Firms need clear rules, certainty to remain in compliance with tax law, says expert

Heightened scrutiny of foreign companies' tax practices is a sign of China's effort to modernize its taxation system to keep up with the fast-changing international business environment, but there is another dimension that concerns the foreign business community - service.

The latest example of the unprecedented effort to plug tax loopholes is the release of a new interpretation on foreign companies' indirect transfers. Under the Corporate Income Tax Law, gains arising from a direct transfer of properties in China are subject to corporate income tax, while those arising from an indirect transfer are not.

This discrepancy has led some foreign taxpayers to package a direct transfer of properties in China as an indirect transfer to avoid the tax.

The State Administration of Taxation released a notice in December 2009 on the issue, but the document was ambiguous on what constitutes a "reasonable indirect transfer" and what does not.

The ambiguity was not dispelled until the SAT on Feb 6 issued another notice offering a detailed explanation. The foreign business community understands the seriousness of the matter and how it takes a considerable effort for the SAT to consult various parties and formulate an enforcement plan.

But the costs associated with the huge uncertainty during a five-year period without a clear explanation are incalculable.

The updated elaboration, along with the previous enforcement of the General Anti-Avoidance Rules, comes amid globalization and China's desire to be a top destination for foreign direct investment. If a country's tax collection regime cannot keep up with foreign investors' increasingly sophisticated ways of dodging taxes, it incurs huge financial losses for that country.

That is why President Xi Jinping, during last year's G20 Summit in Australia, affirmed the importance of "reinforcing international collaboration on tax matters and cracking down on cross-border tax avoidance and evasion".

The SAT was quick to take the cue and announce relevant measures. Zhang Zhiyong, deputy director of the SAT, told his staff during a recent conference that international taxation work should "jump to a new stage" every year. All the necessary legislative amendments should be completed by end-2016, he said.

For foreign companies, especially multinationals that operate in many countries beyond China, a failure to comply with the regulations (whether intentionally or not) can mean a high penalty, especially under current circumstances. China's move last year to levy $140 million in back taxes on United States-based Microsoft Corp highlighted the risk. Microsoft denied any wrongdoing.

What worries multinationals most is the issue of transfer pricing, which involves transactions among divisions of a company. Transfer pricing is often a conduit for corporate tax avoidance, especially if such transactions involve lowering profits for a division domiciled in a high-tax country while raising profits in a lower-tax location.

Tax authorities tend to view "related-party transactions", in which transfer pricing is the core issue, as a method of tax avoidance. In many cases, though, multinationals have legitimate reasons for such deals.

Walter Tong, managing partner of Ernst & Young tax services for greater China who consults frequently with foreign enterprises and Chinese policymakers, said transfer pricing is the most common issue his clients raise.

"Multinationals generally don't care about paying tax. Are there companies that place their profits in the Cayman Islands? Yes, of course. But fewer and fewer are doing so.

"What they care about are the 'rules of the game'. Are they clear? Consistent? Does every country play by the rules? Because any country's failure to play by the rules may result in double taxation or double non-taxation," Tong said.

He said "advanced rulings", along with "advanced pricing agreements", are common practices in developed economies to enhance the predictability of big companies' taxation.

While China has yet to introduce the "advanced ruling" system, it signs many advanced pricing agreements every year. These are popular among multinationals. But the approval process for "advanced pricing agreements" is time-consuming and resource-intensive for the SAT.

Multinationals need to prepare thoroughly and work with their advisers ahead of such reviews.

For corporations, it is vital to submit high-quality financial reports and present a sound technical basis for "advanced pricing agreements", Tong said.

Companies can also seek "compliance agreements" with the SAT to achieve some predictability. "Any communication can help reduce uncertainty," he said.

For its part, the SAT should make the rules on "transfer pricing" more transparent. It should also increase its staff to meet foreign companies' surging demand for "advance pricing agreements".

The SAT has proved its efficiency in plugging tax loopholes. It is time to prove its efficiency in enhancing services.