Asian Tax - Global Tax Blog

5/10/2012

Tax burden analysis on BT-VAT pilot reform in Shanghai

China has two major kinds of turnover taxes—Value Added Tax (“VAT”) and Business Tax (“BT”)—which apply in different scopes of transactions. Generally speaking, importation and sales of tangible and movable goods, services of processing, repairing or maintenance are subject to VAT. The advantage of VAT is that, under the Output-Input Credit System, input VAT can be credited or deducted. But the disadvantage is that the procedure of operation is complex and requires a high standard of accounting system of the business. Also, taxable labor services (most of labor services except for services of processing, repairing, and maintenance), transfer of intangible assets, and immovable property are subject to BT. The calculation and payment of BT are much simpler than VAT, but BT is likely to lead to double taxation as BT cannot be deducted by the customer. Considering the situation above, BT will be gradually replaced by VAT in order to reduce the tax burden of Chinese businesses in the future. A pilot tax reform program stipulates that the BT payer in Shanghai engaging in some industries shall pay VAT instead of BT as of January 1, 2012. We will introduce this tax reform to you and analyze the relevant impacts on the tax burden and the copying strategies.

I. Scope of tax reform

In 2011, PRC tax and finance authorities issued a series of circulars to start this BT-VAT reform. In accordance with Caishui [2011] No.110 (“Circular 110”) and No.111 (“Circular 111”), as of January 1, 2012, some of the taxable services, which are provided by a taxpayer registered in Shanghai or provided by foreign entities to their customers registered in Shanghai, shall be subject to VAT instead of BT. The pilot taxpayer whose office is located in Shanghai shall pay VAT at the Shanghai local tax bureau. And the BT paid by the Shanghai pilot taxpayer at other areas in China can be treated as input tax to be credited against the output tax. However, non-pilot taxpayers engaging in businesses in Shanghai still need to pay BT in accordance with the current valid BT rules.

II. General VAT Payer and Small-Scale VAT Payer

PRC tax authority has divided Chinese VAT payers into general VAT payers and small-scale VAT payers. There are some requirements for being a general VAT payer. For instance, annual turnover shall be more than RMB 5 million, and the VAT payer shall have proper accounting records. If a VAT payer fails to meet these requirements, it shall be a small-scale VAT payer. In accordance with VAT regulations, the general VAT payer shall apply to General Taxation Method and the small-scale VAT payer shall apply to Simple Taxation Method for calculation of tax. The general VAT payer is granted a right to issue the VAT invoice (VAT Fapiao) to the customer and also can credit input VAT invoice issued by the general VAT payer provider against its output tax upon General Taxation Method. However, the small-scale VAT payer neither has a right to credit input tax against output tax by using the input VAT invoice nor is eligible to issue the VAT invoice.

General Taxation Method is as follows:

Tax Amount Payable = (Tax-exclusive Sales × Tax Rate) – Input Tax Amount

And Simple Taxation Method is as follows:

Tax Amount Payable = Tax-exclusive Sales × Levying Rate

Based on these formulas, we see that VAT rates (including Tax Rate and Levying Rate) and the tax burden have a direct relationship, and Input Tax Amount and the tax burden have an inverse relationship (applicable only to the General Taxation Method).

In accordance with Circular 111 and relevant regulations, different taxable services and VAT payers shall apply to various VAT rates instead of BT as of January 1, 2012 (please see chart below). VAT rates of 17%, 13%, 11%, and 6% known as “Tax Rates” apply to the general VAT payer and the foreign provider, VAT rates of 3% known as “Levying Rate” apply to the small-scale VAT payer, and VATs rate of 0% apply to the taxpayer who exports goods or services to a foreign entity. BT rates are 5%–20% (only for entertainment industry), 5%, and 3%.

Industries	Before January 1, 2012 (applicable to BT)	After January 1, 2012 (applicable to VAT)
Industries	Before January 1, 2012 (applicable to BT)	Small-scale VAT payer (input VAT non-creditable)	General VAT payer (input VAT creditable)
Leasing of tangible and movable assets	5%	3% (Levying Rate)	17% (Tax Rate)
Transportation	3%	3% (Levying Rate)	11% (Tax Rate)
Modern services (including research and technical services, information technology services, cultural and creative services, logistics supporting services, accrediting and consulting services)	5%	3% (Levying Rate)	6% (Tax Rate)

III. Impacts on the Tax Reform

How can we assess the impact of the reform program? Is the tax burden reduced or increased after it? We need to compare the current tax burden of a business as a VAT payer with that of the business as a BT payer before the reform.

1. The business becomes a general VAT payer from a BT payer

If the provider of the business is also a general VAT payer, the change of the tax burden of the business depends on Tax Rates and the amount of input VAT from the provider. The general VAT payer provider can issue a VAT invoice to the business. So if the business becomes a general VAT payer, it can credit the input tax against the output tax by using the VAT invoice issued by the provider. Based upon Output-Input Credit System, input VAT is not taxable and cannot be considered as the real cost of the business. In the past, as a BT payer, the business could not credit the input tax, so this would reduce the tax burden. However, VAT Tax Rates are higher than BT rates. This might increase the tax burden. To sum up, Tax Rates and the total amount of input, VAT will jointly influence the tax burden of the business and we need to analyze the impact case by case.
If the provider of the business is a small-scale VAT payer or BT payer, the tax burden of the business will be increased. The provider as a small-scale VAT payer or BT payer cannot issue the VAT invoice, so under this circumstance, the business cannot obtain any VAT invoice to credit input VAT against its output tax. This does not change the tax burden. However, Tax Rates are higher than BT rates, so the tax burden of the business shall be increased.
If the provider of the business is a foreign entity, this business should withhold and pay the VAT for the foreign provider who has no agent in China, and the change of the tax burden of the business depends on Tax Rates and the amount of input VAT. The business should be subject to Tax Rates which are higher than BT rates, so this might increase tax burden. But, in accordance with related regulations, tax bureaus will issue the General Tax Payment Voucher upon the payment of VAT, and the business can credit input tax which is equivalent to the tax payment on the General Tax Payment Voucher against its output tax. In other words, the General Tax Payment Voucher has a similar function of the VAT invoice, so this would reduce tax burden. Therefore, the change of the tax burden will be influenced by Tax Rates and the total amount of input VAT.

2. The business becomes a small-scale VAT payer from a BT payer

No matter if the provider of the business is a Chinese taxpayer (including the general VAT payer, small-scale VAT payer, and BT payer) or a foreign provider, the tax burden would be decreased or remain the same. Neither a small-scale VAT payer (current status) nor BT payer (status in the past) can credit the input VAT against its output, so there is no change on the tax burden. However, if the business becomes a small-scale VAT payer, it shall pay VAT by a constant Levying Rate of 3% which is less than or equal to BT rates, so the tax burden of the business is reduced or remains the same.

3. Exportation of trade in services

Circular 110 stipulates a general rule that exportation of services apply to zero-rate or VAT exemption. Specifically, Caishui [2011] No.131 (“Circular 131”) provides that exportation of international transportation services, research and development services, and design services shall apply zero-rate. Also, for exportation of most other taxable services listed in Circular 131, VAT exemption applies. Please note that zero-rate is different from exemption. Exemption just means that there is no VAT paid in exportation, but zero-rate means all VAT paid before the exportation shall be refunded, which means that the price of the goods or services do not contain any VAT when they are exported. Prior to the reform, the exportation of most taxable services was subject to BT. Therefore, the tax burden of the business who engages in exportation of services shall be reduced.

4. BT incentives

Regarding BT incentives, there is also a transitional arrangement in Circular 110 that BT incentives can still apply but would be subject to changes in the future. As this BT-VAT tax reform is a tax reduction program, the business that enjoyed BT incentives in the past does not need to be concerned.

IV. Coping Strategies

Given these significant changes, we suggest that related business should adjust its structure to enjoy the benefits of the tax reform. A business has to assess and calculate a balanced point based on its characteristic of industries, position in transactions (provider or customer), applicable rate, and the amount of input VAT so that it can make an informed decision whether the business will become a general VAT payer or small-scale VAT payer.

For example, if a transportation business can obtain enough input VAT which can neutralize or exceed the increased tax burden caused by the rise of tax rate from 3% to 11%, it shall become a general VAT payer. As a general VAT payer provider, the business might have some advantages over small-scale VAT payer providers. For example, the customer can use a VAT invoice issued by a general VAT payer provider to credit its input against output for tax reduction purpose.

Until now, the BT-VAT pilot reform program only applies in Shanghai and is limited to several industries, but we believe that it will expand to other areas in China and all industries in the near future. We suggest that you consult with your tax consultants or lawyers regarding this tax reform and update your tax planning strategies.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

Posted at 4:06 PM by makeenan@nixonpeabody.com | Category: Asian Tax; Corporate Tax | Permalink | Email this Post | Comments (0)

9/15/2010

India, like China, is taxing offshore acquisitions

By Paul DiSangro and Wendy Liu

In a landmark tax case, the Bombay High Court found Vodafone liable for tax on its 2007 acquisition of a $10.7 billion controlling stake in one of India’s largest mobile phone companies. What is remarkable about this decision is that the deal occurred outside of India and neither the buyer, seller, nor the target company were Indian companies. India is not the only country to pursue such tax revenue. China is also taxing sales of stakes in Chinese ventures by offshore taxpayers. This territorial-type approach to taxation that is emerging from the world’s fastest growing economies is a wake-up call for private equity and MNCs to re-examine their structures and plan for the risks and costs of taxation where none was assumed to exist.

In the case, the India tax authority contended that Vodafone was obligated to withhold tax at the source because the transaction involved underlying business assets that were located in India. Vodafone countered that it was not obligated to withhold Indian tax because the parties involved were both offshore companies and the target was registered in the Cayman Islands. The court sided with the Indian tax authority. The tax bill could be as high as $2.6 billion, though the court suggested that a portion of the sale price may not be taxable. In a statement, Vodafone said it was reviewing the judgment and considering appealing to the Supreme Court.

The ruling is a game-changer for investing in India. Most foreign investors use offshore entities, often incorporated in zero tax jurisdictions like the Cayman Islands, to invest in Indian businesses. A significant reason for that structure was to gain the ability to sell the investment without triggering Indian taxation.

In addition to the ruling, the Indian government has introduced proposed legislation to fix what it views as a loophole for offshore acquisitions. The proposal, introduced in August, would allow the government to impose a capital gains tax, on a proportional basis, on offshore acquisitions if the acquired company holds more than 50% of its assets in India.

India’s actions appear to be part of a trend developing in the world’s most-successful emerging markets: to tax the economic gains, wherever realized, attributable to business assets based in the territory. China is already doing this.

Last year, the PRC State Administration of Taxation issued a “Notification on Strengthening Corporate Income Tax Management on Non-resident Enterprises Equity Transfer Income,” commonly known as “Circular 698.” Circular 698 authorizes a capital gains tax on the sale of a Chinese resident enterprise by a non-resident company (a direct transfer) and the sale of an offshore intermediary holding company that owns a Chinese resident enterprise by a non-resident company (an indirect transfer). With respect to an indirect transfer, like the Vodafone transaction in India, an offshore deal between two foreign companies would be subject to Chinese taxation if the tax authority finds a tax evasion purpose. Circular 698, effective retroactively as of January 1, 2008, imposes a self-reporting requirement on foreign investors for certain types of indirect transfers.

This year, the first public case involving the taxation of an indirect equity transfer was posted on website of the Jiangdu State Tax Bureau. In the Jiangdu case, a well-known foreign investment group sold a 49% interest in a Chinese joint venture by transferring its shares in an offshore holding company. Since neither the seller, the buyer, nor the holding company was a Chinese resident enterprise, it was anticipated that the capital gains derived from the sale would not be subject to Chinese tax. The taxing authority disagreed, citing the lack of employees, assets, and business activity in the holding company (other than the investment in the JV) as grounds for finding no economic substance at the holding company level. The taxing authority disregarded the holding company and collected a tax payment of RMB 173 million on the gain realized by the seller.

While India and China will remain among the most attractive places to invest, the taxation of offshore deals by India and China will directly raise the cost of acquisitions and thus reduce the return on such investments. Foreign investors (as well as the domestic entrepreneurs) are advised to re-examine their tax strategies and structures when undertaking acquisition through their offshore companies.

For more information on this issue or any tax matter, please contact your Nixon Peabody attorney or:

David K. Cheng, Partner, 415-984-8342, dcheng@nixonpeabody.com
Paul A. DiSangro, Partner, 415-984-8352, pdisangro@nixonpeabody.com

Posted at 2:10 PM by lmozlin@nixonpeabody.com | Category: Asian Tax; International Tax | Permalink | Email this Post | Comments (0)

3/3/2010

PRC Tax Authorities Intends to Scrutinize Foreign Holding Company Structures Operating in China

By David Cheng, Yanwen Le, and Henry Liu

It appears that the Chinese tax authorities have taken an interest in foreign holding companies operating in China. The Chinese State Administration of Taxation (SAT) released a notice (Notice 698) on 15 December 2009 that addresses the transfer of shares of nonresident companies. Notice 698 is effective retroactively from January 1, 2008. It does not apply to the sale on a public securities market. It is common practice for foreign investors to invest in Chinese companies through an interposed foreign holding or operating company, like a Cayman Islands or Hong Kong-based company. Reasons for this structure include, among others, both tax and business purposes, for example, avoiding the lengthy approval and registration process required for a direct transfer (i.e., without a foreign holding or operating company) of an equity interest in a foreign invested Chinese company. In other words, under this structure, a foreign investor can indirectly transfer its interest in the Chinese company by transferring its interest (i.e. sale of stocks) in the foreign holding or operating company (which in turn holds interest in the Chinese company) without complying with Chinese government registration requirement or obtaining the Chinese government approval.

The Chinese tax authorities recently announced in Notice 698 their intention to scrutinize such transaction, including those occurring entirely outside of China between foreign sellers and buyers. Under Notice 698, the foreign investor must disclose such transaction if the foreign holding or operating company (which in turn holds interest in Chinese companies) is located in a jurisdiction that is low taxed or does not tax foreign source income (ex. potentially Cayman Islands or Hong Kong-based holding or operating companies). According to Article 5 of Notice 698, when a foreign investor (actual controlling party) indirectly transfers the equity of a Chinese resident enterprise, if the actual tax burden in the country (region) where the overseas holding company being transferred is located is less than 12.5%, or the aforesaid country (region) does not levy income tax on its residents’ overseas income, it shall, within 30 days from the date when the equity transfer contract is concluded, provide the relevant materials and information to the competent taxation authority where the Chinese resident enterprise whose equity is transferred is located.

The information that is required to be disclosed covers not only equity transfer agreements, but also information of the relationship between the foreign investor and the overseas holding company, between the holding company and resident company, explanation on the reasonable business purpose for the foreign investor to establish the overseas holding company, etc. Relying on such disclosure, the Chinese tax authorities will determine whether the transaction lacks commercial (i.e., business) purpose, resulting in the avoidance of China Enterprise Income Tax ("EIT") withholding. Specifically, it appears that the Chinese tax authorities would likely focus on the business purpose of the foreign holding company, examining whether it has commercial purpose and substance for its establishment and maintenance, other than tax savings. If not, the Chinese tax authorities may disregard the form of the transaction. In other words, the foreign holding or operating company may be disregarded and the foreign investor would be treated as having income from the direct transfer of an equity interest in a Chinese company, thereby generating Chinese source income subject to Chinese tax.

Since the Notice has been recently issued, it is too early to draw a conclusion on how it will be implemented. There will be issues and difficulties, in particular, that may practically impede the implementation of the Notice. The Notice has left behind some uncertainties that will need to be clarified (e.g. how 12.5% tax rate is calculated). Enforcement difficulties will also arise for offshore transfers in practice. How will the Chinese tax authorities monitor such offshore transfers while the withholding agents are unable to be identified? It will also be legally challenging to require foreign companies to submit to the Chinese government information that may not be relevant to Chinese companies. According to Article 10, this Notice shall come into force retroactively on January 1, 2008. This means that nonresident investors that disposed of Chinese companies indirectly even two years ago should review their transactions to see whether additional compliance is required. In view of this Notice, foreign investors should review their China investment structures to determine how best to reinforce their business purpose and commercial substance.

For more information please contact:

David Cheng, Partner, 415-984-8342, dcheng@nixonpeabody.com
Yanwen Le, Partner, +86 21 6137 5507, yle@nixonpeabody.com
Henry Liu, Partner, 212-940-3153, hliu@nixonpeabody.com

Posted at 2:54 PM by lmozlin@nixonpeabody.com | Category: Asian Tax; International Tax | Permalink | Email this Post | Comments (0)

1/13/2009

China issues new transfer pricing regulations and related-party transaction disclosure forms

On January 8, 2009, China’s State Administration of Taxation released the nation’s first comprehensive regulations on transfer pricing. The regulations also codify the nine related party transaction disclosure forms, previously published in Circular 114, to be submitted with the annual tax return. These releases underscore China’s larger goal to be more aggressive, yet strategic, in transfer-pricing enforcement.

Taxation of multinational corporations in China

Before 2008, China maintained two parallel tax systems—one for domestic enterprises and the other for foreign enterprises. A 2005 survey revealed that the two tax systems created an effective tax rate disparity of close to 10 percent between domestic and foreign enterprises, favoring foreign enterprises.

On March 16, 2007, the National People’s Congress enacted a new Enterprise Income Tax Law (EIT) that unified the two tax systems. The EIT, which became effective January 1, 2008, imposed a uniform tax rate of 25 percent on all enterprises, domestic and foreign. The EIT implements several internationally accepted concepts, including adequate capitalization rules and the arm’s-length principle, harmonizing China’s tax laws with those of other developed countries. It also places significant emphasis on transfer pricing, encouraging greater scrutiny of related party transactions.

Related-party transaction rules

The purpose of the EIT is to bring China’s transfer-pricing rules more into line with the rules applied in other developed economies. It provides China’s State Administration of Taxation (SAT) with the power to adjust taxpayers’ taxable income if transactions with related parties are found to have not been conducted on arm’s-length terms.[1] To encourage compliance, it requires taxpayers involved in related party transactions to submit related party transaction disclosure forms along with their annual tax returns.[2] Taxpayers are also required to submit “related documents” regarding the related party transactions when audited.[3] The Implementation Rules of EIT, issued on December 6, 2007, clarify that “related documents” include contemporaneous documents relating to pricing, standards of determining expenses, the computation method, and explanations.[4]

New regulations

On January 8, 2009, the SAT issued China’s long-awaited transfer-pricing regulations. Key areas that the regulations address include:

Reporting obligations for related party transactions;
Contemporaneous documentation requirements;
Transfer-pricing audits; and
Advance-pricing agreements.

The regulations also provided guidance on the application of rules for cost-sharing arrangements, controlled foreign corporations, thin capitalization, anti-tax avoidance, collateral adjustments, and penalties.

Reporting obligations for related-party transactions

The regulations define related parties and related party transactions that have to be reported. They also codify the nine related party transaction disclosure forms published in Circular 114 on December 5, 2008, which must be filed with the annual tax return. The nine forms are:

Form 1: Related Party Relationships;
Form 2: Related Party Transactions;
Form 3: Purchases and Sales;
Form 4: Services;
Form 5: Intangible Assets;
Form 6: Fixed Assets;
Form 7: Financing;
Form 8: Outbound Investment Situations; and
Form 9: Outbound Payment Situations.

The new forms require a broad degree of disclosure to the SAT. For example, Form 2 requires the taxpayer to disclose whether it has entered into any cost-sharing arrangements; Forms 3 and 4 require the taxpayer to disclose the transfer-pricing method applied to its related party transactions; Form 7 requires taxpayers to disclose its debt-to-equity ratio; and Form 8 requires taxpayers to disclose detailed information about the shareholders of related foreign enterprises. A cover page to be submitted with the forms is provided in Circular 114. Because the new forms are to be submitted with the taxpayers’ annual tax return, companies are expected to begin filing the forms as early as May 31, 2009.

Contemporaneous documentation requirements

The regulations provide detailed instructions regarding the information that is required to be documented contemporaneously with the related party transactions. The contemporaneous documents are generally required to be prepared by May 31 following the year in which the related party transaction occurred. For transactions that occurred during the 2008 tax year, the regulations provide a transitional rule that extends the deadline for preparing the contemporaneous documentation to December 31, 2009. [5]

The regulations provide some relief to smaller enterprises that would have been subject to the contemporaneous-document requirements under the draft regulations issued in March 2008. The draft regulations had required all enterprises with annual aggregate related party transactions over 20 million Yuan (US$ 2.93 M) to prepare contemporaneous documentation. The final regulations raised the threshold to related party tangible asset transactions over 200 million Yuan (US$ 29.3 M) or other related party transactions over 40 million Yuan (US$ 5.86 M). [6]

Transfer pricing audits

The regulations prescribe the audit procedures for the SAT to follow. They also contain a list of characteristics for targeting candidates for audit, including:

Large amounts or types of related party transactions;
Long periods of loss, low profit, or inconsistent earnings;
Related party transactions with parties located in tax havens;
Failure to submit an annual tax return or related party transaction disclosure forms, or failure to prepare and maintain contemporaneous documentation; and
Failure to conduct transactions on arm’s-length terms.

Advance pricing agreements

As with the contemporaneous documentation requirement, the regulations also relaxed the draft rules on the type of enterprise that is qualified to enter into advance pricing agreements (APAs). The draft regulations allowed only enterprises with related party transactions over 100 million Yuan (US$ 14.65 M) and operating for at least 10 years to qualify for the APA process. The final regulations lower the requirement to 40 million Yuan (US$ 5.86 M) and eliminated the years-of-operation requirement.[7] The regulations also provide a detailed explanation of the APA process, which shines some light on an otherwise-opaque process. Companies that stand to benefit significantly from the certainty of an APA should consider exploring an APA under the regulations.

Impact of the new rules and outlook on the future

Recent statistics provided by the SAT indicate that China is becoming more aggressive, yet strategic, in its transfer-pricing audits. In 2008, China increased its revenues from transfer-pricing cases by more than $110 million from 2007, while reducing the number of companies audited by nearly 45 percent. Clearly the SAT has decided to hunt elephants instead of rabbits. The recent decline in the growth rate of China’s economy will likely encourage the SAT to continue down that path.

Information provided through the new related party transaction forms will be closely scrutinized by the SAT in targeting candidates for audit. Therefore, it is important that taxpayers not only achieve full compliance, but do so with internally consistent and defensible positions in completing the annual tax return, the new related party transaction forms, and the contemporaneous documentation.

People’s Republic of China Enterprise Tax Law (Enterprise Tax Law), art. 41 (P.R.C.). [Back to reference]
Enterprise Tax Law, art. 43, clause 1 (P.R.C.). [Back to reference]
Enterprise Tax Law, art. 43, clause 2 (P.R.C.). [Back to reference]
People’s Republic of China Enterprise Tax Law Implementation Rules, art. 114 (P.R.C.). [Back to reference]
Special Tax Adjusted Regulations (Regulations), art. 16 and 116 (P.R.C.). [Back to reference]
Regulations art. 15 [Back to reference]
Regulations, art. 48 (P.R.C.). [Back to reference]

For more information, please contact:

Paul DiSangro at 415-984-8352 or pdisangro@nixonpeabody.com

David Cheng at 415-984-8342 or dcheng@nixonpeabody.com

Posted at 8:08 AM by paustin@nixonpeabody.com | Category: Corporate Tax; Asian Tax; International Tax; Tax Controversy | Permalink | Email this Post | Comments (0)