Taxation in China

 

Background
ABG Limited, established in Mainland China in 1998, is a wholly owned subsidiary of Gamma Limited in Hong Kong. The principal business of ABG Limited is investment holding, manufacturing and trading of electronic components and parts. In the recent years, ABG Limited has run its business very well in both local and overseas markets – thus it has accumulated a huge sum of retained earnings (nearly 80% of the total value of the whole company) ready for new investment opportunities or for distribution of dividends.

Being the holding company, Gamma Limited does not have any other operations except the holding investment in ABG Limited. Gamma Limited is a private limited company incorporated in Hong Kong. All directors of Gamma Limited are US citizens. They reside and work either in the USA or Mainland China. Gamma Limited does not employ any staff nor maintain any establishment in Hong Kong. The directors of Gamma Limited do not carry out any management functions in Hong Kong. (See diagram on page 2.)

The holding company of Gamma Limited is Beta Limited incorporated in the British Virgin Islands. Similarly Beta Limited’s only investment is the whole equity interest in Gamma Limited. Beta Limited is intentionally inserted as an intermediary company between Gamma Limited and their ultimate holding company, Alpha Incorporated in the USA, a company founded in Silicon Valley, California and listed on the New York Stock Exchange. Also Beta Limited does not employ any staff nor establish any operations in the BVI. The directors of Beta Limited are all US citizens and they do not carry out any management functions in the BVI.

Miss Margaret Hui, upon her leaving from Ernst & Young, CPA, in its New York office in January 2013, immediately joined Alpha Incorporated to take up the position of the group tax adviser of the Alpha Group. She recently approached you seeking advice on the following two proposed arrangements:

(1) Recently the management of Alpha Group was approached by a British consortium, Raphael Limited, to solicit a sale and purchase deal of ABG Limited, the group’s wholly foreign invested company in China at a very good price. The senior management of the group asked Margaret to consider the deal on the following two aspects:
(i) The senior management wants to dispose the group’s 100% interest in ABG Limited between Gamma Limited (the first tier holding company of ABG Limited) and Raphael Limited directly. In doing so, though Gamma Limited is a non-resident enterprise, Margaret is afraid that the gain arising from the direct disposal of the interest of ABG Limited will be liable to China corporate income tax.
The diagram below shows the holding interest structure of the Alpha Group.

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Alternatively the deal can be made between Beta Limited (the second tier holding company of ABG Limited) and Raphael Limited on transfer of equity capital of Gamma Limited (which wholly owns ABG limited). However, she does not know whether the gain from the indirect disposal of ABG Limited is justified with commercial reasons – thus leading to the potential attack on the gain chargeable to China corporate income tax.

Therefore, Margaret suggests concluding the deal between Alpha Incorporated and Raphael Limited to transfer Beta Limited (the BVI company)’s shares to Raphael Limited instead of the interest either in ABG Limited directly or in ABG Limited indirectly (by transfer of shares of Gamma Limited) as described above. According to this arrangement, the investing group’s 100% interest in the wholly-owned subsidiary in China, namely ABG Limited, can be indirectly sold to Raphael Limited. However, this time Margaret does not know whether the gain arising from transaction may trigger any exposure to China corporate income tax because the subject shares are now related to the non-resident BVI company (the second tier holding company of ABG Limited), namely Beta Limited – thus the gain should be arguably sourced outside China.

(ii) If the indirect disposal of the shares in Beta Limited (the BVI holding company) is potentially liable to China corporate income tax in (i) above, the Alpha Group has to prepare any possible defensive strategies to combat these attacks from the China tax authorities under the general anti-avoidance rules.

(2) The management of Alpha Group also thinks that it may be good time to carry out an exit strategy for ABG Limited. Given that the gain on disposal of ABG Limited (no matter directly or indirectly offshore) is potentially subject to challenge by the Chinese tax authorities, it is considered to make use of the double taxation arrangement between the Mainland of China and Hong Kong to withdraw the huge amount of retained earnings in ABG Limited by way of dividend distribution back to the ultimate beneficiaries. However, Miss Margaret Hui is doubtful with the following issues:

(i) The dividend distribution from ABG Limited to Gamma Limited, under the existing rules, is subject to China corporate income tax. Margaret just wants to know whether the preferential withholding tax rate can be applied in the dividend distribution if China challenges the ultimate beneficiary ownership of the interest in ABG Limited.

(ii) After the dividend distribution if treaty rate is adopted, how can the cash be remitted back to Alpha Incorporated in a tax efficient manner?

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(iii) As regards the indirect disposal of shares in ABG between Alpha Incorporated and Raphael Limited to transfer the shares of Beta Limited (the BVI company) to Raphael Limited, she does not know whether the Chinese tax authorities will continue to attack the indirect offshore transfer of share transaction if the value of ABG Limited has been significantly reduced after the dividend distribution. She also doubts the basis of calculating the gain if any arising from the sale and purchase transaction of the Beta Limited’s shares after the dividend distribution.

Question 1
In respect of the proposed arrangement in item (1) of the case, you are required to help Miss Margaret Hui to understand:

(a) Based on the corporate income tax law and regulations in China, and Guoshuihan [2009] No. 698 (10 December 2009), explain to Margaret the tax implications in respect of the three arrangements of transferring the equity interest in ABG Limited, Gamma Limited and Beta Limited respectively.
(20 marks)

(b) Elaborate the possible defensive strategies to combat the potential attacks from the Chinese tax authorities. What are the valid arguments?
(20 marks)

(Total 40 marks)

Question 2
In respect of the proposed arrangement in item (2) of the case, you are required to explain to Margaret:

(a) What are the China corporate income tax implications on the dividend distribution from ABG Limited under the corporate income tax law and the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (21 August 2006)?
(10 marks)

(b) What are the specific requirements under Guoshuihan [2009] No. 601 for ascertainment of beneficial interest?
(20 marks)

(c) What would be the scenario of dividend flow for the purpose of China corporate income tax if both Gamma Limited and Beta Limited were decided to be ignored by the Chinese tax authorities for the purpose of Guoshuihan [2009] No. 698 and Guoshuihan [2009] No. 601?
(10 marks)

(Total 40 marks)

 

(Note: You should cite the relevant tax laws, regulation and rules as appropriate to support your opinion and analysis in all of your answers to Question 1 and Question 2.)

Marking Scheme: 80 marks are basically assigned to Questions 1 and 2 at 40 marks each respectively. 20 marks (representing 6% of the total continuous assessment or 3% of the overall total assessment) shall be assigned to written English proficiency, presentation, originality, extensive reference, suggestions and arguments.

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To reflect the contributions to the achievement of MAcc Programme Outcomes by enabling students to explain current tax laws, and apply established tax principles and practices to analyze business situations and problems in the specific business setting of the mainland China, develop a critical insight and appreciation through effectively interpret up-to-date tax legislations, rules, and guidelines and analyze practical tax issues relating to their business operation, and apply the current tax law and practices on taxation implications in corporate governance and corporate management decision making, the assessment of the following parts in this Individual Strategic Case will be specifically made:

(a) explain the current laws and apply the principles and practices relating to taxation for individual and foreign-invested entities operating business in the mainland China;
Question 1(a)
Question 2(a) and (b)

(b) effectively interpret tax legislations, rules, and guidelines and analyse practical tax issues through critically evaluate the tax consequences of various types of structure of business transactions and provide professional advices on the China tax system and its operation as well as tax implications on individuals and business entities; and
Question 1(b)
Question 2(c)

(c) apply the tax knowledge in corporate governance and management decision making through strategically formulate and carry out China tax planning ideas and policies in relation to individual and business transactions in order to minimize their explicit tax liabilities or enhance their tax efficiency and effectiveness.
Question 1(b)
Question 2(c)

 

This assignment accounts for 15% of your overall assessment of this Course. (Namely, it represents 30% of the continuous assessment which accounts for 50% of the overall assessment.)

All submitted work must be typed in A4 size paper in hardcopy format without any limit of length in principle (but it is suggested that the length should not exceed a total of 4,000 words including all references and notes). If any submitted work exceeds the threshold of 4,000 words, it is subject to a reduction of the overall marks by 20%. All workings and explanations should be clearly shown and presented.

The submission deadline is 22 May 2016 (Sunday) in class. Any late submission, without justification, will be strictly subject to a reduction of overall marks by 5% per calendar day.

In addition, students have to provide an undertaking on the cover page of the submitted answer that the number of words in total does not exceed 4,000 words and the answer submitted is absolutely his/her own work.

Bonus marks (up to 15 marks) shall be given for those with supporting authorities in addressing the issues in the questions.