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 withholding agent (with respect to the tax it has withheld or collected) fails to pay or underpays the amount of tax that should be paid or remitted within the statutorily prescribed time limit and, after being ordered by the tax authorities to pay or remit the same within a time limit, continues in its failure to pay after the expiration of the stated time limit.
Failing to pay tax by transferring or concealing property — Occurs when a taxpayer who fails to pay the tax due transfers or conceals his property, thereby preventing the tax authorities from seizing the property to satisfy payment of the tax in arrears.
(ii) Penalty ranging from 1 to 5 times of the tax underpaid. Defrauding tax refund — Occurs when one, through the filing of a false export declaration or by other means, fraudulently obtains an export tax refund for goods exported out of the PRC.
Refusal to pay tax — Occurs when a taxpayer refuses to pay tax and resorts to violence or threats in furtherance of the refusal.
(iii) Penalty ranging from 0.5 to 3 times of the tax underpaid. Failing to withhold or collect tax — Occurs when a withholding agent fails to withhold or collect the amount of tax that should have been withheld or collected.
Other Sanctions: Other forms of sanctions are provided in the ATC Law and other tax administrative regulations (e.g., in the Tax Invoice Administration Regulations (TIA Rules)). These sanctions include official warnings, confiscation of illegal income, termination of the right to export tax refunds, and revocation of tax permits. 2
In addition, the tax authorities may undertake other compulsory enforcement measures to implement its tax collection or sanctions, for example, by orders to rectify, withdrawing or stopping the issuance of tax invoices, notifying China's exit administration (an agency akin to U.S. Customs and Immigration Service) to prevent the taxpayer (or its legal representative) from leaving China, cancellation of general taxpayer status, revocation of tax registration certificate, and stoppage of the tax deductions.
3. Level 3 – Criminal Responsibility
If violations rise to the level of criminal offenses as stipulated by the PRC Criminal Law, a taxpayer or suspected offender will be subject to criminal investigations.
The majority of tax crimes are set out in Section 6 (Crimes of Jeopardizing the Administration of Tax Collection) of Chapter III (Crimes of Disrupting the Order of the Socialist Market Economy) in the Criminal Law. The most severe penalty imposed for tax crimes is life imprisonment. Life imprisonment has been imposed for the crimes including those related to counterfeiting or selling counterfeit Value-added Tax invoices, invoices to fraudulently obtain an export tax refund, or to offset taxes payable.
The crime of tax evasion in Article 201 of the Criminal Law was amended by the Amendment 7 to the Criminal Law, issued on February 28, 2009. Before that time, if the amount evaded amounts to more than 100,000 RMB and more than 10 percent of the total of taxes payable, or if a taxpayer commits tax evasion again after having been twice subjected to administrative sanctions by the tax authorities for tax evasion, the taxpayer could be criminally charged and subject to criminal sanctions. Thus, a taxpayer found to be evading a small dollar amount of tax payable (say, 11,000 RMB out of a total tax payable of 100,000 RMB) could be subject to criminal charge if the percentage of the tax evasion is more than 10 percent of the total tax payment. Because the threshold triggering the criminal liability was low, the law has subjected quite a few taxpayers (or their officers, employees, or agents) to criminal investigations and sanctions.
Under the revision made by Amendment 7, the threshold requirements for the crime of tax evasion are increased. Amended Article 201 prescribes that "any taxpayer who files false tax returns or does not file tax returns by means of deception or concealment to evade taxes, if the amount of tax evaded is relatively large and accounts for over 10 percent of the total of taxes payable" is guilty of the crime of the tax evasion. The scope of the provision is tempered by a provision that "any person who has carried out the acts mentioned in the first paragraph, but has paid taxes and fines upon receipt of the recovery notice issued by the tax authorities in accordance with the law, and has been subject to administrative penalties, shall NOT be subject to criminal liability unless the person has already been crimi- nally punished or administratively penalized at least twice by tax authorities for tax evasion in the last five years." Thus, the threshold requirements of the crime of tax evasion have been increased and criminal charges can be avoided if the taxpayer has been subject to administrative penalty before criminal investigation so long as the taxpayer has not been criminally punished or administratively penalized for tax evasion twice in the last five years.
Significantly, a corporation may be subject to criminal tax charges. According to Article 211 of the Criminal Law, where a "unit" (e.g., a company, an enterprise, or a partnership) commits certain tax crimes, it shall be fined, and the "persons who are directly in charge" (e.g., in-charge corporate officers), as well as other persons directly responsible for the crime, shall be punished in accordance with relevant provisions.
Possible Mechanisms to Avoid or Resolve Tax Disputes
To mitigate potential tax risks, MNCs in China should be familiar with the possible mechanisms to avoid or resolve tax disputes. The major mechanisms are:
- Regular consultation with competent tax authorities before or during a tax filing period;
- Negotiation during a tax self-audit or tax audit;
- Tax administrative reconsideration (TAR) within tax authorities; and
- Tax administrative litigation in the PRC courts.
A summary of the timing of the use of each mechanism and a high-level comparison of their key advantages and disadvantages are set out in the accompanying chart.
Tax Administrative Reconsideration versus Tax Administrative Litigation
Summary of 2010 Amendments to TAR Rules
The new TAR Rules were issued on February 10, 2010, and went into effect on April 1, 2010. (They replaced the rules that were issued in 2004.) There are some significant amendments and changes under the new TAR Rules. Most of them are aimed at fairly protecting taxpayers or other parties concerned and giving fair opportunities to claimants and respondents.
1. TAR Scope Has Been Expanded
Under the new TAR Rules, matters under the purview of a TAR have been expanded. It now includes reconsideration of administratively permissible or administratively approved actions, administrative compensations, refusal to issue tax administration certificates for outward business activities, acts of accreditation, specific administrative acts to disclose government information, and acts of assessing tax payment credit rating. In addition, the new rules allow taxpayer or related parties to seek administrative relief against some actions that were previously outside the scope of TAR.
2. Applicant May Have the Right To a Hearing During a TAR
Under the old rules, for any significant and complicated case, the TAR adjudicative body was authorized to decide the case after collective discussion within the TAR organ. In contrast, the new TAR Rules provide that, for major and complicated case, where the claimant makes a request or the TAR organ considers it necessary, the hearing approach (compared with a desktop review approach) may be adopted in conducting the TAR trial. This effectively affords the applicant the right to request a hearing against internal decision-making in a desktop review, which might not include any right of oral argument by the applicant.
3. Reconciliation or Meditation Is Possible
A most eye-catching and meaningful change in the new TAR is for reconciliation and mediation. Under the old TAR Rules, no reconciliation or meditation could be made during a TAR because the authorities held the view that no compromise should be made by tax authority. This position, based on the view that the administrative act has been made on behalf of the government as a whole, has changed because reconciliation and mediation are viewed as increasingly important to resolving disputes in an efficient and fair manner.
Under the new TAR Rules, in certain matters, the applicant (or claimant) and respondent may, before a decision by the TAR administrative body, be reconciled to resolving a matter on the ground the disposition will not harm the public interest while upholding the legitimate rights and interests of other persons. The TAR organ may also mediate between the applicant and the respondent.
The matters that are subject to reconciliation or mediation are, as follows: (1) exercise of discretionary power in undertaking specific administrative acts (such as administrative penalty); tax amount assessed and taxable income tax rate confirmed; (2) administrative compensation; (3) administrative incentives; and, (4) specific administrative acts with other issues concerning rationality.
The reconciliation and mediation provisions are likely to be very beneficial to the taxpayer by shortening the length of any TAR proceeding. In addition, whereas it may sometimes be very difficult for a taxpayer to vindicate their rights under the pressure of the tax authorities having jurisdiction over their matters, the reconciliation/ meditation mechanism provides an avenue for both parties to a TAR to settle the issue in a less adversarial, efficient way.
Finally, under the new rules, a written reconciliation agreement is to be filed with the TAR organ in respect of every reconciliation/ mediation.
4. Major Differences between TAR and Tax Litigation
The TAR rules are broad enough to cover most administrative acts. Specifically, the TAR organ is to accept the administrative reconsideration application against the tax authority in respect of the following administrative acts:
- Taxing acts, including confirmation of taxpaying entity, taxable target, scope of taxation, tax reduction, tax exemption, tax rebate, tax credit amount, applicable tax rate, tax basis, tax payment section, due date for tax payment, tax payment location, tax collection method and other specific administrative acts, tax imposed, collection of late payment surcharge, withholding agent, the act of withholding and remitting tax, collection and remittance, or levy on behalf of other party by an organization or individual as appointed by the tax authority;
- Administratively permissible or approved actions;
- Invoice management acts including sales, collection, invoicing on behalf of another party;
- Tax preservation measures and enforcement measures;
- Administrative penalties including, (i) fines; (ii) confiscation of property and illegal gains; and (iii) termination of the right to obtain export tax rebates;
- Acts of not performing relevant duties according to law, which include: (i) issuing taxation registration; (ii) filling out or issuing tax payment receipt and tax administration certificate for outward business activities; (iii) administrative compensation; (iv) administrative incentive; and (v) other acts of not performing duties according to law;
- Acts of accreditation;
- Acts of not confirming tax payment guarantee according to law;
- Specific administrative acts in disclosure of government's information;
- Acts of assessing tax payment credit rating;
- Acts of notifying the immigration authorities in preventing exit; and
- Other specific administrative acts.
With respect to the first listed items, taxing acts, the claimant should first obtain the TAR administrative body's decision before instituting an administrative lawsuit through the Chinese courts. In other words, in respect of taxing acts, the TAR procedure is a precondition to the tax administrative litigation. For the other items enumerated, TAR is not a condition precedent to tax administrative litigation, so a taxpayer or other parties with standing may bring suit without seeking a TAR.
A careful reading of the relevant laws and rules suggest that a court in a tax administrative litigation will examine the legality only but not the propriety of a particular action by tax authorities, whereas a TAR organ will examine both the legality and propriety of a particular tax administrative act. Specifically, the TAR organ will conduct a comprehensive examination of the factual evidence, legal procedures, legal basis adopted by the respondent as the basis for the specific administrative act undertaken, and the legitimacy and propriety of the content of stated rights and obligations. In contrast, according to Article 5 of the PRC Administrative Procedure Law, courts are to examine the legality of specific administrative acts, which implies that they will not examine their propriety.
5. TAR May Examine Certain Administrative Provisions Promulgated and Acts Carried Out by Tax Authorities
Pursuant to Article 15 of the new rules, where the claimant believes that any of the following provisions, given as the basis for the specific administrative act, is not legitimate, may combine the application for administrative reconsideration of the specific administrative act with an application for examination of the relevant provisions together with the administrative reconsideration organ:
- Provisions of the SAT and other departments of State Council;
- Provisions of other tax authorities at all levels;
- Provisions of local government at all levels; and
- Provisions of local government's departments.
All of these provisions, however, are lower-level regulations (i.e., Gui Ding in Chinese), hence not encompassing high-level regulations (i.e., Gui Zhang in Chinese) or laws (i.e., Fa Lv in Chinese) as defined in relevant legislation laws and regulations.
According to China's Administrative Procedure Law, China courts will only examine the specific tax administrative acts and not abstract administrative acts. The courts will use only the law, administrative rules and regulations, and local regulations as the criteria. In addition, the courts may refer to regulations promulgated and announced by ministries or commissions under the State Council in accordance with the law and administrative rules and regulations, decisions or orders of the State Council, and regulations formulated and announced by governments of provinces, autonomous regions, and municipalities directly under the Central Government, of cities where the governments of provinces and autonomous regions are located, and of the larger cities approved as such by the State Council.
In other words, although the courts will not examine administrative provisions in a vacuum, in examining a specific tax administrative act, they may not refer to the provisions made by tax authorities or local government authorities if those provisions are not in line with high-level laws or regulations.
6. Jurisdiction over TAR and Tax Administrative Litigation
Where there is refusal by a claimant to accept the specific administrative act of the State Tax Bureau (as opposed to the Local Tax Bureau) at any administrative level, the TAR may be commenced through the State Tax Bureau at a higher level. Where there is refusal by a claimant to accept the specific administrative act of the Local Tax Bureau at any administrative level, the claimant usually has the option to apply for TAR through the Local Tax Bureau at a higher administrative level or the People's Government at the same level as the taxation bureau.
Normally, after TAR for specific administrative act has been made by either the State Tax Bureau or the Local Tax Bureau, a claimant can choose to commence a tax administrative litigation as a last resort. Where there is refusal by a claimant to accept the specific administrative act of the SAT (which is the top level tax authority in the systems of State Tax Bureau and Local Tax Bureau), the applicant may apply for TAR through SAT itself.Where there is refusal by the claimant to accept the TAR decision by SAT, the claimant may institute an administrative litigation with the People's Court. Alternatively, it may also apply to State Council for a final ruling. No tax administrative litigation may be brought after the State Council's ruling.
Tax administrative litigation should follow the system of a two-trial system, which means that the case tried by the court of first instance can normally be appealed, with the court of second instance being the court of last instance. The court of the first instance for tax litigation usually is the basic-level people's courts. Normally it should be the court in the same locality of the tax administrative organ that made the specific administrative act. If a case has been examined by a TAR organ under the TAR procedure, however, the lawsuit usually should be brought to the court in the locality of the TAR organ.
7. Choice of TAR or Tax Administrative Litigation
Traditionally, there are low expectations for taxpayers seeking relief from a TAR proceeding and tax administrative litigation, though some statistics indicate that the chance of a taxpayer's winning tax administrative litigation is not low. The reasons for this are varied. Tax authorities may process better tax knowledge than some taxpayers in many instances. (In some situations, this may be attributable to the operable rules being just internal guidelines or local practices, without publication to taxpayers.)
In addition, local-level tax authorities may be evaluated based on the win rates of TAR and tax administrative litigation. In such situation, the performance of some tax officials may be affected, for example, by attempting to dissuade taxpayers from pursuing TAR or tax administrative litigation.
Some taxpayers may view the commencement of TAR or tax administrative litigation as potentially damaging the reputation of tax bureaus or individual tax officers having jurisdiction over tax matters. These taxpayers worry about potential repercussions. In other words, the relationship (or Guan Xi in Chinese) is so important that some taxpayers might sacrifice their current tax benefits or rights in exchange for possible lenient treatments or administration in the future.
All that said, tax authorities have gradually become more accepting toward TAR, especially when SAT (China's highest tax authority) issued the circular Guoshuifa  No. 28, Opinion Concerning Strengthening the Tax Works for Tax Administrative Reconsideration, in 2007. The Opinion encourages the use of TAR as a legitimate mechanism for tax dispute resolution. Further, the new TAR Rules clearly affirm SAT's view that TAR is an appropriate procedure to handle tax controversies as well as an efficient administrative tool to address administrative misconduct, enhance the level of legitimate legal enforcement, and achieve the objective of social harmony. Tax authorities are now more open to TAR as well as other tax dispute solutions.
Thus, TAR will likely become increasingly important as an efficient and effective tax resolution mechanism between taxpayers and tax authorities, as well as enhancing negotiations with tax bureaus in the course of tax self-examination/audit. This is also very important, from a compliance perspective, to avoid any undue influence by tax authorities having jurisdiction over a taxpayer's matters and the potential bribery trap in certain grey areas. hould be given before taking any action but this could be regarded as a final resort for taxpayers seeking relief from unjust administrative acts.
Tax Management System in China and How to Leverage the Use of Professionals
Both the corporate governance for an MNCs' operations in China and the increasing demand of China tax authorities in respect of the compliance of MNCs (especially for those large companies categorized as large enterprises by China tax authorities) call for sound tax risk management system for large enterprises in China). These are emphasized in relevant recent tax regulations. For example, in 2009 the SAT issued tax circular Guoshuifa  No. 90, setting out guidelines for large enterprises' tax risk management, and in 2011 issued tax circular Guoshuifa  No. 71, setting out procedures for administration and management for large enterprise, both of which require the sound tax risk management system within large enterprises and close monitoring by tax authorities.
Large MNCs in China should consider building the necessary components of effective tax dispute solutions into their overall tax risk management system to better manage the risks associated with dealing with tax authorities. MNCs in China should carefully consider all the possible means of tax dispute solutions and, based on the facts of their particular case, select the most appropriate mechanism.
William Zhang is counsel in MWE China Law Offices a Shanghaibased law firm in strategic alliance with McDermott Will & Emery LLP. He has extensive experience in providing general Chinese income tax advice, turnover tax consultation, tax compliance review, tax due diligence, tax restructuring, post-deal integration, and advising on Chinese investment and foreign exchange regulations. Mr. Zhang has advised numerous multinational and China-based clients on various tax and regulatory issues from a range of industries, such as transportation and logistics, property and infrastructure, technologies, manufacturing, and financial institutions. Mr. Zhang is both an attorney and an accountant. He may be contacted at wzhang@mwechinalaw. com. The author expresses his appreciation to Sui Yang Kon of Mc- Dermott Will & Emery and Echo Xu of MWE China for their comments on this article. The views expressed, however, are his own.
1. The additional five percentage points may be waived if the taxpayer has prepared relevant documents (i.e., Contemporaneous Transfer Pricing Documentation) in accordance with the STA Rules.
2. The revocation of a tax permit on a taxpayer could restrict the taxpayer's qualification on certain tax benefit (e.g., tax credit or tax refund).
3. According to the new rules, where the claimant filing the application for administrative reconsideration against a specific administrative act is not aware of the provision upon which the challenged administrative act is based, it may file an application for examination of such provision before the administrative reconsideration organ makes a decision of the administrative reconsideration.