No escape

The banner headlines that accompanied the introduction of the Enterprise Income Tax Law on January 1 were all about the equalization of income tax rates imposed on foreign and domestic companies in China. The tax authorities’ new remit to target offshore firms saw little of the limelight.

But for those familiar with the legally flexible – and tax-free – world of offshore special purpose vehicles (SPVs), which have for years facilitated capital flows in and out of China, this was big news.

“This is going to cause a little bit of discomfort for some organizations,” said Florence Yip, a tax partner at PricewaterhouseCoopers (PwC) in Hong Kong.

China-based companies pay tax on their worldwide income while firms based overseas are liable only for certain kinds of income connected to their local operations. As of January 1, a foreign enterprise that is under “effective management” in China – that is, it makes key business decisions here – is bracketed with domestic enterprises and subject to tax on its worldwide income.

Havens under fire
If a company based overseas is being tapped in its home country for more than the rate specified in the Enterprise Income Tax Law, it has little to fear from China’s tax authorities. For a firm run from China that is incorporated in a tax haven, though, there is cause for concern.

Here’s a typical scenario: Investors want a Chinese company to list overseas, so they set up an SPV in the Cayman Islands and restructure the firm’s domestic operations into a wholly-foreign-owned enterprise (WFOE) in which the SPV has a majority stake. Although the SPV is offshore, the directors are Chinese citizens who run the business in China.

Profits are paid to the SPV through dividends and this income is untaxed thanks to the Cayman Islands’ business-friendly policies. For extra insulation, the directors may also each set up a British Virgin Islands (BVI) holding company to hold their respective stakes in the SPV and avoid paying a personal withholding tax on the income generated.

 Under the new system, this structure is unsustainable. In theory, any foreign firm – regardless of the presence of domestic shareholders – that manages its operations from China could now be drawn into the local tax web. This may be of particular concern to China-focused private equity funds registered in the Caymans but actively managed in China.

“It may be a Cayman fund, but the research is arguably carried out in China, many staff are based in China and certain decisions are made in China. The Chinese tax bureau might take the view that the Cayman fund is subject to China tax,” said Rocky Lee, who heads DLA Piper’s Asia venture and private equity practice.

Even if a private equity fund avoids classification as a Chinese tax-resident enterprise, it still isn’t in the clear. Under the new law, a witholding tax of 10% can be levied on dividends paid to non-resident enterprises if this money comes from a company that is a China tax resident.

However, any discussion of this issue is littered with “mights” and “maybes” because the legislation is untested and, in a number of areas, still poorly defined.

“There is still a lot of uncertainty in terms of how the enterprises would be treated by the State Administration for Taxation,” said John Gu, China tax principal at KPMG in Hong Kong. “So far, the law is still very much a principal-based law and the guidelines are insufficient.”

The implementation rules that accompany the new law define “effective management” in very broad terms, encompassing duties relating to property, human resources and financial record-keeping in addition to the business development and senior management functions. It’s unclear how closely authorities will stick to the letter of the law.

As Yingli Green Energy, a Chinese solar power firm incorporated in the Caymans and listed on the New York Stock Exchange, said in its 2007 annual report, “Although substantially all of our operational management is based in the PRC, it is unclear whether the PRC tax authorities would require (or permit) us to be treated as a PRC resident enterprise.”

Enforcement issues
To a large extent, enforcement of the law depends on company directors being honest. If a Chinese national establishes an offshore company, he must report it as an offshore interest and repatriate any profit within a certain time period so it can be taxed. In most cases, getting people to report their interests is not a problem: Round-trip investments by offshore companies into associated WFOEs are not legitimate unless first approved by the relevant government bureau.

But anyone who tries to dodge taxes by working around these rules is likely to hide their efforts beneath a mound of paperwork. For example, an offshore holding company may be registered under a different name, making it harder for the authorities to establish a link between the individual and his assets.

“We need to distinguish between the small number of people who evade tax and the large number of people who carry out their business in accordance with the law,” said Yip of PwC. She queries whether pursuing a few individuals is an efficient deployment of government resources, given that China’s tax authorities are also responsible for collecting tax returns from every company in the country.

The practical issues raised by the new law will probably be addressed as the legislation evolves. Whatever comes to pass, DLA Piper’s Lee does not believe the changes will dissuade Chinese firms from going offshore or dissuade foreigners from doing business here. Often, the primary goal of going offshore may not be tax avoidance, but seeking an overseas listing. Therefore, the real business considerations are unlikely to change. Foreign funds, meanwhile, simply have to be more careful as to where decisions are made.

“Many funds have protocols to ensure that decision-making does not take place in China,” said Lee. “They may have a telephone conference and then the decisions are officially executed in the US and sent back to China.”

Location, location, location
Taking the geographical innovation a step further, it might transpire that Chinese directors of offshore companies head to their location of incorporation for board meetings and to make key decisions. This prospect is welcomed by Robert Kirkby, technical director of Jersey Finance. He sees it as a chance to develop a cottage industry around corporate structuring, with company directors making the most of Jersey’s private wealth management services during their visits.

However, it all comes down to the nature of their company’s business: If it is just holding an asset, then board meetings in tax havens may be feasible; if its operations are more substantial, then they may struggle to avoid domestic liability.

In the long-run, Chinese nationals that don’t pay domestic tax on their offshore corporate income may just have to change their ways. The only other option is to stop being a Chinese national.

“A lot of people are trying to get new passports,” said a Shanghai-based venture capitalist who asked not to be named.