgin Islands and Cayman Islands, have introduced “economic substance” rules. Some types of companies incorporated in those jurisdictions that seek to establish tax residence there are required to meet economic substance tests. Failure to comply can result in fines, and ultimately striking off; and

(2) Investment transactions must establish a reasonable business purpose to steer clear of anti-avoidance investigation, and any potential tax adjustment and high interest.

(3) Transactions relating to transfer pricing should follow the arm’s length principle to avoid a tax adjustment.

(4) Domestic enterprises that send individuals to work abroad shall comply with the Announcement on Individual Income Tax Policies Relating to Overseas Income to avoid administrative penalties.

In summary, commercial outbound investments face increasing tax compliance challenges. Enterprises should pay close attention to both the domestic regulations of all relevant countries, and also all relevant international tax treaties. Ensuring such compliance is undertaken as part of the whole process of outbound investment is vital.

Xiao Bo is a senior partner and Shaji Ravendran is a legal consultant at AllBright Law Offices

Carl Li AllBright Law Offices customs

AllBright Law Offices
11/F and 12/F, Shanghai Tower
No. 501 Yincheng Middle Road
Pudong New Area, Shanghai 200120, China
Contact details:
Tel: +86 21 2051 1000
Fax: +86 21 2051 1999
Email:

lawyersean@allbrightlaw.com
sr@allbrightlaw.com

Website: www.allbrightlaw.com

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