Since January 1, 2008, China has introduced the general anti-avoidance rules ("GAAR") as a part of the new enterprise income tax regime. In 2009, the State Administration of Taxation ("SAT") promulgated Guoshuifa  No.2 ("Circular 2") covering a variety of tax avoidance arrangements and directing the local tax authorities to use the "substance over form" principle to tackle them. Later in the same year, the SAT released the Guoshuihan  No. 601 and Guoshuihan  No. 698 ("Circular 698") to address beneficiary ownership and indirect equity transfer respectively. Despite the wide application of the GAAR, the underlying procedural mechanism has been missing for so long. On July 3, 2014, the SAT released draft guidance on the GAAR ("Draft Guidance") for public comments. The Draft Guidance is seeking to prescribe a practical clarity for identification and investigation of tax avoidance. The public comment period closed on August 1, 2014.
Under the Draft Guidance, the major characteristics of a tax avoidance arrangement are as follows:
- Its sole or primary purpose is to obtain tax benefits, such as tax reduction, tax elimination, and tax deferral; and
- It is technically compliant with tax laws but inconsistent with economic substance.
To take on tax avoidance arrangements, the Draft Guidance lays out some well-known legal principles, including reasonable commercial purpose, economic substance, and substance over form. Unfortunately, no effort is made to elaborate the details of these principles. Nor any administrative case or example is offered to dispel the vagueness of these principles.
The Draft Guidance authorizes the Chinese tax authorities to conduct several adjustment measures, including the following:
- To re-characterize the whole or part of the transaction;
- To disregard the existence of a party to the transaction, or treat multiple parties to the transaction as one single entity;
- To re-characterize the income, deductions, tax incentives, and foreign tax credits, or reallocate these tax attributes between the parties; and
- Other reasonable measures.
While the Draft Guidance is generally designed to target tax avoidance arrangements lack of reasonable commercial purpose, it will not apply to the following scenarios: (i) arrangements between Chinese resident enterprises not involved in cross-border transactions or payments; (ii) outright tax-related violations such as tax evasion, tax delinquency, tax cheating, or tax violence; and (iii) indirect equity transfer as referred to by Circular 698.
In addition, the Draft Guidance is supposedly applied in deference to (i) Circular 2 with respect to transfer pricing, cost sharing arrangement, controlled foreign corporation, and thin capitalization and to (ii) applicable double taxation agreements as to beneficiary ownership and limitation of benefits.
The Draft Guidance seeks to provide broad authority to the Chinese tax authorities, particularly the SAT, in launching and concluding an investigation of tax avoidance arrangements. The local tax authorities must receive approval from the SAT on such investigation from the beginning to the very end. While such practice has been longstanding since the emergence of the GAAR, the Draft Guidance apparently plans to make it official.
The local tax authorities are authorized to identify taxpayers in suspect transactions and request a sea of information, including the following:
- Background materials;
- Materials on commercial purpose;
- Internal decision-making and management materials of taxpayers, such as board resolutions, memorandums, and emails;
- Detailed transaction documents, such as contracts, side agreements, and payment receipts;
- Communications between taxpayers and tax advisors;
- Communications between all parties to the transactions;
- Documents to disprove tax avoidance by taxpayers;
- Other materials as requested by the Chinese tax authorities.
To the extent that taxpayers do not cooperate, the penalty is quite modest and no more than RMB 50,000 in any case. The Chinese tax authorities can directly make tax assessment, absent taxpayers' cooperation. It is unclear whether such tax assessment can be expanded to include late payment interest or underpayment penalty. Under the Draft Guidance, the in-charge tax authorities are also empowered to require taxpayer's affiliates, counterparties, and tax advisors to submit relevant documents. From a tax enforcement standpoint, however, the Chinese tax authorities cannot officially inflict any meaningful pains on these persons in connection with non-cooperation.
If adopted, the Draft Guidance will streamline the administrative process and improve the interactions between taxpayers and the Chinese tax authorities. Despite so, however, the Draft Guidance probably will have to endure substantial revisions. First, the power of information request is overly broad, while the enforcement mechanism is clearly not there. As a result, taxpayers and their affiliates, counterparties, and tax advisors have every incentive not to cooperate with any investigation at light or no costs. Second, the SAT seems to micro-manage the enforcement of the GAAR in the current version. Although such micro-management will bring about competency, uniformity, and consistency, it could also potentially lead to lengthy administrative delay and render the administrative review meaningless. Ultimately, the SAT must balance the interests of both taxpayers and the Chinese tax authorities to make the enforcement process really work.
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