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Circular 698. Or How China's Tax Authorities Are Plotting To Over The World.

By Dan Harris and Steve Dickinson

Shanghaiist just posted my list of "China?s top 5 business law trends of 2010," which list included China stepping up its tax collection efforts. Drastically. Speaking of drastically, I just read a really excellent article by a swarm of O'Melveny & Myers lawyers, entitled, "China Adopts Controversial Vodafone-style Extraterritorial Tax and Disclosure Rule," discussing China's just circulated Circular 698. The O'Melveny article summarizes an "amazing" part of that circular as follows:

However, Article 5 of Circular 698 then takes an amazing leap. It [Article 5 of Circular 698] states that foreign entities are required to disclose all indirect transfers of PRC resident enterprises to the PRC tax authorities in cases where an intermediate holding company through which such transfers are made are located in a low tax jurisdiction or such jurisdiction exempts income tax on foreign-sourced income. In this case, the foreign enterprise making the indirect transfer must disclose the following documentation to the PRC tax authority in the location of the PRC resident enterprise within 30 days of executing the transfer contract: i. Equity transfer agreement/contract; ii. Representations regarding the relationship between the foreign entity and holding company being transferred in terms of ?capital, operation, sales and purchase etc.?; iii. Representation regarding the operation, employees, bookkeeping, and assets of the holding company being transferred by the ultimate foreign entity; iv. Representations regarding the relationship between the holding company being transferred by the ultimate foreign entity and the PRC resident enterprise, in terms of ?capital, operation, sales and purchases;? v. Representations regarding the reasonable business purpose with respect to the transfer of the holding company; and vi. Other materials requested by the tax authority.

The article then very nicely lays out some truly extreme examples of where foreign companies may be required to report to China on their foreign M&A activity and then asks the following series of questions relating to whether the circular is "even legal:"

(1) Is there a legal basis under any validly promulgated PRC law or administrative regulation which imposes information reporting obligations and tax with respect to such indirect transferors? How does an interpretive circular like 698 derive its PRC legal authority? (2) Does the PRC general anti-abuse rule (?GAAR?) in the EIT grant virtually unlimited power to the PRC tax authorities concerning transactions, including matters of extraterritorial jurisdiction? How does one sentence in a quasi-civil law statute encapsulate an entire doctrine? (3) Is there a colorable theory under international legal principles to assert extraterritorial jurisdiction over the numerous parties potentially described in Circular 698? (4) Will the enormous administrative complexities and burdens created by the disclosure mean erratic compliance and result in grossly unfair application of the rule? Can most foreign entities comply? (5) Will local PRC tax bureaus be staffed with the resources, training, and other administrative infrastructure to deal with those disclosure actually submitted?

This circular is so far out of the norm and so likely to cause an uproar I suspect much of it will never come to pass. No matter what though, it is a great indicator of China's strong desire to increase its taxing powers, especially with respect to foreign companies. For more on Circular 698, check out the following: -- Detailed Analysis of of Circular 698, on the China Tax Insights Blog. -- "China Reinforces Tax Administration of Share Transfers by Non-resident Enterprises," by the Mayer Brown law firm. -- Tax Alerts by PriceWaterhouse and Deloitte. UPDATE: China Tax Insight just did a new post on Circular 698, entitled, "One Last Post on Circular 698," taking Deloitte to task for saying "Circular 698 creates some legal questions as to whether the Chinese government has the right to tax foreign companies."

Full post as published by China Law Blog on December 31, 2009 (boomark / email).