China to increase tax scrutiny on foreign companies

The Chinese government's vow to increase tax scrutiny of foreign companies has sent firms rushing to tax advisors ahead of the implementation on Sunday of new rules designed to rein in cross-border tax avoidance.

Tax professionals and business lobbies alike have welcomed the move as an attempt to bring China's tax regime more in line with international standards.

But it has also caused concern that authorities could use the policy, which came into effect on Feb. 1, as a political tool to put the pinch on foreign companies, on top of what business lobbies lament is an increasingly tough business climate in the world's second largest economy.

"We've definitely been getting a lot of questions from clients on how to avoid being investigated for anti-avoidance measures," said Roberta Chang, a Shanghai-based tax lawyer at Hogan Lovells.

The measures, an elaboration on China's existing "general anti-avoidance rule" or GAAR framework, have more companies taking a hard look at how they structure their businesses.

Under the new policy, for example, a firm that invests in China through companies in Hong Kong or Singapore to take advantage of tax benefits that do not exist between China and its home country could find itself on the wrong side of Beijing tax authorities if it cannot prove it has substantial business operations there or employees on the ground.

"Companies are increasingly putting substance in their holding companies," Chang said.

Andrew Choy, Greater China International Tax Services Leader at Ernst & Young, said the GAAR rules are a signal that companies need to pay attention to tax planning.

"In general, people will be more conservative," Choy said.

Chinese regulators hit Microsoft Corp (MSFT.O) with about $140 million in back taxes last November, an early case of what could be a wave of "targeted actions" to stop profits going overseas, according officials at China's State Administration of Taxation.

With a slowing economy likely to reduce 2015 fiscal revenue growth to a three-decade low of just 1 percent, according to a Deutsche Bank report, it makes sense for Beijing to try to boost its coffers.

Tax specialists say companies need to be aware that China's tax regime is evolving, albeit as part of a global trend to curb tax avoidance.

At a meeting of G20 leaders in Australia in November, Chinese President Xi Jinping endorsed a global effort to crack down on international tax avoidance.

"Compared to the U.S. or the UK, China's tax rules are still simpler. But China doesn't want to be seen as an undeveloped country with tax rules. It wants to catch up to other international players," Chang, of Hogan Lovells said.

FAIR AND TRANSPARENT?

At the forefront of evolving international tax policy is the debate about whether the right to tax should be tilted towards industrialised, capital exporting countries where firms reside, or so-called source countries such as China, where many generate significant profit.

"There is a large element from a government policy perspective that has to do with whether China is going to tax particular profits or some other country," said Jon Eichelberger, a tax expert and partner at Baker & McKenzie's Beijing office.

Chinese state media has said tax evasion and avoidance by foreign companies costs the world's second largest economy at least 30 billion yuan ($4.8 billion) in tax revenues each year.

Larry Sussman, managing partner at O'Melveny & Myers' Beijing office, said the scope of the scrutiny could also reach private equity firms and M&A activity.

"Anything cross-border coming in and coming out, for that matter, which could implicate Chinese investors," Sussman said.

Despite the elaboration to the GAAR rules, they remain loosely defined, giving tax authorities discretion on whether companies meet the demands for economic substance.

James Zimmerman, Chairman of the American Chamber of Commerce in China, said Chamber members welcomed an upgrade to the tax regime, so long as the policies were consistent with China's World Trade Organization obligations.

"AmCham-China is hopeful that the Chinese government will apply the tax laws and regulations in a fair, uniform, and transparent manner, and we will be monitoring China's enforcement record going forward on behalf of our member companies," Zimmerman said.