In recent years, Chinese taxation authorities have been acting against corporations suspected of tax avoidance schemes designed to secure tax advantages but without valid commercial justifications. In response to this, tax authorities carry out special anti-tax avoidance investigations and specific tax adjustments.
Governments in many countries have been continuously encouraging good corporate governance and developing guidance for sound tax risk management. Despite these countries’ diverse regulatory and business environments, they all understand that an effective tax risk management system is vital for both tax authorities and large taxpayers.
Due to rapid economic growth, the State Administration of Taxation (SAT) in China started to focus on anti-tax avoidance management to create a more open and transparent working relationship between tax authorities and taxpayers.
Tax avoidance arrangements refer to scenarios where taxpayers intentionally select convoluted, intricate, and unconventional legal structures primarily or exclusively to achieve tax advantages, thereby ensuring that the “intended tax treatment” favors their own interests.
Tax avoidance arrangements have certain characteristics, according to article 4 of the General Anti-Tax Avoidance Management Measures (Trial), released in 2014 by the STA.
Some of these characteristics are when the sole purpose or main purpose is to obtain tax benefits; and the tax benefits are obtained in a manner that is compliance with the provisions of the tax law but inconsistent with its economic substance.
Different from tax evasion, tax avoidance is the legal usage of the tax regime in a single territory to one’s own advantage to reduce the amount of tax that is payable by means that are within the legal framework. Therefore, it is generally not directly recognized by tax authorities as an illegal act.
However, it can initiate anti-tax avoidance related actions on an enterprise based on the principle of substance over form and by taking into consideration the specific economic behaviors or arrangements involved.
Situations considered as tax avoidance arrangements
Transfer pricing, advance pricing arrangement, cost sharing agreement, controlled foreign enterprise, thin capitalization, among other general arrangements, are listed in article 2 of the measures as situations that can be considered as tax avoidance arrangements by the authorities.
Transfer pricing refers to prices charged between associated enterprises established in different tax jurisdictions for their intercompany transactions. Any Chinese taxpayer engaged in related party transactions with other group entities must demonstrate that such transactions are conducted in a manner consistent with the “arm’s length standard” – under which taxpayers should demonstrate that they transact with related parties in a similar manner and under comparable conditions, as they would with third parties.
Advance pricing arrangement relates to situations under which the enterprise proposes the pricing principles and calculation methods for related-party transactions in the future years, negotiates with the tax authorities, and reaches an arrangement in advance to increase tax certainty.
Cost sharing agreement is an agreement between an enterprise and its group affiliates to allocate the costs incurred in a certain business of the group among the participants in accordance with certain principles.
Controlled foreign enterprise refers to the specific treatment of the portion of income attributable to Chinese resident enterprises involved in profit distribution matters of foreign enterprises that can be substantially controlled by resident enterprises.
Thin capitalization examines whether the ratio of debt investment and equity investment received by an enterprise from related parties complies with the prescribed ratio or the arm’s length principle. To maximize interests or for other purposes, enterprises and investors may reduce the proportion of equity and increase the proportion of loans in the selection of financing and investment methods, resulting in the ratio of corporate debt to owner’s equity exceeding a certain limit.
Tax authorities are authorized by the Corporate Income Law to execute reviews of anti-tax avoidance situations such as abuse of tax preferences; abuse of tax treaties; abuse of corporate organizational forms; using tax havens to avoid taxes; and other.
In case of a review, tax authorities follow the principle of substance over form and focus on aspects such as the form and substance of the arrangement; the time when the arrangement is made and the execution period; the way it is implemented; the relationship between the various steps or components of the arrangement; the financial situation of all parties, and the tax results of the arrangement.
Situations recognized as tax avoidance arrangements
For situations recognized as tax avoidance arrangements, tax authorities will re-characterize the economic substance of the tax avoidance arrangements and cancel the tax benefits obtained by the enterprise.
Companies lacking economic substance—particularly those in tax havens that facilitate tax avoidance in China—may have their existence challenged by the tax bureau to prevent misuse of tax benefits.
Special tax investigation
In some cases, tax authorities may decide to open a special investigation, which includes the following steps:
A Tax Inspection Notice will be sent to the enterprise under investigation, followed by a Tax Matters Notice requiring all relevant information.
If tax authorities do not find any issue that should be subjected to special tax adjustments, they send the Special Tax Investigation Conclusion Notice.
If the tax authorities find that the enterprise should be subjected to special tax adjustments, they will serve the firm with a Special Tax Adjustment Investigation Notice based on the final plan, and the adjustments will be implemented in accordance with legal procedures.
Strategies to mitigate risks
Tax authorities usually implement special tax adjustment monitoring and management on enterprises through daily related-party declaration review, contemporaneous documentation management, and profit level monitoring.
If they identify special tax adjustment risks during the review, they can serve a Tax Matters Notice to the enterprise to remind it of potential tax risks. If a company receives such a reminder or discovers by itself that it has a special tax adjustment risk during a regular audit, it can adjust and pay taxes.
In this case, it must fill in and submit the Special Tax Adjustment Self-Payment Form.
Recognizing potential tax risks early and taking action self-adjusting tax payments, can result in considerable time and cost savings compared to the resources needed to handle a complete tax investigation initiated by the tax authorities. This approach is much easier and affords greater flexibility.
Even after a company amends its tax payments voluntarily, tax authorities maintain the ability to execute tax investigations and make adjustments.
Components of an effective risk management system
An effective risk management system can reduce the tax risks of an organization to an acceptable level. It must include the following six components:
Tax risk management environment: This component manifests itself in the development of a tax risk management policy that reflects the attitude and culture of the organization towards tax risks. A tax risk management policy has both a strategic layer, which sets the tone in the entire company, and an operational layer that prescribes more detailed tax risk policies, such as requirements for external tax opinions and protocols with Chinese tax authorities.
Tax risk objectives: This step establishes if the tax risk management policy is enforced effectively. If the tax risk objectives are achieved, the company should be delivering against its tax risk management policy. Tax risk objectives can be strategic or operational, depending on whether the objectives are high-level or day-to-day in nature.
Tax risk identification and assessment: This represents the awareness and response of the firm to different types of tax risks that may arise from changes in business operation or from day-to-day activities. Amendments in tax laws and regulations can also create significant tax risks.
Design of tax risk controls: This refers to the design of specific processes or procedures to respond to the identified tax risks while considering their respective importance to the organization. This component also includes the design of policies and procedures to ensure that the entire tax risk management process is complete and that all relevant tax risks are identified and considered. Control activities include approvals, authorizations, reconciliations, and reviews.
Tax information management and communication: This entails the development and implementation of communication strategies and procedures to efficiently collect and distribute tax risk-related information with all stakeholders in a timely manner. Information needs to flow across the firm effectively to ensure that tax risk management policy is followed, tax risk objectives are pursued, tax risks are identified, and control functions are fulfilled.
Monitoring: This corresponds to the establishment of a monitoring mechanism to evaluate the success of tax risk controls and communicate the results to the relevant parties. To assess the efficacy of the control activities that have been designed and implemented, it is necessary to monitor their operations. Procedures should be put in place to ensure that the results of the monitoring activities are fed back into the tax risk management process.
A company with an effective tax risk control system can take early remedial actions when necessary, saving considerable time and money, and avoiding a possible investigation by the tax authorities.
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