China s Controlled Foreign Corporation (CFC) Rules

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1 China s Controlled Foreign Corporation (CFC) Rules Liao Tizhong: Deputy Director General of International Taxation of the State Administration of Taxation of the P. R. China In 2008, China launched a major Corporate Tax Reform by introducing the People s Republic of China s Corporate Income Tax (CIT) Law. The new CIT law contained a new chapter devoted to Special Tax Adjustments 1. Under the Special Tax Adjustments chapter, the CFC rules were introduced. It was the first time in China s corporate tax history to introduce CFC rules. I. Economic history setting ground for the CFC rules in China Over the past three decades, China has experienced remarkable economic development. In the past, China adopted a closed and planned economy. Only until 1978 when the Chinese government introduced the Open Door Policy, under which the domestic market gradually became accessible to the outside world. Market economy has officially become on track since1992. Historically China is a country of absorbing foreign direct investment. Outbound investment became the Central Government s strategy since After China s admission to the World Trade Organization in December 2001, China s outbound investment began to grow dramatically. As of today, China has often been widely seen as an engine of world economic growth. Exhibit 1 provides a snapshot of China s inbound and outbound foreign direct investment (FDI) from 1981 to July CIT Law, Chapter 6. 1

2 Exhibit 1: China s inbound and outbound investment from 1981 to July 2011 US$ billion 120 Inbound Outbound Note : Outbound FDI only includes non-financial outbound investments Source: Compiled with data from United Nations Conference on Trade and Development and Ministry of Commerce ( MOC ). Exhibit 2: China s outbound investment into Hong Kong, the Cayman Islands and the British Virgin Islands from 2006 to 2010 Amount in US billion dollar Total foreign direct investment Foreign direct investment into - Hong Kong Cayman Islands The British Virgin Islands (BVI) Investment into the above countries/jurisdictions Percentage (out of total foreign direct investment) 87% 69% 76% 75% 70% Source: Compiled with data obtained from the MOC and the National Bureau of Statistics of China Exhibit 2 indicates that the Caymans Islands and BVI are popular platforms for China s outbound investment flows. As the Cayman Islands and BVI are well-known as tax heavens where no or minimal taxes are imposed, Chinese companies can reduce or minimize taxes by investing in these countries/jurisdictions. It has come to the Chinese government s concern that they need to take measures to tackle these tax avoidance actions. II. The New CIT Law in 2008 The Chinese legislative system itself has been developing rapidly to adapt to the new economic environment. Under the old income tax regime, corporations on the Chinese market were taxed under two different systems, one for domestic enterprises and one for foreign invested enterprises and foreign enterprises. With the new CIT Law, these 2

3 two systems were merged and the preferential tax policies enjoyed by foreigninvested enterprises were abolished, creating a level playing field between domestic enterprises and foreign/foreign-invested enterprises. The new CIT law also included a very important Special Tax Adjustment Chapter under which the Chinese CFC rule was first introduced. The CFC regime was introduced to counteract Chinese companies' attempt to reduce the Chinese CIT liability through setting up entities in low tax jurisdiction and retaining the profits in those overseas entities without commercial reasons 2. Obviously, the Chinese CFC rule is considered to be at very early stage in comparison with other jurisdictions, for example the United States. Nevertheless, the Chinese tax authorities have in the past two years put a lot of effort in improving the CFC rules and its administration. Definition of CFC in China Article 45 of the CIT Law provides that a foreign company controlled by PRCresident companies and/or individuals is incorporated in a foreign jurisdiction where the effective corporate tax is evidently lower than the tax rate of China; and the foreign company defers or reduces its declaration of dividend without valid business reasons, that foreign enterprise will be deemed as a CFC. 1. Definition of control a. Shareholding: Article 117 of the Implementation Rules of the CIT Law provided that control exists when PRC resident companies and/or individuals each directly or indirectly holds more than 10% voting shares and jointly hold more than 50% of the total shares of the foreign company 3. Note that the shares of individuals are also counted when counting the 10% and 50%. In the following example, the Foreign Co. would be considered as China s CFC. Example 1 2 Interpretation and Application Guidelines to the CIT Law and Detailed Implementation Rules to the CIT Law. 3 Detailed Implementation Rules to the CIT Law, Article 117(1). 3

4 Note: the aggregate shares held by PRC residents have exceeded the 50% threshold, i.e. 10.1%+10.1%+29.9%=50.1%. The 9.9% will not count as it falls below the 10% voting shares threshold. In addition, a CFC could be held by different connected / unconnected residents, and a CFC could be held directly or indirectly by the resident(s). In the following example, all A Ltd, B Ltd and C Ltd would be considered as China s CFCs. Example 2 Under the China s CFC determination method, if an intermediate holding company holds over 50% (for example 65%) of the lower tier entities, the shareholding percentage of the China parent to the lower tier entities will be calculated by multiplying 100% (instead of 65% in the example). b. Substance over form: Even if the shareholding percentage does not meet the 50% threshold, a foreign enterprise could still be regarded as a CFC if the PRC resident enterprises or individuals have substantial control over the foreign enterprise in terms of shareholding, funding, operation, and buy & sell decisions, etc Definition of lower tax rate 4 Detailed Implementation Rules to CIT Law, Article 117(2). 4

5 Only enterprises located in a low tax jurisdiction may be deemed as a CFC. Under Article 118of the Detailed Implementations Rules of the CIT Law, lower tax is defined as where the effective CIT rate is less than 12.5% (i.e. 50% of the general statutory rate of 25% 5 in China) 6 for active income. What happened if a foreign company is considered as a China s CFC? Normally, the corporate tax resident in China should record dividend income from its overseas companies when dividend is distributed. However, if CFC rules applies, a PRC corporate tax resident needs to report its share of "deemed dividend" from the CFC in its current corporate resident CIT return, even though there is no declaration of dividend by the CFC 7, which is calculated as follows: Reportable income = deemed dividend x number of holding days / number of days in the CFC s tax year x the PRC resident s percentage of shareholding In other words, the China s CIT Law provides a current inclusion of CFC income into the PRC tax resident enterprise s tax return even if there is no actual distribution of income from the company, to counteract the deferral of income by overseas affiliates. It should also be noted that for income inclusion purposes, there is no differentiation on active or passive income of the underlying CFC. The Chinese CFC rule impose taxation all kinds of the respective share of the income of the CFC, regardless the income is derived from active business or tainted business activities. III. Exceptions to the CFC income pick-up (i.e. deemed dividend) Under the CIT Law and its Detailed Implementation Rules, exceptions to this income pick-up may apply if the CFC is located in a jurisdiction with an effective tax rate of at least 12.5% (high-tax kick out); or there are commercial reasons to keep the profits in the jurisdiction (business reason kick-out). However, the computation of effective 5 CIT Law, Article 4. 6 Detailed Implementation Rules to CIT Law, Article CIT Law, Article 45. 5

6 tax rate for this purpose and the interpretation of commercial reasons have yet to be defined. Chapter 8 of the Special Tax Adjustments Administrative Regulations (GuoShuiFa [2009] 2 ( Circular 2 )) issued on January 8, 2009, sets out the administration regulations for CFC. Circular 2 provides that the CFC rules will not apply for the PRC tax residents that satisfy any of the following requirements: 1. The foreign corporation is not located in a low tax rate country 8 ; 2. The revenue of the foreign corporation is generated from active business operations 9 ; or 3. The annual profit of the foreign corporation is less than RMB5 million 10. On January 21, 2009, following Circular 2, the State Administration of Taxation has issued a white list 11 of non-low tax jurisdictions of 12 countries (including the US, the UK, France, Germany, Japan, Italy, Canada, Australia, India, South Africa, New Zealand and Norway). Whether the exemption rules in other countries are applicable to China s CFC? Exemption rules in other countries Listed company exemption Frequently or regularly traded stock China No exception under the law, but normally a listed company should satisfy the bona-fide commercial purpose and active business test. No exception under the law but normally a listed company should satisfy the bona-fide commercial purpose and active business test. 8 Circular 2, Article 84(1). 9 Circular 2, Article 84(2). 10 Circular 2, Article 84(3). 11 Detailed Implementation Rules to CIT Law, Article

7 CFC is established for bona fide commercial purpose Active company/active business income Specific industry Specific category of income High tax rate White list of countries Black list of countries Minimum exemption i.e the monetary limit of income There is one of the allowable exceptions if it could be proved to the satisfaction of the tax authority that there is a bona-fide commercial reason for the CFC to exist in such a jurisdiction. This is one of the allowable exceptions under the CFC rules: the foreign entity mainly derives active business income 12. No exception. Not specified in CIT Law. Yes, exception where to the foreign enterprise an effective CIT rate of at least 12.5% 11 applies. Yes the US, the UK, France, Germany, Japan, Italy, Canada, Australia, India, South Africa, New Zealand and Norway are on the white list 13. No black list. Exception applies to foreign entity which derives an annual "profit" below RMB5 million 14. IV. Implications of CFC rules The CFC rules only affect the timing of the recognition of dividend income from the CFC for tax purposes. Distributions which have previously been deemed as dividends and already been subject to China CIT under the CFC rules would be exempt from China CIT during the actual distributions. 12 Circular 2, Article Circular Circular 2, Article 84. 7

8 Foreign tax credit (FTC) on deemed dividend Nonetheless, China provides for direct and indirect foreign tax credit subject to limitations 15. The foreign tax paid with respect to the deemed dividends should be creditable against China CIT. There is a comprehensive foreign tax credit (FTC) computation mechanism and detailed guidance 16 relating to how a taxpayer arrive at available foreign tax credit arising from its foreign sourced taxable income and relevant limitation. Unutilized FTCs may be carried forward for five years. Articles 23 and 24 of the CIT Law allow the resident company to relieve from double taxation not only on the relevant foreign income taxes paid by the resident itself ( direct tax credit, e.g., withholding taxes paid on passive income) but also the underlying foreign income taxes on the income that is earned by the foreign subsidiary out of which the dividend is distributed to the Chinese resident company (indirect tax credit). A PRC tax resident company and non-prc tax resident company (deriving foreign source income effectively connected to its business in mainland China) may claim direct FTC on income tax it pays in a foreign jurisdiction. An indirect FTC may also be claimed by a PRC tax resident company for foreign corporate tax paid by a foreign company in which the PRC tax resident company holds more than 20% of shares of that foreign company with a maximum of three layers and such tax paid is attributable to dividends paid by the foreign company to the PRC tax resident company. There are some ownership requirements for claiming indirect FTCs 1. The resident company must hold no less than 20% of total shares, directly or indirectly, in its overseas subsidiaries of not lower than three qualifying tiers. 2. Qualifying First Tier Overseas Co (FTOC) PRC resident company must directly own no less than 20% of FTOC s shares. 15 CIT Law, Article CaiShui [2009] 125 and SAT Notice [2010] 1. 8

9 3. Qualifying Second Tier Overseas Co (STOC) and Third Tier Overseas Co (TTOC) The tier immediately above it must directly hold no less than 20% of the shares of the STOC or TTOC, and the PRC resident company must directly or indirectly hold no less than 20% of the shares of the STOC or TTOC through one or more qualifying overseas companies. The Elimination of Double taxation clause of certain of China s tax treaties may substitute 10% ownership for the 20% ownership requirement. V. Income reporting for the Chinese investors for investment in a CFC Assuming the Chinese investor falls under the definition of corporation and the CFC rule would apply, the State Administration of Taxation has issued Circular GuoShuiFa [2008]114 for the filing of an annual related party return, among others, the Chinese investors have to report on the prescribed Form-8 for investment in CFC, including information on Profits and Loss and Balance Sheet of the CFC. This is only an information return. VI. China s CFC rules are still in early development stage Due to the accelerated tax globalization, one of the key tax policy drivers is to protect China s interest in the globalised environment and resolve international tax matters involving China.. Given the lack of practical experiences of dealing the international situations and limited knowledge on the CFC application, even Circular 2 was only managed to set forth outline on a few aspects without detailed implementation of the CFC rules. Though both the CIT Law and the Individual Income Tax Law adopt a world-wide tax system, the tax administration of offshore income in China is in need of further strengthening. In view of the above, a new dedicated division for CFC will be established by the State Administration of Taxation, which will be administered under the International Tax Department. This new division will focus on administrations for CFCs as well as for overseas resident companies in line with China s increasing outbound investment. 9

10 Also, the Chinese Government is seeking stronger legal support by developing more technical guidelines for proper application and administration of the CFC rules. The Chinese tax authorities may introduce CFC rules in Individual Income Tax law (currently CFC rules are covered in Corporate Income Tax Law only), and formulate more procedural rules to support CFC administration in the Tax Collection and Administration Law. In order for the CFC system to develop in line with international practice, China is taking every effort to improve its legislation to strengthen anti-tax avoidance and to promote international cooperation so as to promote international understanding of the Chinese tax policies and build a tax regime that supports Chinese economic development while respecting fair share of revenue and safe protection of tax base. In March 2011, China s national strategy, i.e., the 12th Five-Year Plan (for years ) was approved by the PRC National People s Congress. The 12th Five- Year Plan emphasizes the going out strategy and importance to support domestic enterprises to invest overseas. It is expected that any tax policy changes (including CFC administration) will be more aligned to the economic goals outlined in the 12the Five-Year Plan. 10