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GAAR is first introduced in the Chinese corporate income tax law in 2008. So the literal aid means that for a transaction to be recognized for tax purposes then it needs to demonstrate a legitimate business purpose. So it cannot be designed to eliminate or reduce or defer Chinese corporate income tax because that’s like the literal definition. In reality, the tax authorities would follow the substance over formal doctrine to apply the GAAR principle. So they can actually combine two different entities into one entity. They can actually combine two transactions into one transaction if they think that doing so would really reflect the true essence of the transaction.
So perhaps the best example of GAAR application in China is the indirect transfer rule situation. So if you have a UK company that owns a Hong Kong company and the Hong Kong company in turn owns China, so this is the holding structure, and then you have the UK company sell the shares in the Hong Kong company – so normally this transaction doesn’t…taxation from China because this is an offshore transfer of a non-Chinese equity interest.
But under Chinese tax rule, the Surplus 698 which is issued under the GAAR, then the Chinese tax authority will actually ask the UK transferor to submit a set of documents to describe the transaction as to the purpose of why having Hong Kong in the middle. And if the documents can’t demonstrate a lot of the commercial substance in Hong Kong, then the Chinese tax authority can ignore the existence of the Hong Kong entity. So the transfer of Hong Kong by the UK company will be re-characterized as a transfer by the UK company of the underlying Chinese subsidiary. So that is a direct transfer and it attracts a 10 percent holding tax on the built in gain. So that is a typical situation in an indirect transfer case.
For companies, how to deal with this kind of a challenge, the basic advice is that we need to satisfy the substance requirement because this indirect transfer rule is designed out of the GAAR principle. GAAR means what? GAAR means to defeat taxpayers’ attempt to avoid tax. So you have to demonstrate that this is not for tax avoidance purpose and the best proof you have available is to show that there is a substance in the company. So you have to show this Hong Kong company how people, has operation, that actually it has valuable assets and they also bear risks.
So that is the main point that we need to pay attention.
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