Tax dispute solutions in China.

• Author: Zhang, William

Background

Since 2007, China has effected tax reforms in the areas of enterprise income, turnover, and property taxes--areas that have gained renewed emphasis pursuant to China's 2011 12th Five-Year Plan. The cumulative effect of these reforms has made China's tax system complicated and confusing to many taxpayers, especially foreign investors from common law jurisdictions such as the United States and certain European Union countries. The confusion goes beyond the substantive tax rules to tax processes and procedures. Thus, even if a Multinational Company (MNC) has sound tax management systems and ample experience handling tax disputes in its home countries, it may experience difficulties comprehending China's complex tax controversy mechanisms and handling tax disputes in China.

Against this background, taxpayers--especially MNCs--are facing an increasing number of tax audits by Chinese tax authorities, in part because of the tax authorities' revenue collection needs and in part because of the aggressive planning adopted by some taxpayers. An example of the former was the 2009-2010 State Administration of Taxation (SAT) audits in which the SAT mandated that 10 selected MNCs conduct tax self-investigations on their tax practices and compliance. SAT regarded the exercise as an effective means of collecting tax revenues by requiring voluntary reporting of unpaid taxes by foreign enterprises (and their Chinese subsidiaries) rather than initiating a direct tax audit.

Further complicating China's tax controversy mechanisms is the implementation of many new tax requirements into China's tax regime, including transfer pricing adjustment rules, controlled foreign cooperation rules, and thin-capitalization rules. These new requirements have caused confusion among many local tax officials about their practical application. Taxpayers face similar confusion. It is not surprising that some local-level tax authorities have inadvertently made mistakes and applied aggressive tax treatments toward compliant taxpayers.

Although China had high statutory tax rates in the past, the country was viewed by some MNCs as a tax haven because of the preferential tax treatment accorded to MNCs and the loose administration of tax collection. This has changed. Tax investigations and audits are now more frequent and they usually result in significant assessments of back taxes and substantial penalties. In light of the changed circumstances, an effective communications process and the skillful use of legitimate tax dispute resolution mechanisms should be a priority for many MNCs, especially those facing ongoing and potential tax investigations.

This article provides a high-level summary of the types and levels of tax risks that a Chinese taxpayer may face. It then suggests the various possible tax dispute resolution mechanisms in China (specially taking into consideration the new amendments to the tax administrative rules promulgated in 2010) available to a Chinese taxpayer.

Tax Liabilities from Violations of Tax Laws and Regulations

Recent Trend in Tax Audits

Tax audits will continue to be a focus in 2012 and beyond. China's SAT issued the 2012 Key Tasks of Taxation Inspection early this year, signalling its intention to investigate certain practices (e.g., issuance of false invoices and the filing of fraudulent export tax returns) as well as suspected tax evasion in certain industries (e.g., in the oil processing, coal, transportation, exports of electronics, furniture and textiles and real estate industry). The SAT has also increased its scrutiny to detect suspected evasion of capital gains tax (especially on capital gains derived by non-Chinese tax residents). In addition, recent communications from the SAT suggest that many large MNCs in China may be targeted for tax audits in the near future. For MNCs, therefore, careful preparation and planning of appropriate tax audit defense strategies should be a top priority.

In 2012, the SAT issued the Internal Operating Procedures for Special Tax Adjustments (for Trial) and the Operating Procedures for Joint Hearing of Major Cases Concerning Special Tax Adjustments (for Trial) to regulate audits by China's taxation authorities at all levels. The procedures address matters such as the management of enterprises' related-party reporting and concurrent documentation, acceptance, investigation, conclusion, and tracking management of various special tax adjustments. Both sets of operating procedures, which have been in effect since March 1, 2012, are intended to enable local-level tax authorities to be more sophisticated in initiating tax audit and investigating tax audit cases.

An MNC needs to consider carefully any potential and current tax controversies given that the tax administrative penalties from violations of tax laws can, in the worst case, result in criminal charges. For an MNC operating in China, there are typically several levels of tax risks in relation to tax law violations:

1. Level 1--Late Payment Surcharge (LPS) Due to Late Tax Filing or Interest Charge Due to Special Tax Adjustment (STA) under Enterprise Income Tax (EIT) Regime.

   (a) LPS: When either a taxpayer, or a withholding agent who has collected tax, fails to pay the tax within a specified time, Article 32 of the People's Republic of China (PRC) Administration of Tax Collection Law (ATC Law) provides that tax authorities with jurisdiction over the matter shall:

   (i) Order the taxpayer or the withholding agent to pay the tax within a fixed period of time; and

   (ii) Impose an LPS on a daily basis at a rate of 0.05 percent of the amount of tax in arrears, from the date the tax payment is in default (i.e., the day following the date on which the tax is due) to the date when the tax payment is re-paid.

   (b) Interest Charges Payable Due to STA under EIT Regime: If the STA makes an upward adjustment of taxable income to related-party transactions or other transactions covered under the pertinent tax rules, then under the EIT laws and regulations, an interest rate shall be levied based on the RenMinBi (RMB) loan benchmark interest rate fixed on December 31 of the tax year in which the underpaid tax accrues, plus 5 percentage points. (1)

2. Level 2--Administrative Sanctions

   Section 5 of the ATC Law sets out the relevant sanctions for various violations of tax collection laws. They are:

   Financial Penalties: The administrative violations attracting stiff tax penalties are classified according to the severity of the penalties imposed:

   (i) Penalty ranging from 0.5 to 5 times of the tax underpaid. Tax evasion--Occurs when a taxpayer forges, alters, conceals, or, without authorization, destroys accounting books or vouchers for the accounts, or overstates expenses or omits or understates income in the accounting books, or, after being notified by the tax authorities to make tax declaration, refuses to do so or makes false tax declaration, which results in failing to pay or underpaying the amount of tax payable.

   Tax evasion also occurs where a withholding agent fails to pay or underpays the tax which he withholds or collects by the aforementioned means.

   Failing to declare, pay, or underpaying tax--Occurs when a taxpayer fails to make tax declaration, thus failing to pay or underpaying the tax payable.

   Failing to pay or underpaying tax within prescribed time limit--Occurs when a taxpayer or a...