Practical China Tax and Finance Strategies Covering Tax and Finance Developments in China

June 2009 Volume 3, Number 6

China Issues Detailed In This Issue Rules on Deductions for China EIT and Asset Losses China’s Ministry of Finance and State Asset Losses -- Administration of Taxation have jointly issued guidance on the ability to deduct New Incentives for Technology asset losses from the enterprise income tax. Companies New technology incentives are available to qualified enterprises located in 20 cities designated as China’s Outsourcing Model By Yongjun Peter Ni, Linda Ng, Jiang Bian and Cities. Page 1 Angel Wu (White Case, China) Controlled Foreign Corporations Detailed Rules on Deduction of Asset Losses Issued in China Under the new Enterprise Income Tax Law, the taxable income is de- The ‘place of actual management’ is a key fined as an enterprise’s total income minus the sum of non-taxable income, determinant on whether an enterprise will tax-exempt income, deductions and net operating loss carryovers. Deduc- be treated as a ‘resident enterprise.’ This is tions include costs, expenses, taxes, losses and other expenses. In order to critical to deferal if the taxpayer is subject provide detailed guidance on loss deduction, the Ministry of Finance and to tax on its worldwide income or is only subject to tax on China-sourced income. the State Administration of Taxation (“SAT”) have jointly issued circular Page 1 Caishui [2009] No 57, the Notice regarding Pre-tax Deduction of Asset Losses, Business in China See Asset Losses, page 11 China’s rating for contract enforcement is actually better than the United Kingdom and Japan. The key to enforcing contracts is knowing provisions that must be included. Chinese Controlled Foreign Page 3 Tax Free Reorganizations in China Corporations: China now has a set of rules providing for so-called “tax-free” (or actually tax-deferred) Actual Management Key to Residence corporate reorganizations.The new rules are Treatment based on the same fundamental principles as the U.S. tax rules regarding corporate By Patrice Marceau and Daniel Chan reorganizations. Page 6 (DLA Piper, China) Hong Kong Issues Guidance on Transfer Pricing Guoshuifa [2009] No. 82 issued by the SAT clarifies when Chinese- The increase in tax planning structures controlled foreign companies will be considered to have their ‘place involving companies located in tax haven of actual management’ in China. ‘Place of actual management’ is a key jurisdictions have heightened tax authorities’ determinant on whether an enterprise will be treated as a ‘resident en- awareness of the transfer pricing issue. terprise’ or ‘non resident enterprise’ which in turn arbitrates between Page 9 the taxpayer being subject to tax on its worldwide income and being subject to tax only on China-sourced income. Circular 82 is retroactive to January 1, 2008. Table of Contents TableSee of page Contents 2 See page 2 See Foreign Corporations, page 15 Contents China Issues Detailed Rules on Deductions for Asset Business in China: Misconceptions on Contract Losses—New Incentives for Technology Companies Enforcement and Chinese Debt Collection Practices By Yongjun Peter Ni, Linda Ng, Jiang Bian and By Dan Harris Angel Wu (Harris & Moure, PLLC, Seattle, Washington).....page 6 (White Case, China)...... page 1 Hong Kong and Transfer Pricing: DIPN 45 Provides Chinese Controlled Foreign Corporations: Actual Additional Guidance Management Key to Residence Treatment By Patrice Marceau and Daniel Chan By Patrice Marceau and Daniel Chan (DLA Piper, China)...... page 9 (DLA Piper, China)...... page 1

New Tax Rules Regarding M&A Transactions in China By Lester Ross and Aileen Goa (Wilmer Hale, Bejing) ...... page 3

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Practical China WorldTrade Executive, Tax and Finance Strategies a part of Thomson Reuters P.O. Box 761 Concord, MA 01742 Tel: 978-287-0301; Fax: 978-287-0302 Production Manager: Dana Pierce Website: www.wtexecutive.com Marketing: Jon Martel Publisher: Gary A. Brown, Esq. Editor: George Boerger, Esq. WorldTrade Executive TAX ADVISORY BOARD

Richard E. Andersen, Esq., Arnold & Porter LLP Yongjun (Peter) Ni, White & Case

Sunghak Baik, Esq., Ernst & Young Antoine Paszkiewicz, Esq., Kramer Levin Naftalis & Frankel LLP (Paris) William C. Benjamin, Esq., Wilmer Cutler Pickering Hale and Dorr LLP Cristian Rosso Alba, Esq., Rosso Alba, Francia & Ruiz Moreno (Buenos Aires) John I. Forry, Esq., University of Navarre (Spain) Daniel Rybnik, EnterPricing (Buenos Aires) Jaime González-Béndiksen Esq., Baker & McKenzie John A. Salerno, PricewaterhouseCoopers LLP Jorge Gross, PricewaterhouseCoopers LLP Michael J. Semes, Blank Rome LLP John M. Kelly, PricewaterhouseCoopers LLP (Dublin) Michael F. Swanick, PricewaterhouseCoopers LLP Marc Lewis, Sony USA Guillermo O. Teijeiro, Negri & Teijeiro Abogados Howard M. Liebman, Esq., Jones Day (Brussels) Miguel Valdés, Esq., Machado Associados Lisa C. Lim, Ernst & Young Pablo Wejcman, Esq., Ernst & Young Keith Martin, Esq., Chadbourne & Parke LLP Published Monthly For Subscribers Only Reproduction or photocopying, even for personal or internal use, is prohibited without the publisher’s prior written consent. All rights reserved under the International and Pan–American Copyright Convention © 2009 Thomson Reuters

On May 7, 2009, China’s Ministry of Finance all tax issues involved in corporate reorganiza- (the “MoF”) and State Administration of Taxa- tions—there are provisions on the treatment of tion (“SAT”) jointly issued the long-awaited tax attributes, several provisions are introduced Notice on Several Enterprise Income Tax Is- to guard the new freedom against abuse, and cer- sues Relating to Enterprise Reorganization tain loopholes are closed. The only major issues Activities, Caishui [2009] No. 59 (the “New related to reorganizations that are not addressed Reorganization Tax Rules”), and the Notice on in the New Reorganization Tax Rules are those Several Enterprise Income Tax Issues Relat- that are technically post-reorganization issues in ing to Enterprise Liquidation Activities, Cai- taxable acquisitions, and they are covered by the shui [2009] No. 60 (the “New Liquidation Tax New Liquidation Tax Rules. Rules”), both dated April 20, 2008, and effective retroactive to January 1, 2008. These rules mark a milestone in China’s tax reform: for the first For the first time, China now time, China now has a set of rules providing for so-called “tax-free” (actually tax-deferred) has a set of rules providing for corporate reorganizations. Before the promulgation of these new rules, so-called “tax-free” (actually corporate reorganizations were governed by one tax-deferred) corporate of two series of SAT circulars, one pertaining to domestic companies and the other to foreign- reorganizations. invested enterprises (“FIEs”). The series for FIEs consisted of Guoshuifa [1997] No. 71 (“Circular 71”) and Guoshuifa [1997] No. 207 (“Circular Summary and Analysis 207”). Circular 71 was intended to be a compre- The New Reorganization Tax Rules address hensive guideline on tax treatment of four types six types of reorganizations and prescribe two of M&A transactions: merger, division, equity types of tax treatment for them. The six transac- restructuring, and asset transfer. Circular 207 tion types include four types of M&A transac- specifically allowed a foreign investor to transfer tions—equity acquisition, asset acquisition, its equity interest in an FIE to a 100% owned sub- merger, and division—along with change of legal sidiary at cost (thus realizing zero gain), provided form and debt restructuring. A reorganization of that the transaction was motivated by a reason- each of these types is a taxable transaction unless able business purpose. Under those Circulars, it meets the requirements for a taxfree transac- many foreign investors were able to reorganize tion. This report focuses on M&A transactions. their China operations without significant tax consequences. However, the new Enterprise Taxable Transactions Income Tax Law, which unified the previously In a taxable M&A transaction, the target must separate tax regimes for domestic enterprises recognize gain or loss from the transfer of assets and FIEs, effectively repealed those Circulars as or the target shareholders must recognize gain of January 1, 2008. or loss from the transfer of their shares, and the A remarkable difference between the New purchaser takes the fair market value (in most Reorganization Tax Rules and the previous cases the purchase price) as its tax basis in the patchwork of SAT circulars is that the new rules equity or assets. Net operating losses (“NOLs”) are based on the same fundamental principles as may not be carried over to the purchaser (to the U.S. tax rules regarding corporate reorgani- offset its own tax liability). Surviving parties can zations. They also recognize a broader range of continue to enjoy their pre-existing tax holidays M&A and debt-restructuring transactions already (subject to proportional reduction in the case of common outside of China. The New Reorgani- a division), provided that they separately meet zation Tax Rules are also designed to address the qualification criteria.

See New Tax Rules, page 4

Practical China Tax and Finance Strategies © Thomson Reuters 2009 New Tax Rules, from page 3

Tax-Free Reorganizations operations of the transferred assets must con- When a transaction qualifies as a tax-free tinue for at least 12 months after the transfer, transaction, recognition of gain or loss from the any nonequity payment (defined to include cash, transaction (other than gain allocable to “boot”) bank deposits, accounts receivable, marketable is deferred until a future recognition event. The securities, inventory, fixed assets, other assets, deferral (rather than permanent exemption) is assumption of liabilities, etc., together commonly preserved through the concept of “substituted referred to as “boot”) must be less than 15% of basis.” For example, in a stock-for-stock deal the total purchase price, and target sharehold- (a tax-free equity acquisition), the basis in the ers may not transfer purchaser’s equity which purchaser’s stock which the target’s shareholders they receive until 12 months after the transfer. receive is the same as their basis in the target’s The principle under lying these requirements is, according to Assistant Professor Jiguang Zhai of China University of Political Science and Law, The new rules are based on the one of the drafters of the New Reorganization Tax Rules, that a corporate reorganization should same fundamental principles not trigger tax liability to the parties as long as the U.S. tax rules regarding as they have not cashed out their stakes in the business operations. Finally, to qualify for tax- corporate reorganizations. free treatment, parties to reorganizations must report the transactions when filing their annual tax returns for the year in which the transactions stock transferred; this type of substituted basis is are completed. called “exchanged basis.” At the same time, the purchaser’s basis in the target’s stock acquired Cross-Border Reorganizations is the same as the stock’s basis in the hands of Cross-border transactions are subject to the target’s shareholders; this type of substituted additional restrictions or adjusted tax-deferred basis is called “transferred basis.” Similarly, in treatment. The New Reorganization Tax Rules a stock-for-assets deal (a tax-free asset acquisi- enumerate three types of crossborder equity or tion), the target takes an exchanged basis in asset acquisitions that are eligible for tax-free the purchaser’s stock which it receives, and the treatment: transfer of equity interest in a resident purchaser takes a transferred basis in the target’s enterprise by a non-resident enterprise to its 100% assets received. Tax-free mergers and divisions non-resident enterprise subsidiary (“foreign Co- are treated the same way. By imposing substi- to-foreign Sub”), transfer of equity interest in a tuted bases, the rules make sure that the built-in resident enterprise by a non-resident enterprise gain in the equity and assets will be taxed when to its 100% resident enterprise subsidiary (“for- the new owners make a taxable disposition in eign Co-to-domestic Sub”), and transfer of equity the future. It is in this sense that the commonly or assets by a resident enterprise to its 100% used term “tax-free” is inaccurate. Finally, the last non-resident enterprise subsidiary (“domestic benefit of tax-free treatment in tax-free mergers Co-to-foreign Sub”). Other types of cross-border and divisions is that NOLs can be carried over transactions are not eligible for tax-free treatment to the new owner, subject to certain limitations. unless otherwise approved by the MoF or SAT. Treatment of tax holidays is subject to the same For domestic Co-to-foreign sub transactions, the rules as govern taxable reorganizations. favorable tax treatment is a 10-year concession rather than an open-ended deferral: gain realized Criteria for Tax-Free Reorganizations must be recognized over a 10-year period using The criteria for tax-free treatment are essen- a straight-line method. For foreign Co-to-foreign tially the same as the combined criteria contained Sub transactions, two additional requirements in the Internal Revenue Code and case law of must be met: (1) the Chinese capital gains with- the U.S., such as business purpose, continuity holding rates applicable to the transferee and the of business enterprise (“COBE”), continuity of transferor must be the same (which will depend shareholder interests, the “all or substantially all” on the terms of any applicable income tax trea- requirement, and limitation on boot. Specifically, ties), and (2) the transferor must undertake in the transaction must have a bona fide business writing to the governing tax bureau that it will purpose, 75% or more of the target’s total equity not transfer its interest in the transferee for three or assets must be transferred, the original core years after the transfer. Presumably, these addi-

Initial Reactions Conclusion Although business and tax professionals gen- The new rules reflect the Chinese govern- erally welcome these new rules, some are already ment’s growing sophistication and familiarity concerned about the potential impact of certain with international tax and corporate practices. provisions that are less favorable than previous In the past, the bulk of tax planning techniques rules. During the period from January 1, 2008 to used by parties to enhance deal value were use- May 7, 2009, many overseas holding companies less in China. These new rules will change that transferred their interests in PRC operating and, as the government has intended, facilitate companies to Hong Kong intermediate holding bona fide M&A activity. companies with the goal of taking advantage of The new rules will also present new chal- the lower dividend withholding rate under the lenges to both the government and taxpayers. PRC-Hong Kong tax arrangement. Many such Given the brevity of these rules and the broad transactions were entered into on the assumption range of transactions governed by them, they that Circular 207 remained in effect until it was are vulnerable to abuse. The New Reorganiza- officially repealed. As the New Reorganization tion Tax Rules introduce the step-transaction Tax Rules are effective retroactive to January 1, doctrine, which authorizes tax bureaus to treat 2008, those companies now must prove that their multiple transactions taking place within a 12- transactions qualify for tax-free treatment under month period as a single transaction based on the above requirements. This may be a challenge if the Hong Kong company does not perform substantive functions or its functions are not The new rules will also present supported by adequate documentation. Another point of concern is the rigidity of new challenges to both the the additional restrictions for cross-border trans- government and taxpayers. Given actions. The policy underlying the additional restrictions presumably is to prevent tax leakage the brevity of these rules and through sham outbound transactions, but these the broad range of transactions restrictions can also impose additional barriers and costs on legitimate intra-group consolida- governed by them, they are tions. For example, suppose a multinational vulnerable to abuse. corporation wants to consolidate two of its PRC operating companies, one held through a Hong Kong holding company and the other through a the substance-over-form principle. Together with Cayman holding company, by having the Cayman the business-purpose requirement, this rule will company transfer its equity interest in its WFOE prove to be a powerful anti-avoidance device. to the Hong Kong company in exchange for the However, sophisticated techniques could be used Hong Kong company’s stock. Even if this transac- to plan not only direct tax consequences but also tion is motivated by legitimate business reasons, tax attributes, and we have yet to see if the exist- it will not qualify for tax-free treatment because ing anti-avoidance rules will be sufficient. it does not fit under any of the three enumerated From the taxpayer’s perspective, many key forms. To achieve its business goal on a tax-free issues, such as the criteria for reasonable busi- basis, the multinational must take the additional ness purpose, the determination of fair market step of first transferring its equity interest in the value, and the specifics of COBE, remain vague. Hong Kong company to the Cayman company, Much of the vagueness is probably intentional, so that the Hong Kong company becomes a 100% since certain issues—such as the step-transaction subsidiary of the Cayman company. Then, when doctrine and the reasonable business purpose the Cayman company transfers its WFOE to the requirement—are by their nature much better ad- Hong Kong company, the transaction can be eli- dressed by a “facts and circumstances” approach gible for tax-free treatment. In contrast, Circular than by a set of codified criteria. As a result, we 207 would have allowed one-step restructuring, are likely to see communications between tax as it allowed tax-free equity transfers not only to bureaus and taxpayers becoming a more impor- See New Tax Rules, page 6

Practical China Tax and Finance Strategies © Thomson Reuters 2009 New Tax Rules, from page 5 tant part of tax practice. Although currently there are no formal procedures for obtaining rulings Lester Ross is co-partner-in-charge of WilmerHale’s from the Chinese tax authorities, some national Beijing office and a partner in the firm’s Antitrust tax bureaus at provincial or municipal levels and Competition, Asia Corporate, and Environ- are prepared to provide verbal guidance upon mental Practice Groups. He is also a member of the request. Some issues, however, can be clarified Emerging Energy Technology Group. Mr. Ross’ by administrative guidance. For example, what practice concentrates on mergers and acquisitions, are the details of the COBE requirement—does foreign investment, competition, financial services, a purchaser have to continue the historical busi- project finance, energy and environmental law matters ness of the target, or can the purchaser use the and capital market. He can be reached via e-mail acquired assets to operate a similar business? at [email protected] or by phone at +86 10 These questions can determine the feasibility of 8529 7588. Aileen Gao is an associate in the Beijing a deal, and companies will welcome guidance office of WilmerHale. She can be reached by e-mail when contemplating M&A transactions. at [email protected] or by phone at +86 10 8529 7588.

Business in China: Misconceptions on Contract Enforcement and Chinese Debt Collection Practices By Dan Harris (Harris & Moure, PLLC, Seattle, Washington)

Enforcing Contracts In China. Way, number 83 on the list. Not the worst, but still a Way Better Than You Think challenging place to do business. China gets low At a recent meeting of foreign scores in areas that are quite familiar to me in my businesspersons in Qingdao, I sat next to a daily practice: Starting a Business 151, Employing very unhappy man who loudly stated: “Chinese Workers 111, Paying Taxes 132. contracts are not worth the paper they are However, in the category of Enforcing written on.” I told him: “Your statement is not Contracts, China is rated as number 18. This true. As a matter of fact, the Chinese courts do means that China has one of the best systems in very well at enforcing clear written contracts.” the world for enforcement of contracts. Compare As usual, I was greeted with disbelief. The that with India, which is rated 180 out of 181 problem with this person’s statement is that countries, or Brazil, which is rated at 100. The it becomes a self-fulfilling prophecy. People China rating is actually better than the United who think China will not enforce contracts Kingdom, which comes in at 23, and better tend to ignore the issue. They either enter into than Japan, which comes in at 21. It is therefore no contract at all or they enter into a poorly a serious mistake to place China in the same drafted contract or they enter into a contract that category as some of its developing country is not enforceable in China. This is the actual competitors. story for this particular individual. As he now Given the facts, why do people continue knows, this attitude about Chinese contract to say that Chinese contracts are not worth the enforcement is a mistake. paper on which they are written? This appears to My view of the Chinese contract enforcement be based on the following three basic reasons: process is based on over 30 years of experience • Chinese companies have an unfortunate in China. However, I am clearly not the only tendency to ignore contract terms in dealing person who has come to this conclusion. Every with foreigners. They do this not so much year the World Bank publishes its Doing Business because they believe they can prevail in rankings. This report ranks 181 countries by ease any eventual lawsuit, but rather, because of doing business. As might be expected, China they assume (too often rightfully) that the ranks about in the middle of this list. It is ranked foreigner will not sue. This leads them to

© Thomson Reuters 2009 June 2009 believe they can violate contract terms with and the Chinese company was refusing and little risk. threatening to sue. I advised my client not to • Many contracts entered into by foreigners pay anything, based on two legal maxims. One, are simply unenforceable in China. A typical possession is nine-tenths of the law, and two, unenforceable contract is not written in never fund someone who is threatening to sue Chinese, not subject to Chinese law and you. provides for enforcement outside of China. So I met with this US client last week on Such contracts are truly usually not worth the something completely unrelated and I asked paper on which they are written, but this is him “whatever happened with that Chinese not due to a defect in China’s legal system. supplier that had been threatening to sue you?” • Many contracts are too vague to allow for His response was that absolutely nothing has effective action by the courts. The Chinese changed. Every few weeks, the Chinese company courts are good at enforcing simple, clear emails seeking its $350,000 and threatening to contracts where the standards for default sue. My client responds by offering $200,000 in are objective and where the penalty requires full settlement and the Chinese company refuses. little analysis. The Chinese courts are not We laughed and moved on. good at making a contract for the parties, as is common in the U.S. and English legal The China rating in contract systems. It is therefore essential to use contracts in a way that will produce a good enforcement is actually better result in court. I see many foreign parties who want to base a claim on a complex set than the United Kingdom, which of emails, oral communications and practice comes in at 23, and better than over time. This does not typically work in China. An aggressive lawsuit based on a clear Japan, which comes in at 21. written contract does work. 2. Many years ago, my firm was retained by The Chinese court system is one of the gifts a Chinese company to collect on approximately the Chinese system gives to foreign investors. $500,000 owed the Chinese company by a US Given the other obstacles and difficulties the company. My firm mapped out our litigation Chinese system poses for foreign investors, it strategy, which involved suing an Alabama based is really a big mistake not to take advantage of company in Washington Federal Court. We spent the Chinese court system for enforcement of an inordinately long time discussing with the contracts. client the costs involved in such litigation and the strategies we would employ. The Chinese Owe Money To A Chinese Company? company hired us and sent us a decent sized No Need to Pay retainer. If you owe money to a Chinese company for We emailed the Chinese company to say the product and you cannot pay all of your creditors, retainer had arrived and they emailed me back skip out on the Chinese company. Near as I can with a laundry list of things we should do on the tell, there is nearly a 100% chance they will never case. Nothing on that list corresponded to what sue you to recover. we had told them we needed to do and one of the I am NOT advocating not paying your things on the list was flat out ridiculous. We had debt, but I am saying that if you have to choose a few weeks earlier told the Alabama company among your creditors on who to pay, the Chinese that if they did not pay by such and such a date, company should be your choice. I am saying this we would sue them. Amazingly enough, item #1 based on the following: on the list from the Chinese client was that I fly 1. About a year ago, a client had come to down to Alabama to try to talk settlement. We me for a consultation regarding a dispute it wrote the Chinese company and explained that was having with its Chinese OEM supplier. The they had hired us because we were US attorneys Chinese company was threatening to sue my and, as such, we know what we are doing in client for about $350,000, per its invoices. My terms of dealing with US companies on what client was refusing to pay the Chinese company had now essentially become a US case. We told due to a spate of bad product. My client was the Chinese company that the absolute worst seeking a $150,000 credit for the bad product See Business in China, page 8

Practical China Tax and Finance Strategies © Thomson Reuters 2009 Business in China, from page 7 thing we could do would be to fly to Alabama Our Chinese client is owed millions by a US to talk settlement and that doing so would be company and that US company figured it would tantamount to our saying that we were not really not need to pay. What this US company did serious about suing. The Chinese company then not figure was that our client would alert the confessed that they were not really serious about other manufacturers of the non-payment and suing and that they just wanted us to settle the now none of those manufacturers will make case. I then gave them the maxim about how product for this US company either. Once the you have to be prepared to try a case to settle a US company started running out of product, case and they told me they had decided not to go it started paying our client again. On the other forward with the matter and asked us to return hand, if you have but a small presence in China the retainer, which we did. and you can switch your manufacturing over to I emailed them the other day just out of some other country.... curiosity to ask how their case was going and they asked us to take their case on again. We Trademark Protection In China – vehemently declined and noted how they needed Is your Trademark Registered? to retain an attorney immediately because they Over the last six months or so, my firm’s were now facing serious potential statute of work for Chinese companies going international limitation problems. has zoomed, and with that, my knowledge of how 3. We were once contacted by a Chinese Chinese companies “handle” foreign companies company owed around $300,000 by an American has zoomed as well. One of the things I have company. We asked him all sorts of questions learned is that Chinese companies understand about the debt and he gave good answers so we the value of trademarks -- YOUR trademark. Let me explain. I am going to have to be very vague here so as The Chinese courts are good at to avoid revealing any confidential information, but I can be specific enough so you can get the enforcing simple, clear contracts gist. Two stories: where the standards for default 1. Chinese company manufactures product for US company. Product ships from China are objective and where the with US company name on it and US company penalty requires little analysis. distributes it throughout North America. China company also sells its product in North America under its own brand name. US company is trying to get Chinese company to lower its prices and asked him to send us the documents. Turns out Chinese company is balking. US company is his debt was about ten years old and way past talking of finding another manufacturer. Chinese the time we could sue. We asked him why they company tells me that people in China “very had waited so long and the explanation was friendly” to them registered the US company’s that they had been trying to work it out. I am name in China for this product years ago and so not kidding. if anyone else tries to manufacture this product My firm has been handling cases like these in US company’s name, Chinese company for Korean and Japanese and Russian and will be able to stop them based on trademark German and companies from other countries for violation. years. China is different. Sorry. China company is very smart. It knew that This is not to say, however, that foreign it could not register the trademark itself because companies that do not pay may not face China trademark law prohibits an agent to repercussions other than a law suit. For example, register the trademark of the company for whom if you are a foreign company with a real presence it is acting as agent, so Chinese company did not in China, not paying a Chinese company might register the trademark itself. US company is going end up causing you real problems in China and to be in for a very rude awakening if it ceases to you must consider this before choosing not use this Chinese company for its manufacturing. to pay. Just by way of example, we represent Now here’s the part that ought to really scare a large Chinese manufacturer in an industry you. I asked my Chinese client how they knew where there are only around five companies to secure the trademark and the response was capable of manufacturing this particular product. “everybody in China knows about this.”

© Thomson Reuters 2009 June 2009 2. US Company A is in a very contentious Vacuums get filled and if you are having battle with US Company B. US Company A had product made in China with your name on it, for many years been working with US Company you had better register your trademark in China, B, with US Company A assisting US Company even if (especially if?) your China presence is B in China. But when things started going bad, through a third party. US Company A had a Chinese company secure On the flip side of this, if you are a company a China trademark for a name that is absolutely that gets paid to handle China outsourcing for essential for US Company B. US Company B does Western companies, you would be well advised not know this yet as US Company A plans not to to put something in writing somewhere (perhaps tell them unless and until things get really bad, in your contract with the Western company) along the lines of a loss at trial, if things ever get making clear that you are of the view that your that far without resolution. client should be registering its trademark and Because US Company A is a US company, I that you will not be doing that for them. Such a was a bit concerned that its having orchestrated provision will help protect you from a negligence the registering of a China trademark of a name or breach of contract lawsuit should what I that is absolutely critical for Company B might described above happen to your Western client. somehow subject Company A to legal liability in the US. However, I have discussed this with many US lawyers expert in this sort of thing and Dan Harris is a partner in the Seattle, WA law firm all of them are of the view that this is not going of Harris & Moure, PLLC. Harris & Moure is an in- to be the case because Company A’s actions were ternational law Boutique firm with lawyers in Seattle completely legal in China. Amazingly enough, and in China. Harris & Moure also maintains a China US Company A has a paper trail showing that law blog at www.chinalawblog.com. Mr. Harris can it strongly advised US Company B of the need be reached by phone at (206) 224-5657 or via e-mail for US Company B to register its trademark in at [email protected]. China.

Hong Kong and Transfer Pricing: DIPN 45 Provides Additional Guidance By Patrice Marceau And Daniel Chan (DLA Piper, China)

The Hong Kong IRD has long promised a Section 20(1) of the Inland Revenue Practice Note1 on transfer pricing even though Ordinance the Inland Revenue Ordinance does not really This is the only transfer pricing-like provi- have a particularly robust framework for trans- sion of the Inland Revenue Ordinance. The section fer pricing. In the past, transfer pricing was not applies where a Hong Kong resident deals with an issue detrimental to Hong Kong since groups a closely connected non resident and the…busi- of companies usually diverted profits to Hong ness is so arranged that it produces to the resident Kong rather than out of Hong Kong. In recent person either no profits…or less than the ordinary years however, we have seen more and more profits which might be expected to arise in or derive tax planning structures involving companies from Hong Kong. In such case, the…business done located in tax haven jurisdictions such as the by the non-resident person…shall be deemed to be British Virgin Islands and the Cayman Islands carried on in Hong Kong, and such non-resident and, as a result, the authorities have become person shall be assessable and chargeable with tax in more aware of the issue. respect of his profits from such business in the name of the resident person as if the resident person were Generally, the Hong Kong tax authorities can his agent. Because the wording of the section is achieve transfer pricing adjustment by various somewhat convoluted, in practice, the provision means such as: is rarely invoked by the tax authorities. See Transfer Pricing, page 10

Practical China Tax and Finance Strategies © Thomson Reuters 2009 Transfer Pricing, from page 9 Asset Losses, from page 1

Section 16 of the Inland Revenue Ordinance being taxed in the hands of two entities located This is the general provision confirming the in different jurisdictions. Economic double taxa- right of taxpayers to deduct expenses…to the tion would occur if a payment from a Hong Kong extent that they are incurred…in the production of entity to a foreign entity is considered income profits …chargeable to tax.The words ‘to the extent for the recipient but is denied as a deduction for that’ provide the tax authorities the flexibility the payor. The other is what is called juridical to deny this or that deduction if they are of the double taxation where the same entity is taxed view that the profits assessable in Hong Kong in two jurisdictions on the same profits. For in- within a related group are insufficient. By simply stance, juridical double taxation can occur where questioning the validity of a deduction, the au- a Hong Kong company with a branch in another thorities can effectively adjust the transfer price jurisdiction is taxed in both Hong Kong and the of the goods and services transacted between other jurisdiction on the same income. the Hong Kong company and the other entities The DIPN details the conditions, procedures of the group. to follow and methods of adjustments when a Hong Kong resident is caught in either juridical Section 61A of the Inland Revenue Ordinance or economic double taxation. While of limited use Section 61A is the general anti-avoidance for now, we suspect that it will become ever more provision of the Inland Revenue Ordinance and it relevant as the next few years, particularly given provides wide authority to the Commissioner to the attention given to transfer pricing around the review transactions and adjust their tax results world in recent times.

1. The official name of the relevant publication is De- In the past, transfer pricing was partmental Interpretation and Practice Notes. These not an issue detrimental to Hong are guidance produced by the tax authorities to set out their position on particular matters. Kong since groups of companies 2. Paragraph 13 of DIPN 45 says that [t]he basis on which transfer pricing adjustment are to be made is ex- usually diverted profits to Hong plained in another Departmental Interpretation and practice Note. As we are not aware of a DIPN yet on transfer Kong rather than out of Hong pricing, perhaps the author of DIPN 45 was jumping Kong. the gun and one will be issued very soon. Mr. Marceau is a Canadian living in Hong Kong where it is found that the taxpayers did not abide since 1996. He is partner in the Corporate group of by appropriate commercial principles. DLA Piper Hong Kong specializing in Hong Kong DIPN 452 is unfortunately not yet the long and regional taxation. Mr. Marceau has extensive awaited official view on the topic of transfer pric- experience advising corporations and high net ing and it deals only with adjustment to transfer worth individuals on tax planning and litigation pricing in the context of transactions involving matters. His practice focuses on tax planning for Hong Kong and a jurisdiction with which Hong individuals, including estate planning, establishing Kong has a tax treaty. Given that right now Hong and advising on the use of trusts for tax planning Kong has tax treaties only with Thailand, Luxem- purposes (particularly from a Canadian angle) as bourg, Belgium and Vietnam (not yet in force), well as local, regional and international tax issues as well as a tax treaty like arrangement with the for corporations and other business entities. Mr. Mainland of China, the new DIPN will have lim- Marceau may be reached by phone at +852 2103 ited impact for the time being. However, given 0554 or via e-mail at [email protected]. the firm intent of the government to expand the Mr. Chan’s practice focuses on providing advice to tax treaty network, and the steps it is undertak- multinational clients and Hong Kong-based clients on ing to make itself attractive to treaty partners19, investment and taxation in the People’s Republic of the expectations are that the treaty network will China (PRC). Recently he has focused on supply chain expand in the next few years. management, distribution and retail sectors in China. The DIPN distinguishes two types of double He has undertaken numerous transactions relating taxation which can arise as a result of transfer to direct investment, acquisitions, reorganizations, pricing adjustments. The first is what it calls tax, customs and employment in the PRC. He may economic double taxation and refers to double be reached by phone at +852 2103 0821 or via e-mail taxation arising as a result of the same profits at [email protected]

10 © Thomson Reuters 2009 June 2009 Asset Losses, from page 1

followed by circular Guoshuifa [2009] No 88, the Bank Deposits Administrative Measures of Pre-tax Deduction of As- Cash deposited in the financial institutions set Losses. The latter lays out the detailed imple- with valid deposit licenses and lost due to their mentation rules on deduction of asset losses. Both bankruptcies, liquidations, creasing operations circulars take retroactive effect back to January or closures can be claimed as losses. 1, 2008. We have summarized the salient points of the two circulars as follows. Accounts Receivable and Advance Payments Bad debts regarding accounts receivable Scope of Asset Losses and advance payments due to one of the follow- Under the two circulars, asset losses that can ing reasons can be claimed as losses: be deducted are divided into three categories, based on the nature of the asset: In order to encourage • Losses related to monetary assets such as cash, bank deposits, accounts receivable and technologically-advanced service advance payments; enterprises, the Ministry of • Losses related to non-monetary assets such as inventory, fixed assets, constructions in Finance, the SAT, the Ministry progress, and biological assets; and of Science and Technology and • Losses related to debts and equity investments such as loans, guarantees, letters the Ministry of Commerce have of credit, overdrafts, students loans, asset jointly issued circular Caishui managements and equity investments. (2009) No 63 that provides For this purpose, losses resulting from bad loans made by enterprises, the business licenses a number of tax incentives of which do not allow for making loans, cannot to qualified technologically- be deducted. However, this doesn’t include entrustment loans, i.e. an enterprise makes a loan advanced service enterprises. to another enterprise through a bank under an entrustment arrangement. Losses resulting from such entrustment loans can still be deducted. • Losses due to the bankruptcy, closure, dis- Also, since capital gains are taxed in the same solution, disappearance or death of the manner as ordinary income in China, capital debtor; losses from equity investment can generally be • Losses resulting from debt restructuring or deducted against ordinary income. force majeure; and • Losses resulting from being more than 3 Timing for Claiming Asset Losses years overdue, with solid evidence of insol- As a general rule, an enterprise can claim vency. asset loss deductions only in the year when the losses are recognized or actually incurred. If for Inventory, Fixed Assets and Other any reasons an enterprise cannot claim deduc- Non-Monetary Assets tions in that year, upon the approval of the tax Losses due to shortage, damage, scrap, theft authorities, it can make retroactive deductions or force majeure such as a natural disaster can be in a later year and apply for a tax refund ac- deduced after offset against insurance claims and cordingly. compensations from responsible parties. For this purpose, the input VAT paid on the inventory in Conditions for Claiming Asset Losses question should be transferred out for VAT credit The two circulars set out detailed conditions purposes and deducted together with inventory for claiming each type of asset loss. losses.

Cash Loans Cash shortages can be claimed as losses after Bad debts regarding loans falling into one of offset against compensations from responsible the following situations can be claimed as losses parties. See Asset Losses, page 12

Practical China Tax and Finance Strategies © Thomson Reuters 2009 11 Asset Losses, from page 11

after completing all the possible recovery mea- Approval Requirement sures and necessary legal procedures: Based on the two circulars, except for 6 • Losses due to the bankruptcy, closure, dis- types of asset loss such as losses due to inven- solution, disappearance or death of the bor- tory shortage, fixed asset scrap, and trading of rower or guarantor; stock, bonds, mutual funds, etc through public • Losses due to the severe natural disaster or securities markets, asset losses shall be approved accident without sufficient insurance com- before they can be deducted. pensations; • Losses due to the legal penalties on the Evidence borrower for violations of laws (e.g. death In order to support asset loss deductions, penalty) whose assets are insufficient for enterprises shall prepare sufficient evidence in- repaying the loan; cluding external evidence and internal evidence. • Losses resulting from debt restructuring; External evidence includes court decisions, police • Losses resulting from foreclosure; and reports, certifications from professional organiza- • Losses specifically approved by the State tions, etc. Internal evidence includes contracts, Council. internal memos, internal approvals, etc.

Other notable points As a prerequisite, qualified Other notable points include the following: enterprise have to be certified as • Losses due to illegal operations are not de- ducible. technologically-advanced service • Losses recovered in later years shall be enterprises by the province level included in the taxable income of those years. authorities in charge of science • Losses from operations outside China cannot and technology, commerce, be deducted against the income from operations within China. finance, tax, and development and reform, respectively. New Tax Incentives for Technologically- Advanced Service Enterprises In order to encourage technologically- Equity Investments advanced service enterprises, the Ministry of Losses from equity investments falling into Finance, the SAT, the Ministry of Science and one of the following situations can be claimed Technology and the Ministry of Commerce have as losses after offset against insurance claims, jointly issued circular Caishui (2009) No 63 that compensations from responsible parties and provides a number of tax incentives to qualified deemed recoverable value (5% of the book value technologically-advanced service enterprises. of the investment): • Losses due to the bankruptcy, closure or dis- Qualified Cities solution of the investee; The new incentives are available to the quali- • Losses due to the severe insolvency of the fied enterprises located in the following 20 cities investee that has ceased operations for more that have been designated as China’s Outsourc- than 3 years and doesn’t have a restructuring ing Model Cities. The 20 cities are: plan; • Beijing • Losses on minority investment the term of • Tianjin which has either become due or run for more • Shanghai than 10 years, due to the insolvency of the • Chongqing investee that has been making losses for three • Dalian years; • Shenzhen • Losses due to the severe insolvency of the • Guangzhou investee that has been liquidated or has been • Wuhan in liquidation process for more than 3 years; • Haerbin and • Chengdu • Other situations specified by the finance or • Nanjing tax authorities. • Xi’an

12 © Thomson Reuters 2009 June 2009 • Jinan exchange, customs, etc. during the past 2 • Hangzhou years; • Hefei • The enterprise has strong R&D ability and • Nanchang more than 50% of its total staff have colleague • Changsha or junior colleague degrees; • Daqing • The income from qualified services is more • Suzhou than 70% of annual income; and • Wuxi • The enterprise has the relevant international industry certifications and the offshore out- Incentives sourcing income received from foreign cus- Qualified enterprises are eligible for the fol- tomers is more than 50% of annual income. lowing new tax incentives: • A 15% reduced enterprise income tax rate; Certification Process • Deduction of staff education expenses up to As a prerequisite, qualified enterprise 8% of total wage expenses with the excess have to be certified as technologically-advanced being carried over to later years; and service enterprises by the province level au- • Business tax exemption for the income from thorities in charge of science and technology, offshore service outsourcing. commerce, finance, tax, and development and reform, respectively. The above incentives are valid from January 1, 2009 to December 31, 2013. Calculation of Non-deductible Interest Expenses Due to Failure to Contribute Scope of Technologically-Advanced Services Registered Capital Timely Clarified The qualified services are dividend into three The SAT has recently issued circular Guoshui- categories: han [2009] No 312 to clarify the interest deduc- • Information technology outsourcing (“ITO”), including software development, information technology R&D, information system Under the two circulars, asset maintenance, etc. losses that can be deducted are • Business process outsourcing (“BPO”), including business process design, back of- divided into three categories, fice function, internal control, supply chain based on the nature of the asset. management, etc. • Knowledge process outsourcing (“KPO”), including IP research, data mining, pharma- ceutical R&D, etc. tion issue regarding an enterprise the investors of which have failed to make a timely capital There is a detailed catalog of qualified ser- contribution. Specifically, if the registered capital vices that comes with the circular. Interested of an enterprise is not contributed within the companies can check the catalog to see if their prescribed time limit, the interest incurred on businesses are considered qualified services. its loans cannot be deducted to the extent of the difference between the committed capital and Conditions for Enjoying the Incentives the actually contributed capital. An enterprise can enjoy those incentives The formula used to calculate such non-de- if all the conditions listed below are met: ductible interest expenses is as follows: • The enterprise is engaged in one or multiple qualified services; Non-deductible interest expense • Both the registration place and the operation in a period = Total loan interest in place of the enterprise are in those cities; that period × (Capital contribution • The enterprise has a legal person status shortage in that period ÷ Total loan and hasn’t violated laws in the areas of im- amount in that period) port and export, finance, taxation, foreign See Asset Losses, page 14

Practical China Tax and Finance Strategies © Thomson Reuters 2009 13 Asset Losses, from page 13 Foreign Corporations, from page 1

Hong Kong Inland Revenue (Amendment) that is used specifically and directly for any (No. 2) Bill 2009 manufacturing process; computer hardware, The Hong Kong government published other than that which is an integral part of Inland Revenue (Amendment) (No. 2) Bill 2009 any machinery or plant; and computer soft- (the “Bill”) in the government gazette on June 12, ware and computer systems. 2009. The Bill proposes to make the following • Section 26E will be amended to empower an amendments to the Inland Revenue Ordinance assessor to make an additional assessment of (the “IRO”) to improve the administration of the tax payable due to a taxpayer’s revoca- the IRO: tion of a claim for deduction of home loan • Section 16(2)(e) will be amended to allow the interest after the statutory period of 6 years deduction, from assessable profits, of inter- provided under section 60(1) of the IRO. The est payable on capital expenditure incurred assessor may exercise the power within 2 years of the revocation of the claim. As a general rule, an enterprise • Section 71(7)(d) will be amended to empower the Commissioner of Inland Revenue to can claim asset loss deductions refund to holders of tax reserve certificates the principal value of the certificate together only in the year when the losses with interest without requiring the holders are recognized or actually to return the certificate to the Commissioner where the certificate has not been accepted incurred. as a tax payment. • Section 81 will be amended to extend the period within which prosecution of an of- on the provision of machinery or plant for fense in respect of breach of secrecy may be research and development, prescribed fixed brought from 6 months to 6 years. assets, and environmental protection ma- Other proposed amendments to the IRO chinery. For this purpose, prescribed fixed include the following changes to improve the assets include specified machinery or plant operation of the Board of Review:

• Section 65(4) will be amended to empower the chairman of the Board of Review (instead of the Chief Secretary for Administration) to nominate members to attend meetings of the Invitation to Publish Board at which appeals are to be held. • Section 65(7) will be amended to empower Since 1991, WorldTrade Executive has a person who ceases to be the chairman, a published periodicals and special reports deputy chairman or a member of the panel concerning the mechanics of international to continue to perform certain functions re- law and finance. See http://www. lating to an appeal in which the person was wtexecutive.com. If you have authored a involved before. special report of interest to multinationals, • A new section 68A will be added to empower or compiled data we want to hear from the Board of Review to correct clerical mis- you. takes or other errors (arising from any ac- cidental slip or omission) in the decisions of By publishing with WorldTrade Executive, the Board. a part of Thomson Reuters, you establish your firm as a thought leader in a particular For more information, please contact Yongjun Peter practice area. We can showcase your work Ni at [email protected], Linda Ng at lng@whitecase. to the many corporate leaders and their com, Jiang Bian at [email protected], or Angel advisers who turn to us for insights into Wu at [email protected]. Peter is a tax partner at complex international business problems. White & Case Shanghai and leads the firm’s Greater To discuss your project, contact Gary China tax practice. Linda is a counsel based in White Brown, 978-287-0301 or editor@wtexec. & Case Hong Kong. Jiang is a senior tax associate at com. White & Case Beijing and Angel is a tax associate at White & Case Shanghai.

According to Circular 82, an overseas compa- ests and other equity investment proceeds ny controlled by one or several PRC enterprise(s) received from other Chinese resident enter- will be considered a ‘resident enterprise’ due to prises1; its ‘place of actual management’ being in China • Investor(s) of the company are taxed on where all of the following conditions apply: dividends, interests and other equity invest- • senior management responsible for day- ment proceeds on the basis that such returns to-day production and operation of the originate from China for purposes of the new company is located primarily inside China and their management duties are performed An overseas company primarily inside China; • the company’s financial decisions (e.g. bor- controlled by one or several PRC rowing, lending, raising capital, financial enterprises will be considered risk control, etc) and decisions on employment (e.g. appointment, dismissal, wage and a ‘resident enterprise’ due to its compensation, etc) are made or approved in ‘place of actual management’ China; • significant assets, financial and accounting being in China if certain books, company chops, minutes of meet- conditional all are applicable. ings of board of directors and meetings of shareholders are maintained or stored inside China; and EIT Law (including any available exemption • at least half of the directors of the company therein). reside in China. • For the Chinese investors, the company is not considered a Controlled Foreign Corporation Once again, the authorities will follow pursuant to Article 45 of the new EIT Law. substance over form when assessing the circum- However, foreign entities controlled by the stances. Circular 82 provides the following guid- Company could be considered CFCs of the ance on the legal and tax treatment of a company Chinese investors. considered a resident enterprise because of its • A company may apply for registration as place of actual management. a resident enterprise at the tax bureau in • The company is eligible to the PRC tax exemption treatment on dividends, inter- See Foreign Corporations, page 16

Practical International & US/Domestic TaxTax StrategiesStrategies SeriesSeries PROVEN, PRACTICAL WAYS TO MANAGE YOUR INTERNATIONAL TAX BURDEN

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charge of the region of either its place of to deem the Hong Kong company to be a resident actual management or the location of the enterprise for EIT Law purposes. Chinese domestic enterprise investor, subject to the verification by the tax bureau and the 1. Article 26 of the new EIT Law and Article 83 of the final approval by the SAT. Failure to apply Implementation Rules will authorize the tax bureau to make its own preliminary determination on the tax Mr. Marceau is a Canadian living in Hong Kong resident status, subject to confirmation by since 1996. He is partner in the Corporate group of the SAT. DLA Piper Hong Kong specializing in Hong Kong • Where a company is also considered a and regional taxation. Mr. Marceau has extensive resident of another jurisdiction, the rules of experience advising corporations and high net any applicable tax treaty (or arrangement) worth individuals on tax planning and litigation would apply to resolve any double taxation matters. His practice focuses on tax planning for issues. individuals, including estate planning, establishing • Interestingly, an enterprise established in and advising on the use of trusts for tax planning China by the overseas company will be con- purposes (particularly from a Canadian angle) as sidered as established by a foreign enterprise well as local, regional and international tax issues and thus be able to maintain its status as an for corporations and other business entities. Mr. foreign investment enterprise under PRC Marceau may be reached by phone at +852 2103 law. 0554 or via e-mail at [email protected]. Mr. Chan’s practice focuses on providing advice to Furthermore, the guidelines set out in Circu- multinational clients and Hong Kong-based clients on lar 82 can easily extend more generally to when investment and taxation in the People’s Republic of a foreign company can be considered a resident China (PRC). Recently he has focused on supply chain on the basis of place of actual management. management, distribution and retail sectors in China. Take for instance a Hong Kong company whose He has undertaken numerous transactions relating senior staff are expatriates who are all located to direct investment, acquisitions, reorganizations, in the PRC working for an affiliate of the Hong tax, customs and employment in the PRC. He may Kong company. be reached by phone at +852 2103 0821 or via e-mail It is clear that the principles developed in at [email protected]. Circular 82 could extend to their circumstances

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