News Flash. China Tax and Business Advisory. What to Learn from the Vodafone Case for China Tax. February 2012 Issue 4.

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1 News Flash China Tax and Business Advisory February 2012 Issue 4 Our Tax Controversy Services Team Contacts Northern China Xiaoying Chen Tel: +86 (10) xiaoying.chen@cn.pwc.com Central China Jane Wang Tel: +86 (21) jane.y.wang@cn.pwc.com Southern China Janet Xu Tel: + 86 (20) janet.xu@cn.pwc.com PwC China's Tax Controversy Services (TCS) practice helps companies face and respond to increased pressure and attention from tax authorities in China by preventing, managing, and resolving tax disputes. Our success is based on a powerful combination of deep technical expertise, tax appeals and alternative dispute resolution experience, and our local knowledge and global perspective.our team includes former government officials who can capitalise on their first-hand understanding of process and procedures and long standing relationships as well as specialists with technical expertise in all areas of China tax. What to Learn from the Vodafone Case for China Tax The Indian Supreme Court ( SC ) pronounced its long awaited decision in the landmark Vodafone case on 20 January It has concluded that the Indian tax authorities should not tax the capital gain from the sale of a foreign company s shares outside India, even though the transaction involved an indirect transfer of an underlying Indian company. This News Flash highlights the SC s key judgments / observations on the Vodafone case, compares the similarities and disparities with China s tax rules on overseas indirect equity transfer ( indirect transfer ) stipulated in tax circular No.698 ( Circular 698 ) issued by the State Administration of Taxation ( SAT ) in December 2009, and more importantly, analyzes the potential influence of the Vodafone case on the SAT s position on indirect transfers. The Vodafone case Starting from 1992, the Hutchison Group acquired significant direct and indirect interests in Hutchison Essar Limited ("HEL"), an Indian operating company. A simplified version of the ownership structure is depicted below.

2 Pursuant to a sale and purchase agreement between the parties in February 2007, Hutchison Telecommunications International Ltd ("HTIL") sold the sole share of CGP Investments Ltd ("CGP"), a Cayman Islands company, to Vodafone International Holdings, B.V. ( Vodafone ). In the same year, the Indian tax authorities issued a notice to Vodafone seeking to hold it liable for its failure to withhold Indian taxes on payment of the sales consideration to HTIL, the seller. The amount of tax involved was significant -- around US$ 2 billion. This unveiled the long battle of Vodafone against the Indian tax authorities before the Bombay High Court and thereafter before the SC. 1 After a period of four years involving two rounds of litigation at the Bombay High Court, followed by a twomonth hearing of the case at the SC level, the SC finally rendered its judgment on the case. The salient points of the SC judgment include: The current provisions of the Indian domestic tax law dealing with the source of capital gains cannot be read as "look through" provisions for purpose of collecting Indian taxes on a transaction of shares of a foreign company. In the application of the judicial anti-avoidance rule, the principle of substance over form or piercing the corporate veil should be applied to sham transactions aimed at tax evasion and not to genuine and strategic tax planning. The transaction in the current case was a bona fide foreign investment transaction, which fell outside India s territorial jurisdiction. PwC Observations Similarities and disparities between the Vodafone case and indirect transfer under Circular 698 It appears that the issuance of Circular 698 in December 2009 could easily be mistaken as the response of the SAT to the Vodafone case which has been in litigation in the Indian courts since However, as a matter of fact, the two events were challenging the same type of transaction (i.e. indirectly transferring the equity of a domestic company through the sale of an offshore holding company) based on different technical grounds. The main technical issues in the Vodafone case lied on the source of the capital asset being transferred and the application of the judicial anti-avoidance rule. On the first issue, the principle used in determining the source of income arising from the transfer of equity interest is set out clearly in the detailed implementation regulations to the China Corporate Income Tax ( CIT ) Law; therefore, it is not an issue from a China tax perspective. On the second issue, unlike India which does not have a general anti-avoidance rule ( GAAR ) in its tax legislation and has to rely on judicial anti-avoidance rules to challenge the transaction, China has introduced GAAR into its CIT Law effective 1 January Furthermore, in the Implementation Measures on Special 1 Here is the link to the PwC India News Alert that contains many more details of the Vodafone case _Vodafone_International_BV.pdf News Flash China Tax and Business Advisory 2

3 Tax Adjustments issued by the SAT in early 2009 ( Circular 2 ), the Chapter of GAAR has a specific provision to empower the tax authorities to re-characterize tax-avoidance transactions by looking through an intermediate holding company that does not have economic substance. With the above comprehensive legal bases, the release of Circular 698 did not come as a shock. We note that the Indian authorities are proposing a new set of Direct Tax Code. In the proposed Direct Tax Code (2010) 2 there is a provision allowing the taxation of indirect transfer of a capital asset located in India. In addition, GAAR would also be introduced to allow the Indian tax authorities to attack tax avoidance transactions. What to learn from the SC judgment on the Vodafone case As mentioned above, the SC judges had to consider whether the judicial anti-avoidance rule (e.g. "substance over form" or "piercing the corporate veil" principle) in the Indian legal system is applicable in the Vodafone case. Some of the SC judges key judgments and observations in this regard well deserve noting for China tax purpose: Topic Indian SC's decisions / observations Observations for China Tax planning is not ruled out Onus of proof is on the tax authority How to assess a transaction The SC reinforced the principles it laid down in a precedent case (Azadi Bachao Andolan case in 2003) that genuine and strategic tax planning cannot be ruled out. Holding structures are recognized both in Indian corporate as well as tax law and the use of special purpose vehicles and holding companies is common in Indian legal structures. The burden of establishing that a structure is abusive lies with the tax authorities. The tax authorities may invoke the "substance over form" principle or "piercing the corporate veil" test principle only after it is able to establish on the basis of facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant. While the Revenue authorities examine the transactions, it must consider the transaction holistically and not adopt a "dissecting" approach. Some factors that must be kept in mind include: the concept of participation in investment; the duration for which the holding structure existed; the period of business operations in India; the generation of taxable revenues in India; the timing of exit; and the continuity of business upon exit. This responds to the much discussed question in the international tax arena on whether tax planning is ruled out after the Vodafone case. The SC judgment asserted that genuine strategic tax planning is still possible if it is within the framework of law. It should be this case not only in India but in China as well. None of the Chinese tax laws and regulations explicitly pin-point tax planning as a sin. Even the Chinese GAAR would only attack tax planning if the main purpose of which is tax avoidance. The Chinese tax laws and regulations do not explicitly state which party shall bear the onus of proof in tax matters. Unfortunately, in the practice of China, the taxpayer is quite often required to justify that the main purpose of arrangement is not for tax avoidance, even in the process of an administrative appeal. The Chinese tax regulations advocate a similar holistic approach to examine transactions. Circular 2 has provided a number of factors to be considered holistically in assessing whether an arrangement is for tax avoidance. Some of the factors overlap with those stated by the Indian SC. 2 The draft Direct Tax Code (2010) proposes that income from transfer of shares of a foreign company by a non-resident shall be taxed if, at any time during 12 months preceding the transfer, the fair market value of the assets in India, owned directly or indirectly by the company, represents at least 50% of the fair market value of all assets owned by the company. News Flash China Tax and Business Advisory 3

4 Business purpose is a key Does a nonresident have withholding obligation Anti-tax avoidance provisions are a matter of policy The corporate business purpose of a transaction is evidence of the fact that the transaction undertaken by Vodafone is not an "artificial device". While the final conclusion is unanimous that Vodafone does not have withholding obligation in the present case, the rationales held by different judges behind the conclusion are not exactly the same: In the majority decision, the judges seemed to indicate that as long as a payment is chargeable to tax in India, the payer (Vodafone in this case), no matter it is a tax resident or not, should be obliged to deduct tax from the payment. But in the present case, as the share transaction is not chargeable to tax in India, Vodafone should not have the withholding obligation. In the minority decision, the judge held that the withholding obligation under the current Income Tax Act (section 195) only applies to tax resident in India. The question of applying a "look through" provision under domestic law or "limitation of benefits" under tax treaty is a matter of Government policy. These anti-tax avoidance measures cannot be invoked in absence of specific provisions in domestic law or tax treaty to such effect. Similarly, under China's CIT law, purpose is a crucial factor in applying GAAR. However, the SAT found that "purpose test" is rather subjective or abstract and difficult to be substantiated in some cases. If that happens, the SAT would prefer to adopt substance test which is more objective and easier to ascertain. However, in the practice of local level tax bureaus, substance test has dominated the non-tax avoidance purpose test which has inevitably resulted in more disputes with taxpayers. The same issue also occurs in China. The tax laws and regulations do not explicitly discharge non-tax resident payers from withholding obligations. However, in circulars issued by the SAT addressing tax compliance of non-tax residents, the SAT does not explicitly spell out the withholding obligation of non-tax resident payers. In that regard, the withholding obligation of non-tax resident payers is still pending clarification from the policy-makers. Hopefully, the upcoming new Tax Collection and Administration Law which is currently under revision by the SAT would shed light on this unclear issue. As mentioned above, the GAAR in the CIT Law, the specific provisions in Circular 2, together with Circular 698 provide a sound basis for the Chinese tax authorities to look through an intermediate holding company with no commercial substance in a taxavoidance transaction. In addition, tax treaties concluded or re-negotiated by China since 2006 have included a specific clause allowing both competent authorities to invoke its domestic anti-avoidance laws and measures on treaty shopping or abuse cases. This puts China ahead of India in terms of legal basis to counteract tax-avoidance. What to expect for Circular 698 in future So far, the Indian SC judgment on Vodafone case is welcome in general by the industries and tax practitioners in India and globally. Some have expressed their wish to see other countries' tax authorities taking a less harsh approach towards indirect transfer, which undoubtedly were referring to China in light of the widely discussed Circular 698. At the time Circular 698 was released in December 2009, the SAT made it clear that Circular 698 was taken as an experiment of the implementation of GAAR in China. The SAT, from the very beginning, has been expecting an experimental phase in order to gain more experience in this new area and observe the impacts to and responses from foreign investors and tax authorities in indirect transfer transactions. Also the SAT has well recognized that Circular 698 would possibly bring about disputes with the competent authorities of other News Flash China Tax and Business Advisory 4

5 tax jurisdictions because it could boil down to the issue of taxing right allocation -- at the place of source (China) or place of residence (foreign transferor s home tax jurisdiction). As Circular 698 is now running into its third year, it should be time for the SAT to revisit the policy with the experience and feedbacks collected over the past two years. Coincidently the Vodafone judgment comes out at the right time to serve as a valuable reference for the SAT. We understand that the SAT has started to review the strategy and approach on indirect transfer under Circular 698 before the Indian SC rendered the judgment on the Vodafone case. It is possible that the SAT would soon clarify and improve the current practice on indirect transfer by introducing further guidelines for the reporting procedures, tax authorities' internal reporting mechanism, tax authorities' feedback system to non-tax resident transferors, or even allow certain "safe-harbour" rules for indirect transfer, etc. Conclusion At the time of the CIT reform back in 2008, China was determined to tackle aggressive tax planning schemes to protect her tax base. Relevant provisions have been put in place in her domestic laws and regulations as well as sino-foreign tax treaties. We do not see any sign that China would be back off her implementation of GAAR. China is now engaging deeper into the global system. She is responsive to the sensitive and important issues and developments in the international tax arena. The Vodafone verdict will certainly influence, but not dictate, China s tax policies. We understand that the intention of Circular 698 is not to bring uncertainty or additional burden, collect more tax revenue, or claim extra-territorial taxing right on non-tax residents in respect of offshore indirect transfers, but to counteract true tax avoidance transactions. We observe that the current deficiency facing Circular 698 is the proper implementation of such policy so that sham or tax-avoidance transactions could be detected and assessed and, on the other hand, the interest of genuine business transactions would not be jeopardized. We hope that the SAT can come up with clearer rules and provide more guidance to local level tax bureaus to strike the balance. News Flash China Tax and Business Advisory 5

6 In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PricewaterhouseCoopers client service team or your other tax advisers. The materials contained in this publication were assembled on 06 February 2012 and were based on the law enforceable and information available at that time. To make enquiries about our China tax and business advisory services, please feel free to contact the following lead specialist partners: Financial Services Matthew Wong Tel: +86 (21) matthew.mf.wong@cn.pwc.com Transfer Pricing Spencer Chong Tel: +86 (21) spencer.chong@cn.pwc.com Indirect Tax Alan Wu Tel: +86 (10) alan.wu@cn.pwc.com Mergers & Acquisitions Nick Dignan Tel: nick.dignan@hk.pwc.com China Business & Investment Advisory Anthea Wong Tel: +86 (10) anthea.wong@cn.pwc.com International Tax Services Edwin Wong Tel: +86 (10) edwin.wong@cn.pwc.com Domestic Enterprises Tax Services Elton Huang Tel: +86 (21) elton.huang@cn.pwc.com Customs & International Trade Damon Paling Tel: +86 (21) damon.ross.paling@cn.pwc.com Registration & Corporate Compliance Matthew Wong Tel: +86 (21) matthew.mf.wong@cn.pwc.com Tax Accounting Services Terry Tam Tel: +86 (21) terry.sy.tam@cn.pwc.com Value Chain Transformation Steven Tseng Tel: +86 (21) steven.tseng@cn.pwc.com Tax Controversy Services Xiaoying Chen Tel: +86 (10) xiaoying.chen@cn.pwc.com International Assignment Services / Human Resources Services Northern Region Edmund Yang Tel: +86 (10) edmund.yang@cn.pwc.com Central Region Stacy Kwok Tel: +86 (21) stacy.kwok@cn.pwc.com Southern Region Jacky Chu Tel: jacky.chu@hk.pwc.com Our regional contacts: Beijing Edward Shum Tel: +86 (10) edward.shum@cn.pwc.com Chongqing Robert Li Tel: +86 (23) robert.li@cn.pwc.com Dalian Rex Chan Tel: +86 (411) rex.c.chan@cn.pwc.com Guangzhou Daisy Kwun Tel: +86 (20) daisy.kwun@cn.pwc.com Hangzhou Jenny Chong Tel: +86 (21) j.chong@cn.pwc.com Hong Kong Charles Lee Tel: charles.lee@cn.pwc.com Macao Pat Wong Tel: pat.lk.wong@hk.pwc.com Nanjing Jane Wang Tel: +86 (25) jane.y.wang@cn.pwc.com Ningbo Ray Zhu Tel: +86 (21) ray.zhu@cn.pwc.com Qingdao Steven Wong Tel: +86 (532) steven.wong@cn.pwc.com Shanghai Peter Ng Tel: +86 (21) peter.ng@cn.pwc.com Shenzhen Charles Lee Tel: +86 (755) charles.lee@cn.pwc.com Singapore Lennon Lee Tel: lennon.kl.lee@sg.pwc.com Suzhou Linjun Shen Tel: +86 (512) linjun.shen@cn.pwc.com Taiwan Steven Go Tel: +886 (2) steven.go@tw.pwc.com Tianjin Kelvin Lee Tel: +86 (22) kelvin.lee@cn.pwc.com Xiamen Mike Chiang Tel: +86 (21) mike.chiang@cn.pwc.com Xian Elton Huang Tel: +86 (29) elton.huang@cn.pwc.com This China Tax and Business News Flash is issued by the PwC TAX Knowledge Management Centre in China and Hong Kong, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PricewaterhouseCoopers partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui Tel: +86 (10) matthew.mui@cn.pwc.com Please visit PricewaterhouseCoopers websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Consultants (Shenzhen) Ltd. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Consultants (Shenzhen) Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.