Xinjiang Case：China Tax Authority’s Success in Preventing Treaty Shopping
Guoshuihan[2008]1076
1 Case review
2003.3
A company of Xinjiang Uygur Autonomous Region (hereinafter referred to as Company B) and a company of Urumqi City (hereinafter referred to as Company C) jointly funded the establishment of LNG Production and Sale Company (hereinafter referred to as Company A). The registered capital of Company A was 800 million yuan. Company B was the major investor, which invested 780 million, accounting for 97.5% of the registered capital. Company C invested 20 million yuan, accounting for 2.5% of the registered capital. Company A's investment ratio was:
Company B—97.5%; Company C —2.5%.
2006.7
Company B and Company C signed a joint venture agreement with a company of Barbados (hereinafter referred to as Company D), so Barbados Company D began to take a stake in Company A by purchasing part of the shares of Company A held by Company B. Barbados Company D paid $ 33.8 million to Company B, and began to hold 33.32% of the shares of Company A. After the share transfer, Company A's investment ratio changed to:
Company B—64.18%; Company C —2.5%; Barbados Company D—33.32%.
27 days after the agreement signed
Company B, Company C and Company D signed a capital increase agreement, according to which Company B increased investment by 266 million yuan (just the income of selling its equity to Company D, $ 33.8 million).After the capital increase, the registered capital of Company A was changed to 1.066 billion yuan, and Company A's investment ratio changed to:
Company B —73.13%; Company C —1.88%; Barbados Company D—24.99%.
2007.6
Barbados Company D decided to transfer its shares of company A to Company B at the price of $ 45.968 million, and signed a share transfer agreement with Company B. So far, Barbados Company D obtained the net revenue of $12.17 million ($ 45.968 million - $ 33.8 million) just within one year’s time.
2 Tax-related issues in this case
Barbados Company D applied to Chinese tax authority for not paying tax for its income from the shares transfer. It claimed that according to the provision("Article 13 Capital gains") of the tax treaty between China and Barbados, the income $ 45.968 million of shares transfer shall be taxable only in Barbados. Chinese tax authority carried out a survey about its residence status and the applicability of tax treaty provisions, and found some doubts about Company D.
2.1 Company D’s purpose of holding shares of Company A
Firstly, Barbados Company D was registered in Barbados by the US NB investment group in May 2006. Just one month after its registration, it signed the joint venture agreement with China’s companies, and the fund invested in China was imported from the bank account of Cayman Islands. Barbados and Cayman Islands are two famous tax havens.
Secondly, Barbados Company D’s holding period was less than 1 year before the shares transfer, and the net revenue of this transfer was up to $ 12.17 million, equivalent to 92.72 million yuan. Its yield rate was as high as 36%. What’s more, the yield rate was not the result of actual operating, and it was just determined by the contract in advance.
Thirdly, as the foreign party of a joint venture, Barbados Company D didn’t invest according to the principle ”joint investment, joint management, risk sharing, benefits sharing”. Instead, it merely completed the legal procedure of setting up a sino-foreignjointventure, and got a huge amount of income. Company D’s behavior appeared to be investment, but in fact it was difficult to determine it was investment, loan or financing, or just to help China’s domestic enterprises to complete the procedures of transformation, and maybe there existed some other complicated economic problems.
In general, Barbados Company D didn’t have a reasonable commercial purpose in the entire transaction.
2.2 Company D’s residence status
Although Company D provided materials to China tax authority, but the materials could only prove that it was registered in Barbados, not enough for the residence status. And according to China tax authority’s investigation, all the three directors registered of Company D were the US citizens and their home addresses were all in the US.
3 Final outcome of the case
The state tax bureau of Xinjiang Uygur Autonomous Region reported the case to SAT. SAT launched the tax information exchange mechanism with Barbados. SAT found that Company D was just an offshore company in Barbados, and Barbados did not levy tax on offshore companies, that is, Company D did not take any tax liability in Barbados. But the treaty between China and Barbados says “a resident company in Barbados” shall have the obligation to pay tax to Barbados government. So, SAT finally determined that Company D was not “a resident company in Barbados” in the treaty, and could not enjoy the treatment of the treaty between China and Barbados. Company D’s income from investment in China should be taxed according to China’s domestic law. The tax Company D paid to China tax authority: $12.17 million *10 % (WHT) = $1.217 million (9163728 CNY by then-current exchange rate).
In this case, Barbados Company D tried to utilize Article 13 of China-Barbados tax treaty to avoid tax in China. The China-Barbados income tax treaty was originally signed on 15 May 2000.
The contents of “Article 13 Capital Gains” are as follows:
(1) Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State.
(2)Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment( alone or with the whole enterprise) or of such a fixed base, may be taxed in that other State.
(3)Gains derived by an enterprise of a Contracting State from the alienation of ships or aircraft operated in international traffic by that enterprise or movable property pertaining to the operation of such ships or aircraft shall be taxable only in that Contracting State.
(4)Gains from the alienation of any property other than that referred to in paragraphs 1, 2 and 3 shall be taxable only in the Contracting State of which the alienator is a resident.
Barbados Company D focused on the fourth situation above. According to paragraph 4, the capital gains derived from the disposition of equity interests in a Chinese company by a Barbados resident company will be exempt from the 10% Chinese withholding tax. There are few tax treaties signed by China and other countries including the provision that capital gains are only taxable in the taxpayer’s resident country. In common situations, capital gains are also taxable in the source country, not to mention Barbados is a tax haven. So, China-Barbados income tax treaty is a big loophole. That’s why the US group in the case sets up a shell company (Company D) in Barbados.
In order to update and fix the tax treaty, a new protocol was signed on 10 February 2010.Under the Protocol, full Chinese tax exemption on capital gains derived by a Barbados investor from the disposition of equity interests in a Chinese company will only be available, provided that: 1) the Barbados investor's shareholding in the Chinese company is less than 25% during the 12 month period before the disposition of equity interests; and 2) no more than 50% of the value of equity interests disposed of is derived, directly or indirectly, from immovable property situated in China.
