The Economic Substance Doctrine and China’s Power to Tax Income from Indirect Equity Transfers by Non-Resident Enterprises

Abstract

The indirect transfer of equity in a Chinese resident corporation by a foreign investor that is a non-resident enterprise through transferring shares in an intermediate holding company is a common technique used in cross-border capital flows. According to the Corporate Income Tax Law of China, the place where a company is located (i.e., registered) determines the location of transfers of equity in that company and which country has the power to tax that transfer, which also gives rise to the problem of the legal scope of this taxing power. The State Administration of Taxation has issued relevant documents to establish the economic substance doctrine, adopting a “look-through approach” to negate the existence of an intermediate holding company and accordingly claim jurisdiction to tax in order to deal with the growing problem of base erosion and profit shifting. The taxing power on indirect transfers does not apply, however, to a transfer which has reasonable commercial purposes or meets the special provisions in tax treaties. China should develop rules through legislation to clarify the specific circumstances relating to such “reasonable commercial purposes”, to provide specific exemption from tax for cross-border internal restructuring-related indirect equity transfers, to introduce an advance ruling system, and to perfect the mechanisms for monitoring revenue sources.