Introduction to China’s CFC Rules/Xiaoyi XIE

Introduction to China’s CFC Rules/Xiaoyi XIE

As an anti-tax avoidance regulation, the Controlled Foreign Company (CFC) rules primarily aim to prevent resident enterprises or individuals in China from retaining profits in low-tax or no-tax jurisdictions through overseas entities, thereby evading their tax obligations.

China introduced the CFC rules since 2007, but it was not until 2012 that the first CFC case emerged. ACo is a Shandong company, which has a subsidiary, BCo, in HK. In order to enjoy dividends exemption benefits, BCo applied for resident enterprise status, which exposed its entire corporate structure to Shandong tax authorities. They subsequently identified problems concerning BCo’s profit distribution. The final conclusion was that BCo should be treated as CFC of ACo, and the non-distributed profit of BCo should be included in the tax base of ACo. 

According to Article 45 of Enterprise Income Tax Law of the People's Republic of China(EIT) and Article 117 of Regulation on the Implementation of the Enterprise Income Tax Law of the People's Republic of China(Implementation Regulation),if an enterprise established in a country (region) where the actual tax burden is significantly lower than 12.5%, which is controlled by a resident enterprise or by a resident enterprise together with a Chinese resident, fails to distribute or reduces the distribution of profits without reasonable business needs, the portion of the above-mentioned profits attributable to the resident enterprise shall be included in the current income of the resident enterprise.

The EIT and the Implementation Regulation lay down three cumulative conditions for the application of the CFC rules: 

1. the CFC is controlled by Chinese resident( including enterprise or individual); 

2. the actual tax burden is less than 12.5%;

3. the non-distribution of profit has no reasonable business needs.

According to Chapter 8 of Measures for the Implementation of Special Tax Adjustments (for Trial Implementation)(No. 2 [2009] of the State Administration of Taxation)(Measures), with regard to ‘control’, 2 tests are used:

1. Objective standard: a Chinese resident shareholder, on any day of the tax year, directly at a single tier or indirectly at multiple tiers, holds 10% or more of the voting shares of a foreign enterprise individually, and collectively holds 50% or more of the shares of that foreign enterprise; or

2. Subjective standard: Chinese resident shareholder(s) has de facto control over the CFC in terms of capital, operations, and procurement and sales.

The second test supplements the fisrt test and it’s in line with OECD’s recommendation. The taxpayer had little grounds for dispute on this point.

With regard to ‘actual tax burden’, similar to EU’s rules, it’s the effective tax rate that matters, rather than the nominal tax rate. The taxpayer of another case(Suzhou case) argued that Hong Kong has a corporate tax rate of 17%, which is higher than 12.5%. However, the tax laws of Hong Kong explicitly do not levy taxes on passive income and offshore-sourced income. As a result, the effective tax burden is zero. The current regulations only provide a whitelist, but do not specify a blacklist. Unlike the circumstances of this case, the determination of an overseas entity's effective tax burden usually involves the complex tax laws of multiple jurisdictions, making it difficult for the tax authorities to obtain the true picture of its actual tax burden abroad.

With regard to ‘reasonable business needs’, actually the existing rules do not clarify what constitutes reasonable business needs, which poses a challenge for tax collection. And it’s usually one the key disputes between tax authorities and companies. The lack of detailed rules may lead to inconsistent enforcement by different tax authorities, thus creating unfairness across regions.