China Tax Update

1. Asia Tax Executives Forum China Tax Panel 9th May 2012, Singapore China Tax Update Peter Guang Chen (Vice President, Asia Pacific) Charles River Associates Jocelyn Lam (Executive Director) Goldman Sachs Baker Lihua Li (Senior Tax Manager, North Asia) Damco (part of A P Moeller / Maersk)

2. Agenda • CHINA: What you can do to keep in step with rule changes • The move towards GST; the Shanghai VAT pilot programme • China’s tax treaties - new developments • Indirect Transfers and Circular 698 • The experience of China’s direct tax reform in 2008 v India’s in 2012 • Recent Transfer Pricing Developments

3. The move towards GST Shanghai’s VAT pilot programme

4. Shanghai’s Pilot VAT Programme • On Nov 17 2011, Caishui [2011] No.110 and Caishui [2011] No.111 were jointly issued by the SAT and MOF • The implementation and transitional rules has taken effect since 1 January 2012 • At current stage, only certain industries in Shanghai are subject to the pilot program • The concept is that for services and other types of income which are now subject to the Business Tax (“BT”), they will now be subject to the Value Added Tax (“VAT”)

5. Shanghai’s Pilot VAT Programme Other than the above, other services or activities which are now under the existing Business Tax (BT) regime are still subject to BT

6. Shanghai’s Pilot VAT Programme For overseas entities providing services to customers in China, and who are subject to the Pilot VAT programme: • The VAT withholder is generally the service recipient, if the overseas entity does not have an agent in China • This is consistent with the existing rules on Business Tax • VAT liability = (total amount to be paid by service recipient) ÷ (1+ VAT rate) x VAT rate • The VAT withheld will become an “input credit” which the service recipients in China are allowed to claim the VAT withheld for the overseas entities as its own input VAT credit

7. Shanghai’s Pilot VAT Programme • Perspectives from the financial services industry • Although FS is outside the scope of the Shanghai Pilot VAT programme, it is nevertheless affected through its dealings with vendors which are in the pilot programme • Discussions between the MOF / NPC with various industry groups as to relevant rules for the financial services industry • How should the industry be preparing itself, in anticipation of the VAT Pilot program to be adopted by Beijing as early as 1st July 2012, and the nationwide roll out by 2015

8. Shanghai’s Pilot VAT Programme • Perspectives from the forwarding / shipping industry • The forwarding / shipping industry is one which is directly affected by the Pilot VAT programme in Shanghai • Practical issues due to the pilot programme on the transportation / shipping industry • VAT exemption on service export, Import activity from overseas party • the financial subsidy programme which local government aim to offer to the company whose tax burden is negatively affected.

9. China: Tax Treaties Development

10. China – Tax Treaties & TIEA – Recent Developments • In the last 12 months • Income Tax Treaties / Arrangements: • 7 income tax treaties “entered into force” or became “effective: Uzbekistan, Zambia, Syria, Macau, Czech Republic, Malta, Turkmenistan • 2 protocols / treaties were “signed”: United Kingdom, Latvia • 1 protocol’s “negotiation was finalized”: Canada • Tax Information Exchange Agreements (“TIEA”): • 5 TIEAs “entered into force” or became “effective”: Bermuda, Jersey, Argentina, BVI, Guernsey • 1 TIEA was “signed”: Cayman Islands

11. China – Treaties/Protocols signed/negotiated within last 15 months

12. China – Treaties/Protocols signed but not yet “EOF” or in effect As of 9th May 2012

13. China – Income Tax Treaties – Recent Developments • The: “beneficial ownership” requirement of Circular 601 in claiming treaty benefits • Is “beneficial ownership” requirement applicable in Treaty / Double Taxation Agreements (DTA) capital gains tax relief claims, despite the fact that neither the Chinese domestic law nor the Circulars issued by the SAT treat “beneficial ownership” as a qualifying criterion for treaty capital gains relief • May “substance” within the “group” support a claim for treaty benefits? • In mid-2011, a draft to clarify Circular 601 was released by the SAT to the tax industry and outlined certain situations where a claim can be made on the basis of substance in group holding companies. The draft circular, is still under discussion and it is uncertain when it will be finalized and made official

14. China – Income Tax Treaties – Recent Developments • Practical experience in audit situations after the issuance of Circular 75 - the triggering of “permanent establishment” status in secondment arrangements • Interpretation of PE concept • Service PE: • Connected projects • Calculation of 183 days/6 months • The 12 month holding period requirement for entitlement to reduced rate dividend withholding tax rate – the reason why a Luxembourg company’s application for treaty benefit was denied by the SAT in September 2011 • Circular 81 (Guoshuihan [2009] 81] laid out the 12 month rule in 2009. Then, Circular 75 (Guoshuifa [2010] 75) was issued to interpret the China – Singapore tax treaty, and discussed the 12 month rule of Circular 81 at length. However, Circular 75’s interpretation can apply to any treaty with similar provisions to the Singapore treaty, such as the one China has with Luxembourg, which has the almost identical language as the Singapore treaty on the dividend withholding rate.

15. Update on Circular 24 Bulletin No. 24, issued by China SAT in 2011 • Circular 24 was issued to clarify withholding tax obligation of non- • resident taxpayer • Impact on passive income (e.g. dividend declaration) • Impact on service income (e.g. central charges)

16. China: Indirect Transfers and Circular 698 16

17. Indirect Share Transfers – Circular 698 Background • Historically, transfers of FIE shares among affiliates were permitted at cost • EITL: FIE equity shares transferred in restructurings must now be effected at fair value • Circular 698 • Targets practice of transferring intermediate holding companies that hold interest in FIE shares • Imposes extensive reporting requirements in certain cases • SAT can disregard intermediate holding company

18. Indirect Share Transfers – Circular 698 Implications of the Vodafone Decision • Vodafone as potential inspiration for Circular 698 • Overview of Indian Supreme Court decision in favor of taxpayer • Certain distinctions minimize importance of decision for Chinese tax • Potential reference for SAT regarding prospect of competent authority disputes

19. Indirect Share Transfers – Circular 698 • Update on enforcement actions by SAT • January 2012 (published) case from Shanxi resulting in RMB 403m in PRC tax collected from a transfer of HK company • SAT’s 4th May 2012 meeting on supplementary circulars in Xiamen • Trends and impact on existing and future planning of investment structures by MNCs

20. China: Tax Reform Experience of China as compared to India’s Proposals

21. Tax Reform – China vs India Thoughts from our panelists: • Differences: China is to align the foreign and domestic tax regimes and lower tax rates. India does not have same objective • Similarities: codifying GAAR which leads to controversies and • industry lobbying in treaty claim context • Impact on how fund investment/ market access products should be structured, and leading to increased need for treaty/ competent authority • China’s focus: more on quality than speed in economy development • MNCs VS. SOEs • High-tech and certain encouraged industry (e.g. offshore service sourcing)

22. China Recent Transfer Pricing Developments

23. China – Transfer Pricing Highlights Audit Targets for 2012 • Audit Targets Announced by Jibianhan [2012] 1. An internal document that instructs the local tax authorities to perform mandatory and voluntary tax investigations in 2012, specifically including: •  taxpayers that conduct capital transactions • enterprises that receive VAT special invoices from purchases of refined oil • nonresident enterprises engaged in financial industry •  real estate developers and construction and installationcompanies •  local commercial banks • high-income individuals • Local tax authorities instructed to close more than 90 percent of selected investigation cases and to collect more than 90 percent of unpaid tax audit income this year

24. China – Transfer Pricing Highlights – recent events • Nationwide transfer pricing database project • Started In 2012, SAT is establishing a system which will contain nationwide information on related-party transactions and contemporaneous documentation. It will allow the SAT to conduct comparative analyses on related-party transactions conducted in different industrial sectors, tax years, and geographical areas • APA statistics and performance • At the end of 2011, 120 companies have applied for bi-lateral APAs • In 2011 China has conducted 10 bilateral discussions with seven countries including the US, Japan and Korea on 29 APAs and corresponding adjustment cases • However, only seven of them have reached consensus through MAP • On April 12, 2012, the SAT released the second annual APA report, covering periods from 2005 to 2010

25. Indirect Share Transfers – Circular 698 SAT Propensity to Attribute Premium Value to Chinese Assets • Valuation analyses may need to address “premiums” assigned to Chinese assets by the SAT • SAT rationales for premiums may include: • Location savings • Marketing intangibles associated with Chinese customers • High expected growth rates

26. China – Transfer Pricing Highlights – recent events China’s first Thin Capitalization Audit Case Concluded • In Dec 2011, it was reported that the SAT concluded its first thin capitalization case in Shanxi Province made a tax adjustment of more than CNY 30 million (about US$4.72 million)in enterprise income tax on a Chinese subsidiary of a Japanese multinational company • The Chinese subsidiary of Japan MNC maintained debt-to-asset ratios of 91.26 percent in 2007, 87.32 percent in 2008, and 93.86 percent in 2009 • SAT’s Transfer Pricing headquarters – personnel shortage • Self Assessment requested of many multinational companies by the SAT

27. China – Transfer Pricing Highlights – Cost Sharing Arrangements Cost Sharing Arrangements (CSA) in China • Regulatory Background • Enterprise Income Tax Law (EITL) • Article 41, paragraph 2 provided statutory basis for Cost Sharing arrangements . Also see the EITL’s Implementation Regulations (EITL.IR Article 112) • Special Tax Adjustments (STA) – Implementation Measures • Chapter 7 provides detailed regulations on the administration of Cost Sharing arrangements in China • Within thirty (30) days from date that CSA (cost sharing agreement) is reached, CSA to be submitted to the SAT. SAT to submit for examination and approval. • Contemporaneous Documentation requirement for CSA, provided for in Article 74 of the STA Implementation Measures. Documentation to be submitted by June 20th after year end.

28. China – Transfer Pricing Highlights – Cost Sharing Arrangements Cost Sharing Arrangements in China • Many companies are transferring R&D and service functions to China, establishing global R&D and shared service centers • China is also now seen as a desirable market for many MNCs • MNC’s subsidiaries in China increasingly performing marketing and brand building of their products for the China market • Cross border payment of royalty fees and service fees are subject to income tax (ie. the EIT) withholding at 10% and also Business Tax 5.5%* • Cost sharing can reduce inter-company royalty and service fee payments – Resulting in lower income tax (EIT) and Business Tax withholdings • Cost sharing can also reduce capital requirements of China subsidiary in some cases • Special challenges in calculating payments under CSAs in China

29. China – Transfer Pricing Highlights – Cost Sharing Arrangements Cost Sharing Arrangements in China – the buy in payment issue • In China, the SAT’s regulations do not provide guidance on how to use specific methods to determine arm’s length transaction value (转让定价方法，以确定市场价格) • Buy In payments • Comparable uncontrolled price method is generally not preferred by tax authorities • In the USA, the income method is commonly used and accepted by the IRS • Under income method: calculate NPV (net present value) of future stream of non-routine cash flows from use of pre-existing IP

30. China – Transfer Pricing Highlights – Cost Sharing Arrangements Cost Sharing Arrangements in China – the buy in payment issue • In China, SAT does not list specific methods to compute buy in payment • No current consensus of what will best satisfy the SAT, however, following factors are much focused on: • How future economic benefit is predicted and measured • Costs pool allocation – excluding stewardship expenses, and costs which are not of direct benefit to IP development • China’s cost advantage and market premium (成本优势和市场溢价) to be considered as to effect on buy in payment and cost sharing contribution payment

31. China – Transfer Pricing Highlights – Cost Sharing Arrangements Cost Sharing Arrangements in China No CSA CSA Parent (USA) Parent (USA) EIT BT / VAT Licensing fees / royalties payment Licensing agreement- use of IP CSA entered into Buy In payments Subsidiary (China) Subsidiary (China)

32. Appendix Intercompany Payments

33. Inter-Company Charges with Affiliates in China • When structuring an inter-company charge with an affiliated company in China, many factors have to be considered in advance • Regulatory restrictions on particular economic activities • Examples: Financing activities / Outbound Lending • Dividend distribution limitation (i.e., accounting profit requirement) • Capital repatriation generally not permitted • Foreign exchange control • Only permitted categories of payments are remittable • Various document requirements • Tax • Requirement to obtain tax clearance certificate in many cases • Cost: income tax (EIT), Business Tax (BT), Value Added Tax (VAT)

34. Inter-Company Charges with Affiliates in China • The extremely restrictive regulatory environment governing repatriation of cash out of China leads to the following phenomenon: • “trapped cash” at many multinationals in China • Because of the perceived difficulty of repatriating cash from affiliated companies in China, there is a tendency for multinationals to “keep profits low” at their China subsidiaries through transfer pricing arrangements and various type of inter-company charges against the China subsidiary / affiliated company

35. Accounting Profits Settle Income Tax Offset prior year loss, if any Provide for statutory after-tax reserves Distributable Profits Inter-Company Charges with Affiliates in China ProfitsRepatriation – Conditions for Dividend Declaration Common Misconception: It is difficult to take profits out of China! • To remit dividends to parent company, the following are to be submitted to the bank: • Tax return copy • CPA audited financial report • Resolution of Board of Directors • Foreign Exchange registration certificate • Credit report prepared by accounting firm

36. Inter-Company Charges with Affiliates in China • The major objectives to achieve, when structuring inter-company charges with an affiliated company in China are: • The payor (ie. the China affiliate) can claim a deduction against its corporate income tax (the Enterprise Income Tax “EIT”) • The payee (ie. the non-Chinese recipient) is not subject to excessive tax in China • The China tax paid can, if possible, be credited against the payee (ie. the non-Chinese recipient)’s home country tax • Payment can be remitted by the payor out of China through the banking system, clearing the hurdles of foreign exchange controls (as administered by SAFE “State Administration of Foreign Exchange”)

37. Inter-Company Charges with Affiliates in China • How transfer pricing arrangements can affect or be affected by the structuring of inter-company payments in China? • For inter-company payments other than the buying and selling of merchandise, the inter-company pricing can be challenged when a tax clearance certificate is required. The result can be that if the tax authority is not satisfied with the inter-company price (for example, a royalty charged against the Chinese affiliate), then the payment simply cannot be remitted outside of China • Due to the imposition of both income tax (EIT) and other turnover taxes (such as Business Tax and/or VAT), there is pressure on multinationals to re-characterize certain outbound payments by affiliates in China • Getting the “transfer pricing” arrangement wrong, will be costly not just because of “corporate income tax” (EIT), but as a result of the turnover taxes also

38. Appendix Recent Cases on Intercompany Payments 38

39. Inter-Company Charges with Affiliates in China - Examples • Example 1 – the “G-UK” Company • Facts • G company is a UK company which owns valuable technology, some of which has been patented. It has a subsidiary in China “G-China”, which has in the past manufactured the products for G-UK, and then immediately sold the manufactured products to G-UK. G company is part of a large multinational group, and is subject to financial reporting in the US. • In the last 2 years, however, G-China began selling some of G-UK’s products in China. However, G-UK has not charged G-China any royalty / license fees for the sale of its products (ie. the G-UK brands and the embedded technology, etc). • G-China has been profitable in the last few years, and has paid EIT in China at the rate of 25% on its net profit.

40. Inter-Company Charges with Affiliates in China - Examples • Example 1 – the “G-UK” Company (continued) • Problem: • From a TP standpoint, G-China should have been paying royalties to G-UK when it began selling G-UK’s products in China. The risk is that the UK Inland Revenue may, under UK’s TP rules, impute royalty income to G-UK, and therefore G-UK will be liable for additional UK corporate income tax. • However, there is no ready mechanism in place for G-China to amend its prior years’ tax returns, to adjust and get a refund for prior year taxes. • Consequences: • Immediate : G-UK and its parent company group is under pressure from its auditors to provide for a tax expense provision reserve, for FIN 48 reporting purposes in the US • Longer term: If G-UK is assessed additional UK corporate income tax, and if it cannot readily obtain a refund of the EIT G-China has paid in China, then it will be double taxed on the same income, for the group as a whole • Solution: • Is a competent authority proceeding / mutual agreement procedure (“MAP”) a realistic possibility in this case, under the UK-China tax treaty ?

41. Inter-Company Charges with Affiliates in China - Examples • Example 1 – the “G-UK” Company (continued) • Competent Authority proceeding / MAP under the UK-China tax treaty • Under the existing UK-China tax treaty (1984), Article 25 provides for a competent authority proceeding • There is a new UK-China tax treaty, signed but not yet effective. Article 25 in new treaty has essentially the same provisions, except that there is statute of limitation relief. • In theory, MAP proceeding can be initiated in the UK, or possibly, in China • If MAP proceeding is initiated in China, then Guoshuifa [2005] 115 (“GSF 115” issued1st July 2005) will govern. • However, a competent authority proceeding is discretionary as to whether the tax authorities will agree to commence one. Also, not all competent authority proceedings result in agreement.

42. Inter-Company Charges with Affiliates in China - Examples • Example 2 – the “L-US” Company • Facts • The L-US company is a multinational group in the software language localization business, and is very profitable in its home country, USA. It has a subsidiary in China, the L-China company. The L-China company provides services to various customers, performing the Chinese localization of various major software programs. Some of its customers are affiliated companies outside of China within the L-US group. • The L-China company is required to prepare contemporaneous transfer pricing documentation, because it’s intercompany transactions with affiliates exceed the threshold requirement ( > RMB 40 million in fees payments), and has done so since 2008. Under its TP documentation, L-China is described as not engaged in “software development”, bur rather as simply engaged in certain programming functions, and to perform minor modifications to certain parts of the software. • In 2010, under a circular Caishui [2010] 64, a company which performs outsourcing in certain types of industry/functions, can obtain an exemption from Business Tax (BT), on its “outsourcing business revenue”.

43. Inter-Company Charges with Affiliates in China - Examples • Example 2 – the “L-US” Company (continued) • Facts (continued) • The “software development” business is one type of qualifying industry / function which can qualify a company to have the Business Tax exemption under Caishui [2010] 64. This is the only possibility for L-China if it wants to get the BT exemption. • Problem • As the Business Tax (BT) rate is 5% (effectively 5.6%, if local surcharges are added) on gross revenue, the tax exemption under Caishui [2010] 64 can provide significant tax savings for L-China. • Can L-China maintain that it is in the “software development” business for purposes of Caishui [2010] 64, without changing its TP documentation’s position that it is not engaged in “software development” for EIT purposes?

44. Inter-Company Charges with Affiliates in China - Examples • Example 3 – the “M” Company • Facts • The M Company is engaged in the design, development and manufacturing of integrated circuits (IC’s) and other electronic equipment. It has a subsidiary in China, M-China, which has been in operation since 2009. M-China provides design services solely for its parent the M Company. • The M Company has not paid any service fees to M-China since its inception. Therefore, M-China has not shown any revenue for the 2009, 2010 years, and therefore operated at a loss for those two years. It is now February 2012, and the management of M company decided that it should compensate M-China for the year 2011 on a cost-plus basis (around cost + 10%). There is no inter-company service agreement in place. The management is wondering whether they can do so, and what problems, if any, should they anticipate. • Problem • With the year 2011 year completed, and it is already February, it means that the interim accounts of M-China have already been submitted to the local tax bureau, without showing any revenue. Further, if service fees should have been charged by the M Company against M-China during 2011, then invoices should have been issued during the year, with the requisite Business Tax (BT) of 5.5% collected from the customer, the M Company.

45. Inter-Company Charges with Affiliates in China - Examples • Example 3 – the “M” Company (continued) • Problem • Since the 2011 year is over, and it is already February, the interim accounts of M-China have already been submitted to the local tax bureau, showing zero revenue. Further, if service fees should have been charged by the M Company against M-China during 2011, then invoices should have been issued during the year, with the requisite BT of 5.5% collected from the customer, the M Company • If M-China now pays M-China a service fee of cost + 10%, for the year 2011, then there can be late penalty and interest for the EIT tax and BT tax which should have been collected and paid over during 2011 • Also is it possible to, on the one hand, adjust M-China’s 2011 for financial statement and taxable income, but yet without having the billings / official invoices to show for it during 2011? • Solution • Official invoices showing the correct amount of BT or VAT should be issued as soon as possible for 2012, based on an agreement for intercompany services effective for the year 2011. A meeting should be arranged with the tax official in charge at the local tax bureau, for a discussion of the matter on 2011 and prior years.

46. Inter-Company Charges with Affiliates in China - Examples • Example 4 – the “P” Company • Facts • The P Company is engaged in the sale of pet related products to customers within Continent E. It obtains almost all of its products from unrelated factories and suppliers in China. It has done its procurement through two Representative Offices (RO) the P Company has in China. The P Company owns a number of patents and trademarks it has developed for its products over the years. • P Company believes that there will be a significant increase in the consumer demand for pet related products in China and the rest of Asia in the future. • In 2012, the P Company will establish a WFOE (Wholly Foreign Owned Enterprise) in China, P-China, to replace the two ROs It will also set up a new company in Hong Kong, P-HK. The plan is that the new WFOE will provide procurement services to the P Company and P HK, and also will develop products and brands for the China market, to which P-China will sell. P-HK is to develop products and brands for the markets outside of China and the E Continent, and will be responsible to sell to customers in those areas.

47. Inter-Company Charges with Affiliates in China - Examples • Example 4 – the “P” Company Issues • What intercompany agreements are needed as between the P Company, P-China and P-HK? • Possible solutions • Procurement Services contract between P-China, as the service provider, and the P Company and P-HK as the service recipients • The P Company should consider structuring a Cost Sharing Agreement (CSA) between itself and P-China and P-HK, as to existing intellectual property and on future products development costs • If designed properly, a cost sharing agreement (CSA) arrangement can provide both income tax and turnover tax advantages in China and in HK

48. Example: New IP/Product Development/Exploitation Model in China Example 4 – the P Company Diagram P Company (in Continent E) sales Customers in Continent E Continent E rights, ex PRC rights and rest of world Holding Company Cost-Sharing Agreement sourcing services To customers in rest of the world, excluding Continent E and PRC P-HK(Hong Kong Limited Company) sales Owns rights to rest of world, ex Continent E and PRC rights P-China (China WFOE) sales PRC customers PRC rights Intercompany Agreements and Payments • Procurement Services Agreement between P-China WFOE and P Co. and P-HK • P Co. and P-HK to pay service fees to P-China • Cost Sharing Agreement between P Co., P-China, P-HK • P-HK to pay P Co buy in payment • License Agreement between (a) P Co. and P-China and (b) P Co. and P-HK

49. Contact InformationNotice / Disclaimer 49

50. Contact Information Peter Guang Chen (Hong Kong) Email: pchen@crai.com Phone: +852 8127.7500 +852.3927.5222 (direct) +852.6587.9097 (mobile) Joshua Wan (Hong Kong) Email: jwan@crai.com Phone: +852 8127.7500 +852.3927.5333 (direct) +852.5688.1570 (mobile)