China: Corporate Taxation

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- China: Corpoorate Taxation
- China: Double Tax Treaties and Transher Pricing
- China: Import and Export Taxation Regime

China: Corporate Taxation

Companies which are resident in China pay tax on their world-wide income. 'Resident' here means that their central management and control is located in China. Non-resident companies with a permanent establishment in China pay tax only on their China-source income, including 'effectively connected' income. Foreign-owned companies will normally qualify as non-resident, although if there are Chinese partners the situation may be complex.

As regards tax rates, under a 2008 reform, China has unified the income tax treatment of domestic and foreign enterprises with the new Enterprise Income Tax Law (the “New Law”). The New Law, which became effective January 1st 2008, provides for a 25% statutory rate that applies to both domestic and foreign-funded enterprises and, subject to transition relief, enterprises that have enjoyed preferential treatment. Many foreign-funded enterprises will face higher rates due to the new unified rate and the loss of tax holidays and certain other incentives, but new and high-technology enterprises may still benefit from a 15% rate.

Also included in the New Law are international taxation concepts wholly or partly new to China: the determination of residence under the “managed or controlled” concept; controlled foreign corporations; cost-sharing agreements; thin capitalisation; and deemed paid foreign tax credits. The New Law also strengthens transfer-pricing administration. The New Law only provides a framework of general tax provisions. Important details on the definition of numerous terms were left to detailed implementation regulations and supplementary tax circulars.

In addition to the loss of tax holiday and reduced rate benefits, some withholding tax rates may also increase under the New Law.

Foreign-funded enterprises being taxed at 15% (or nil) usually benefit from a five-year transition to adjust to the new tax rate.

China has a large number of taxes - around 25 - although companies are not subject to them all. The most important taxes for a manufacturing operation are likely to be value added tax; industrial taxes, and enterprise income tax.

Foreign investment enterprises include equity joint ventures, cooperative or contractual joint ventures and entities wholly owned by foreigners. A foreign investment enterprise is subject to tax on its worldwide income.

Prior to 2008, PRC tax law already included transfer-pricing rules. Under these rules, all fees paid or charged in business transactions between related parties must be determined according to an arm's length standard. If the parties fail to meet this requirement, the tax bureau may make reasonable adjustments by using one of the following methods:

For purposes of the transfer-pricing rules, related parties result from direct or indirect ownership, common control by a third party or a relationship with common interest. Intercompany transactions covered by the transfer-pricing rules include sales or purchases of goods, technology transfers, provision of services, financing transactions and other business transactions.

In January, 2005, China's State Administration of Taxation (SAT) Deputy Director Wang Li said it would intensify its efforts to crack down on tax evasion and would concentrate its efforts on large taxpayers and international taxation.

Wang was reported by Chinanews as stating that SAT will focus on improving administration and enforcement in the areas of international and foreign-related tax and will strive to strengthen cooperation with foreign institutions and tax administrators.

Wang also directed the tax authorities at all levels to carry out more assessments and audits on foreign enterprises and revealed that SAT will seek to integrate the administration of key taxpayers at the local level, while also establishing more effective monitoring systems for key foreign corporate taxpayers.

In a separate move to level the tax playing field between domestic and foreign-invested firms, the latter lost their exemption from paying land use tax. As part of a plans aimed at helping the government exert more control over the use of development land, land use taxes, which had remained static for almost twenty years, tripled, and both domestic and foreign companies now pay the same rates.

The new tax rates range from between 1.5 yuan to 30 yuan (US$0.20 to US$3.84) per square metre depending on the location of the land and its intended use.

Foreign companies operating in China will no longer be able to claim value-added tax rebates on purchases of locally-manufactured equipment under a reform which went into effect on January 1, 2009.

The move is part of structural reform to China's VAT system and was confirmed by China's Ministry of Finance and State Administration of Taxation in an announcement on December 29, 2008.

The new rules mean that foreign companies will no longer be able to claim VAT refunds on purchases made after January 1, although some rebates were still be permitted under a transitional arrangement which runs until June 30, 2009. However, from 2009, company spending on capital equipment will be deductible for income tax purposes, a change which is expected to save firms around CNY120bn (USD17.6bn) in tax.

China is in the process of moving from a production-based VAT system to a consumption-based one, replicating a model in place in many other countries with VAT systems. The reforms permit companies to offset input VAT on investment in fixed assets against VAT payable to the government, a move that will benefit manufacturing and heavy industry in particular.

The government had already trialled the system in several areas of China but has now rolled out the system nationwide, not only to advance its tax modernisation agenda, but also to give the corporate sector a timely economic boost amid global economic uncertainty.

The VAT reforms are expected to save companies in China in the region of CNY100bn (USD14.6bn) to CNY150bn in tax.

In September, 2009, China’s State Administration of Taxation (SAT) announced that taxes were being introduced on employee benefits, such as telephone and transport allowances.

If no other specific means exists to distinguish between corporate and personal usage, 20% of an employee’s telephone allowance and 30% of a car allowance are determined to be taxable.

Payments to an employee for insurance and redundancy are also be deemed to be taxable. The SAT also announced that companies would not be allowed to deduct employee pensions from their corporate profits, and it also augmented its controls over fuel tax payments.

These measures are seen as a tightening and a hardening of procedures by the SAT in the face of a recent decline in tax collections. In the past, a company has been able to increase its employees’ incomes by increasing their non-taxable allowances, rather than their taxable salaries or bonuses.

This has obviously reduced the country’s tax revenue and has, apparently, been more prevalent in government agencies and state-owned companies. Employees will now be liable to account for the additional taxes, when the regulations come into effect.

In January, 2010, the Chinese Ministry of Finance, acting through the State Administration of Taxation, issued a Circular to clarify corporate income tax provisions with regard to income earned abroad.

According to the Circular, if the tax paid abroad cannot be accurately verified, then the tax paid in the related country (region) should not be deducted from tax payable in the current period, nor deducted from the annual tax amount. The Circular clarifies terms that have been effective since January 1, 2008.

Item 5 of the Circular stipulates that corporate pre-tax income earned abroad should be calculated in accordance with Article 7 of the Implementation Rules of the Enterprise Income Tax Law and the amount of income tax payable for income earned abroad is as defined in Article 78 of the Implementation Rules.

The Circular also defines the amount of income tax that is deductible on income earned abroad as the tax payable and actually paid for the enterprise income earned abroad. The Circular specifies six types of taxes that do not fall into the category of deductible corporate income tax on income earned abroad.

A formula is given for businesses to calculate the amount of deductible tax. Two conditions are outlined in which taxation authorities approve the use of some simple methods for calculating the amount of income tax paid for income earned abroad.

The corporate income tax on income earned from Hong Kong, Macao and Taiwan is levied according to the Circular. If a tax treaty exists between Chinese government and the relevant foreign country prescribing rates that differ from the Circular, the treaty rates prevail.

The Circular also has a list of 15 countries with much higher statutory tax rates than China's, such as the US, France and Japan.

In February, 2010, China's Ministry of Finance and the State Administration of Taxation (SAT) issued a further Circular on the same subject.

The Circular sets forth the specific method for determining the amount of actually allowable overseas income tax as well as upper limits for tax credit by country for the current period, SAT announced on February 11.

The Circular further clarifies that such foreign taxes cannot be carried forward to subsequent years for deduction and exemption.

In April, 2010, China's State Council released new guidelines for foreign investment in China which include tax incentives and easier procedures, especially in the lesser developed 'West Delta' region.

At a press conference in Beijing, deputy director of the National Development and Reform Commission, Zhang Xiaoqiang, and Vice Minister of Commerce, Ma Xiuhong, launched new rules to encourage foreign investment towards the high-end manufacturing, hi-tech and eco-friendly sectors and to central and western China.

However 'environmentally unsound and energy-gorging projects in industries running at overcapacity' are to be discouraged.

Inward investment may also qualify for support under China's stimulus package for 10 key industries (a RMB4 trillion (USD586bn) package announced in November 2008). Companies in the "encouraged" category, would benefit from lower land prices.

Multi-national companies will be encouraged to establish regional headquarters, R&D centers, purchase centres, financial management centres and other functional departments in China.

By the end of 2010, imports for scientific and technological development at foreign R&D centers may qualify for exemption from tariffs, value-added tax, and goods and services tax, according to the regulations.

Foreign companies are especially encouraged to increase their investment in China's central and western regions, known as the 'West Delta', particularly in eco-friendly and labour-intensive businesses. The 'West Delta' comprises Chongqing Municipality, Sichuan Province and Shanxi Province. Existing tax incentives for qualifying foreign companies will continue for new investment in this region, and, in addition, existing foreign investment in China's coastal regions will be supported in moving west.

690,000 foreign companies have invested in China, creating 45 million jobs, said the Ministry. China has topped the list for attracting inward investment for the last 17 consecutive years, and by the end of 2009, had secured USD945.4bn in inward investment during this period.

On February 20, 2010, the State Administration of Taxation issued the Provisional Measures for Tax Collection and Administration for Foreign-Enterprise Representative Offices, applying retroactively from January 1, 2010. The Measures apply to all ROs, bringing their treatment into line with that of other corporate forms and making the continued use of the RO format much less attractive.

In June, 2010, the government introduced a 'Resource Tax' of 5% on coal, gas and oil production in Xinjiang province. In July the tax was extended to 12 more of its western provinces in an effort to inject finances in the poorest regions of the country, which are badly in need of investment in infrastructure and jobs. Among the biggest projects earmarked by the Chinese government are 13 solar power projects.

The new tax is levied on the selling price of the commodities rather than based on volumes produced. This is expected to increase tax revenues substantially.

China will also reduce corporation tax for companies in the western regions by 10%, to 15%, in a further attempt to provide incentives to businesses in the region. Giants such as Petro China, which dominates the industry, may look at increasing prices in the wake of the tax hike.

The western regions of China are very rich in natural resources but in terms of wealth, they are years behind the affluent and booming eastern coastal regions of the country. The government has stated that it wishes to begin to close the divide between east and west and no doubt it also hopes that the injection of revenues in the western regions may placate those living in these remote areas of the country, where some civil unrest has reared its head in recent years, notably in Xinjiang province in 2009.

In August, 2010, the Chinese State Administration of Taxation (SAT) issued a public notice in relation to the corporate income tax treatment of corporate restructurings to clarify certain technical and procedural matters that had been left unclear in a circular released in April 2009.

The Public Notice seeks to resolve issues associated with Circular 59 published last year which have discouraged corporate restructurings because of uncertainty of tax treatment.

The Public Notice elaborates on the definition of “equity consideration” and the documentation requirements for various types of corporate restructuring. It also elaborates on the continued availability of tax incentives after corporate mergers and de-mergers.

Other issues covered in the latest public notice include the importance of “fair value” of assets and liabilities and the necessity of valuation reports from recognized professionals, explanation of procedures for adoption and approval of special tax treatment, adjustments after breaches of special tax treatment criteria, the definition of “reasonable commercial purposes” as a prerequisite for special tax treatment; and transitional requirements for corporate restructuring which took place in 2008 and 2009

The Notice is effective for restructurings taking place since January 1, 2010.

In September, 2010, in a series of critiques of the Chinese taxation regime published by the European Union Chamber of Commerce in China (EUCCC), the Chinese business tax on services was described as a "critical obstacle to the growth of the service sector and other high-value knowledge industries in China".

The EUCCC also said that its detrimental effects on service providers had been "accentuated by the recent shift from a production-based to a consumption-based VAT regime".

Business tax is applied at a standard rate of 5% on the gross turnover derived from: the provision of services rendered in China; assignment and licensing of intangible assets; and sale or rental of real estate, provided that such activities are carried out within China.

The EUCCC said the structure of business tax could lead to double or even higher multiple levels of taxation. Business tax is mainly levied on gross turnover with no corresponding input credit for business tax paid along the supply chain as there is with VAT. As a flat tax on gross income, if a taxpayer has a very small profit margin, the imposition of the business tax can actually contribute to an economic loss.

The EUCCC also disapproved of business tax being imposed on services performed for foreign customers, whereas outside China, export of services is typically zero-rated under VAT systems.

Sales of goods, repair, replacement and processing services, as well as the importation of goods, are not subject to business tax in China, but instead to VAT levied at a standard rate of 17%. As a result of a recent change, the EUCCC said these taxpayers may now offset input VAT related to fixed asset purchases. The fact that VAT is not recoverable for payers of business tax clearly penalizes service industries, as compared to the manufacturing and trading sectors, according to the EUCCC. The Chamber also criticizes the repeal of the preferential tax treatments which aimed to compensate the non-deductibility of VAT on fixed asset purchases since January 1, 2009.

These preferential tax treatments consisted of VAT exemption on imported equipment or a refund of input VAT paid on domestically purchased equipment. They were enjoyed by foreign-invested as well as domestic enterprises pursuing an activity regarded as “encouraged” under various investment categories.

However, according to the EUCCC, enterprises engaging in activities for which business tax applies now face an increase in their fixed asset investment cost of 17% (corresponding to the non-exempted/refundable upstream VAT).

The EUCCC considers the situation to be especially harsh for equipment leasing and finance leasing enterprises. Such enterprises suffer from both an irrecoverable 17% VAT paid on equipment purchases and a 5% business tax levied on equipment rental fees, a tax burden which does not arise when the equipment is purchased.

The EUCCC recommended:

• Restoration of the previous VAT exemption and refunds of VAT on equipment purchases for certain service industries as well as R&D companies;
• Extension of these exemptions and refunds to equipment leasing and finance leasing businesses;
• Elimination of double business tax on subcontracting of labour, service and sublicensing of IPR activities by allowing deduction on subcontracting/sublicensing costs for business tax purposes; or
• Replacement of business tax with a VAT on service income and other items of income currently subject to business tax.

The EUCCC also said that foreign companies face 'major difficulties regarding tax registration and settlement' because of inconsistent practices among the local tax authorities.

According to an EUCCC report, tax administration for services of non-residents as promulgated by the Chinese State Administration for Taxation (SAT) on January 20, 2009 (Decree No. 19) has caused Non-Resident Enterprises (NREs) major difficulties in settling Enterprise Income Tax (EIT) and Business Tax (BT) and performing related tax formalities due to:

• The impracticability of making a tax settlement in Chinese yuan;
• Complications when a project is carried out in several locations in China; and
• Inconsistent practices regarding the timing of tax settlements.

The EUCCC said foreign exchange restrictions prevented NREs from settling taxes in foreign currency and foreign enterprises could not open CNY bank accounts in China. As a result, local tax bureaus could not enforce Decree No. 19 and, the EUCCC said, settlement of taxes mostly continues to be performed through withholding at source.

The EUCCC thought this generated a great deal of confusion regarding the way in which tax formalities should be performed. In practice, the requirements imposed on taxpayers varied greatly from one locality to another and even within the same locality from one project to another, the report observed.

The EUCCC was unhappy that no procedure existed for consolidated tax settlement of BT. This created a discrepancy in the place where EIT and BT were settled and obliged NREs to allocate income between various establishments in China making proper accounting records more difficult to maintain, the EUCCC said.

Service projects contracted by NREs often include two phases: a first phase where only offshore services are provided and a second phase where both offshore and onshore services are provided. To the EUCCC it was unclear where BT related to offshore services had to be paid in the first phase, if the place of the withholding agent and the performance of the onshore services in the second phase were different. This sometimes caused tax bureaus in both places to claim BT payment on offshore service income, said the EUCCC.

In practice, many local tax bureaus continued to levy EIT and BT at the time of payment of the related income (i.e. before completion of related foreign exchange formalities) despite the provisions of Decree No. 19 on quarterly EIT and BT monthly payments. The EUCCC thought this created additional uncertainty for NREs.

The EUCCC recommended:

• New foreign exchange rules permitting NREs to open CNY bank accounts to allow settlement of taxes in compliance with the requirements set out by Decree No. 19, or failing this, reversion to the former system of withholding taxes at source;
• Simplification of tax formalities for projects implemented in different locations, by permitting NREs to register only at the location of their main establishment in China and settle BT on a consolidated basis at that location;
• Clarification of which tax authority is competent for settlement of BT on offshore service income for projects involving the provision of both offshore and onshore services; and
  Consistent implementation by local tax authorities of the provisions of Decree No. 19 on EIT quarterly and BT monthly settlements.

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China: Double Tax Treaties and Transfer Pricing

China has double tax treaties with more than 80 countries. The rates of withholding tax on China-source payments are as follows for some key countries:

Various conditions attach to some of these rates.

A comprehensive double tax arrangement (“New DTA”) with Hong Kong Special Administrative Region (“HKSAR”) Government came into effect from 1 January 2007, in China. This replaced the limited scope arrangement for the avoidance of double taxation signed in 1998. The reduced withholding tax rates on dividends, royalties and interest under the comprehensive double tax arrangement are amongst the lowest rates available in other double tax treaties signed by China.

The SAT issued a tax circular in April 2007 to provide interpretation and implementation guidelines on the New DTA on the side of China. It is important to note that the interpretation in this circular is applicable to other tax treaties that China has concluded with other countries/regions if the content of the relevant articles are the same and no other interpretation and implementation guidelines have been provided before. As such, this circular might have widespread and far-reaching impact on tax residents in HKSAR and other countries/regions.

China concluded a new double tax treaty (“New DTT”) with Singapore in July 2007. After ratification by both countries, the New DTT replace the existing one which has been in force since 12 December 1986. Among others, the withholding income tax rates for dividend and royalty are further reduced in the New DTT. In addition, the “Capital Gains” clause is changed.

In August, 2009, a second protocol was added to the double taxation agreement between Singapore and China that originally became effective at the beginning of 2008.

The major change in the new protocol relates to Article 22 of the original agreement that talks to the elimination of double taxation on dividends. In the new protocol, where income is derived from a dividend paid by a company which is a resident of Singapore to a company which is a resident of China, and which owns not less than 20% (previously 10%) of the shares of the company paying the dividend, the tax credit in China will take into account the tax paid in Singapore by the company paying the dividend in respect of its income.

In December, 2009, the governments of China and the Bahamas signed an OECD model agreement on the exchange of tax information. The agreement was signed by the Bahamaian Minister of Foreign Affairs and Deputy Prime Minister, Brent Symonette, and Chinese Ambassador to the Bahamas, Dingxian Hu.

Thanking the Chinese Ambassador for his influential role in the negotiation of the Tax Information Exchange Agreement (TIEA), Symonette noted that the agreement was the first of its kind undertaken by China.

The TIEA is the sixth concluded by the government of the Bahamas which incorporates the accepted international standards in respect of transparency and effective information exchange in tax matters. It is the third TIEA concluded by the government of the Bahamas with a member of the G-20.

The Deputy Prime Minister also touted the agreement as another milestone in the ever deepening relationship between the Bahamas and China. Together with the Investment Promotion and Protection Agreement with China, the TIEA provides an enhanced framework for economic cooperation.

The investment agreement was signed in early September on the occasion of a visit to the Bahamas by Wu Bangguo, Chairman of the Standing Committee of the National People’s Congress of the People’s Republic of China.

It addresses the conditions for creating, stimulating, encouraging, promoting, improving, and protecting investment by Bahamian and Chinese investors in both countries.

In December, 2009, the government of the British Virgin Islands (BVI) concluded an Organization for Economic Cooperation and Development (OECD) model Tax Information Exchange Agreement (TIEA) with China.

The TIEA allows the signing parties to request information from each other that is relevant to a tax investigation. As provided in the agreement, such information would typically relate to bank accounts or the beneficial ownership of companies or trusts.

In February, 2010, Barbados and China signed a Protocol to amend the existing Double Taxation Agreement (DTA) between the two countries.

Minister of International Business and International Transport, George Hutson, and China's Ambassador to Barbados, Wei Qiang, initialled the document, which amends the existing 10-year old Convention for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income.

The agreements incorporate changes to China's domestic law, while improving the treaty-based mechanism for tax information exchange.

Commenting, Hutson said: "I am aware that there has been much speculation about this protocol as to what the changes, as agreed, may mean for eligible taxpayers in our two countries. However, I am satisfied that taxpayers will find that our treaty. with the additions contained in this protocol, remains clear, certain and full of opportunity for the avoidance of double taxation with respect to income on capital.”

"Importantly, the protocol makes abundantly clear our commitment to internationally accepted principles of transparency and tax information exchange, to which we have agreed. I am, therefore, pleased that in this regard, we are able to bring the language of this treaty into conformity with [existing rules] in our tax treaty network."

Explaining the need for amending the agreement, Wei said: “We wanted to take into account the new circumstance we've come to face and to have the agreement fully meet its objectives. Now, with today's signing ceremony, and thus the conclusion of this protocol to the agreement, I think we can safely say that new horizons have been opened for our entrepreneurs in both countries to explore and exploit their business opportunities in a sound and confident manner for the benefit of both sides.”

In April, 2010, Argentina and China signed a draft agreement on tax information exchange to help promote their growing bilateral trade.

Wang Kang, deputy director of China's State Administration of Taxation, said the draft agreement was signed by him and Argentine Director of Federal Administration and Public Revenues, Ricardo Echegaray.

It was agreed that President Cristina Fernandez's impending visit to China would be the ideal opportunity to sign the final agreement.

The standard tax information exchange agreement produced by the Organization for Economic Cooperation and Development was used as a basis for negotiation and all key issues were discussed and resolved amicably, according to both sides.

In July, 2010, the Maltese government announced that it had concluded negotiations with China towards revising the convention for the avoidance of double taxation and fiscal evasion between the two countries. The new text is based on the OECD Model Tax Convention on Income and on Capital and also recent tax treaties concluded by both countries. When ratified the agreement will supersede the existing treaty dating back to February 1993.

Welcoming the prospect of a revised agreement with China, Malta’s Minister for Finance, the Economy and Investment, Tonio Fenech stated: “This agreement will provide investors from both countries with more attractive conditions for investment in Malta or China. Such conditions may also help Chinese investors to tap in a more efficient way into the European market. China is a country which is still growing strongly and offers significant investment potential.”

Alongside provisions to improve the environment for prospective investors, the agreement also contains provisions for the exchange of tax information, in accordance with the internationally agreed standard on transparency and information exchange. The government said the pact would establish better channels for the exchange of information, which would be instrumental in the territories' mutual efforts to prevent fiscal evasion.

Fenech continued: “The signing of this double tax agreement will be another important milestone in the relations between Malta and China and will contribute to deepen and strengthen already very good relations between our two countries.”

“[The pact] will also strengthen our growing network of over fifty tax treaties; This improves the value of our country to potential investors, which is a key objective in our efforts to attract new and better jobs to our shores.”

In July, 2010, Singapore and China signed a further protocol to incorporate into their existing double taxation agreement (DTA) the new internationally-agreed Organization for Economic Cooperation and Development standard for the exchange of information for tax purposes.

The protocol was signed in Beijing on July 23 by Moses Lee, Singapore’s Commissioner of Inland Revenue, and Wang Li, China’s Deputy Commissioner of the State Administration of Taxation. The original DTA was signed on July 11, 2007.

The protocol will give the tax authorities of both countries a greater ability to exchange taxpayer information and to exchange information on a wider range of taxes. It also provides that neither tax authority can refuse to provide information solely because it does not require the information for its own domestic purposes, or because the information is held by a bank or similar institution.

Transfer Pricing

In May, 2005, the tax authorities of China and Japan negotiated the first-ever advance pricing agreement (APA) for a major Japanese electronics company, paving the way for multinational companies from other countries to invest in China, while reducing the risk of double taxation.

"The decision has wide ranging implications for other multinationals doing business in China, related to the level of risk, time, and expense they incur when calculating certain taxes," explained Bill Dodge, a partner with Deloitte Tax LLP and leader of the Global Transfer Pricing practice, which helped negotiate the agreement. "For the first time, multinationals have the option to negotiate certain tax burdens up to five years in advance, rather than separately determining and defending each year," he added.

Transfer pricing refers to the allocation of profits, for tax purposes, across parts of a multinational company. The tax laws of many countries require that companies establish an 'arm's length' price for a product or service. For example, if a US-based company purchases a component from one of its divisions in China, the price must be similar to a 'comparable' price that another company in the United States would have paid for the same component.

An advance pricing agreement (APA) allows a company to negotiate the price of a product or service associated with transfer pricing over a period up to five years, rather than renegotiating at the end of each year. This helps companies plan their future tax liabilities, reduce the risk of noncompliance, and minimize the time and cost of determining and defending on a yearly basis.

"The decision demonstrates that the Chinese taxation authorities continue to become more transparent in taxation matters, and are willing to follow generally accepted principles from other countries," added Dodge.

"Multinational companies now have the ability to operate more efficiently in China, with easier tax planning, reduced preparation or negotiation costs and less risk," he observed.

In May, 2010, the Chinese State Administration of Taxation (SAT) and the Hong Kong Inland Revenue Department (IRD) held a joint public seminar in Hong Kong, under the auspices of the Hong Kong Taxation Institute, to discuss the latest transfer pricing developments.

After the new China Corporate Income Tax (CIT) law was enacted, several new transfer pricing regulations were introduced in China; in particular two recently released tax circulars had introduced the principle of "returns commensurate with the functions and risks", which has been widely applied in transfer pricing practice, to determine the attributable profits of the permanent establishment of non-residents.

Meanwhile, the IRD has also built up its transfer pricing practice framework by issuing the much-awaited Departmental Interpretation and Practice Notes ("DIPN") No. 45 and 46.

The speakers included representatives from Hong Kong's IRD, China's SAT and PricewaterhouseCoopers. They considered the following developments to the transfer pricing environment in China:

• SAT has actively promoted UN development initiatives, such as the UN Practical Manual on Transfer Pricing;
• SAT could envisage a China-Hong Kong bilateral advance pricing agreement, but the IRD said it was not yet ready, preferring to receive advance ruling applications on transfer pricing for the time being;
• SAT intended to implement more specific protocols regarding domestic related party transaction adjustments;
• SAT described its "substance over form" policy when considering anti-avoidance cases;

With regard to tax audits, the SAT acknowledged its focus on four key areas in identifying targets: domestic companies operating abroad (particularly those going into low tax jurisdictions); conversions from manufacturing to service-based companies; intellectual property transactions; and issues surrounding the interplay of transfer pricing, thin capitalisation, controlled foreign corporations, and cost sharing.

The seminar also considered the following transfer pricing developments in Hong Kong:

• The IRD worked on the basis of OECD Transfer Pricing Guidelines, but would accept other non-OECD methods if they "satisfy the arm's length standard";
• The IRD also did not insist on using the interquartile range for companies' transfer pricing arrangements - it would usually accept as deductible year-end adjustments before close of books when adequately supported with documentation;
• The IRD pointed out the different statutes of limitation in China (10 years) and Hong Kong (6 years) and emphasized that activation of mutual agreement procedures should pay due regard to the earlier Hong Kong limits;
• The IRD said it would apply transfer pricing principles to domestic related party transactions;
• The IRD described Hong Kong's territorial source concept governing the taxability of income/profit and emphasized its ascendancy over transfer pricing principles.

SAT and the IRD said they had already co-operated with exchange of information in at least 20 instances in the last 12 months. The two tax authorities also confirmed the OSIRIS database and Standard & Poor's databases as suitable for transfer pricing analyses.

In August, 2010, China's State Administration for Taxation (SAT) directed local tax authorities to prepare statistics relating to the transfer pricing practices of companies in their tax jurisdictions as part of a wider review of transfer pricing by the central government.

'Circular 323,' issued by the SAT in July, calls on local tax authorities to evaluate contemporaneous transfer pricing documentation for the tax years 2008 and 2009. At least 10% of all annual pricing reports must be selected for review, based on one or more of the following criteria: companies with tangible related party transactions of more than CNY200m per year; companies non-tangible related party transactions exceeding RMB40m per year; loss-making companies with limited functions and risks; companies which are undergoing follow-up transfer pricing reviews; companies with issues relating to thin capitalization; and companies with cost-sharing arrangements.

The circular stipulates that the reviews must determine whether the transfer pricing documentation adequately describes five key areas of focus, including the company's organizational structure, the nature of its business, its related party transactions, comparability analysis and transfer pricing methodology.

The local tax authorities were required to furnish the SAT with their analytical reports by October 31, 2010.

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China: Import and Export Taxation Regime

Evidently, China's membership of the World Trade Orgainzation since 2005 has made for plenty of changes to its import/export taxation regime. But there remains plenty of scope for dissension, and not all cases have gone against China.

In September, 2009, United States Trade Representative Ron Kirk welcomed China’s decision to amend a law which imposes tariffs on imported auto parts for use in the manufacture of cars.

According to Kirk, US officials had been informed by the Chinese government that the charges had been eliminated as of September 1.

China's announcement comes after the World Trade Organization (WTO) agreed with the United States and the European Union that these charges were contrary to WTO rules.

Commenting on China’s decision, Kirk stated that: "We are pleased that China has informed us that it is eliminating the additional charges on imported auto parts in response to the WTO ruling. Ending these charges will help ensure a level playing field for the high quality auto parts made in America, and is an important example of the importance of enforcing our international trade agreement rights."

Kirk warned, however, that the US government will be “carefully reviewing” the changes.

The WTO Appellate Body confirmed in December, 2008, that China had breached its WTO obligations by creating a system for the registration and taxation of imported car parts that promoted the use of domestic components over imported car parts.

Under China’s system of tariffs, introduced as part of the 'New Automobile Policy' in 2004, if imported parts assembled in a specific model exceeded a certain threshold, an additional charge of 15% was imposed on top of the normal 10% customs duty.

The additional charge was easily triggered, either by a specific combination of even a few imported parts, or if the imported parts represented 60% or more of the price of the final vehicle.

In July 2008, a WTO Panel found that this system was in breach of the General Agreement on Tariffs and Trade (GATT) Article III, which does not allow internal fiscal and regulatory measures to discriminate against imported products in favour of domestic products.

The Panel additionally concluded that, even if the charges were to be classified as customs measures rather than internal measures, they would still breach GATT Article II, by imposing a customs duty higher than the one agreed to by China when it joined the WTO.

China appealed the Panel's conclusion before the WTO Appellate Body in September 2008, but the Appellate Body's final report largely confirmed the Panel's conclusions.

In December, 2009, China announced increases on import tariffs for fuel oil and jet fuels, commencing 2010. Both tariffs will be increased by 1%, to 3% for fuel oils, and to 6% for jet fuels. The change does not, however, affect tariffs on diesel and gasoline, the tariff for which will remain at 1%; this tariff was introduced in 2008, reduced from 5-6%.

As part of its agreement with the World Trade Organization (WTO), China is also reducing tariffs on other imports starting 2010. Tariffs on imported indium are being reduced to 5% (from between 10% and 15%), and are being reduced by 23-38% on imported rubber. There will be further tariff reductions on over 600 other products, including phosphate ore, coal and naphtha. Consequently, tariffs on industrial products are to fall on average to around 8.9%, and on agricultural products to around an average of 15.2%.

The increase in fuel tariffs aims to reduce energy consumption and help combat pollution in China.

One peculiar feature of China's taxation system is the existence of export rebates, effectively making up for deficiencies in the VAT syste.

In December, 2009, China’s Ministry of Commerce announced that it would maintain export tax rebates into 2010, in the light of continuing trading challenges due to the economic crisis.

Exports from China fell by 1.2% in November. Warning against “blind optimism,” the Ministry revealed that it believes that continued intervention is necessary to aid economic recovery. Government figures show that imports, meanwhile, had increased by 26.7%.

Since the start of the economic crisis, China had raised export tax rebates seven times, eliminated export tariffs on a number of goods, and provided USD84m in short-term export credit insurance.

China has also announced that it is to work towards increasing imports, particularly high-tech goods and sources that are scarce in China.

Furthermore, Commerce Minister Chen Deming announced that the Ministry would, in 2010, aim to open new markets for foreign trade and increase domestic consumption, including increased subsidies for car scrappage schemes, establishing an e-payment system for rural communities, offering further financial aid to businesses (particularly small and medium-sized enterprises), and encouraging the development of e-business ventures.

In April, 2010, however, a US government trade report found that uneven application of value-added tax (VAT) in China continued in 2009 in contravention of world trade rules.

Despite a 2007 Chinese agreement to settle a World Trade Organization (WTO) dispute on prohibited tax subsidies, which was supposed to eliminate VAT and income tax refunds tied to the purchase of domestic products over imported products, the 2010 National Trade Estimate Report found that China had increased VAT rebates on certain exports, and continued to exempt domestic enterprises from any import tax and VAT for imports of designated key parts and raw materials.

"Importers from a wide range of sectors report that, because taxes on imported goods are reliably collected at the border, they are sometimes subject to application of a VAT that their domestic competitors often fail to pay," stated the report, adding that: "In addition, China’s selective exemption of certain fertilizer products from the VAT has operated to the disadvantage of imports from the United States."

According to the report, China retained an "active VAT rebate program for exports," and Beijing had increased export VAT rebates on many products seven times since July 2008.

"In October 2008, China announced VAT rebate increases on 3,486 products including textiles, toys, garments, furniture, and some high-value added electrical machinery, representing approximately one quarter of China’s total exports," the report stated.

Chinese VAT ranges from 5% to 17% depending on the product, and is China's single most important revenue source.

The report also criticized China’s 1993 consumption tax system because a "substantially different" tax base is used to compute consumption taxes for domestic and imported products. "The tax burden imposed on imported consumer goods ranging from alcoholic beverages to cosmetics to automobiles is higher than for competing domestic products," the report claimed.

The June, 2010, decision to abolish tax rebates to commodity exporters ended what the US considered ‘unfair subsidies’, though the effects on Chinese steel producers could be serious. The removal of the rebates, which amounted to 9% for steel production, were effective from July 15, 2010 and affected the production of hot rolled steel, coil, some narrow cold-rolled coil products and hot-dipped galvanized coil. China also announced the removal of 5% rebates for the production of starch, ethanol and copper products, including bars, wires and some nickel products. China is the world’s biggest producer of many base metals and also one of the world’s biggest consumers.

The move is also intended to reduce output for export because of the huge internal demand in China for base metal production, as well as easing trade tensions between China and in particular, the US. China’s steel exporters have already fallen foul of anti-dumping measures imposed by the US government, partly because of the tax rebates which it regards as unfair.

In August, 2010, Chinese vice-minister of commerce, Jiang Yaoping, announced that export tax rebates would be cut on certain products with the aim of restricting the export of "high-pollution, high-energy consumption and resource-dependent" products and accomplishing energy and emission reduction targets for the five-year plan period (2006-2010).

"We may make adjustments to some energy-consuming products in line with our energy-saving strategy, but the scope of the adjustment will be small," Jiang said.

China removed export tax rebates on 406 items effective from July 15, 2010, including certain steel products, non-ferrous processed metal products, silver powder, alcohol, corn starch, crop protection products, medicine, chemicals, plastic products, rubber and related products. The tax rebate rates on these items ranged from 5% to 17%.

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