How Controlled Foreign Corporation Rules Works in China
Background
China's Controlled Foreign Corporation (“CFC”) rules under Corporate Income Tax (“CIT”) law has been effect since 1 January 2008, in order to prevent China tax resident companies from leaving profits in low-tax jurisdictions through various arrangements without business substance. And the CFC rules were also introduced by the new Individual Income Tax (“IIT”) law for China individual taxpayers effective from 1st January 2019.
Definition of CFC rules
A China resident shareholder (including resident enterprise, resident individual or resident enterprise and resident individual) is subject to income tax on undistributed profits kept without reasonable business purposes by a controlled foreign company incorporated in a low-tax jurisdiction.
Under the CIT law, the “low-tax” jurisdiction means its effective tax rate which is less than 50% of China’s CIT rate (i.e. less than 12.5%), while it is not clear under the new IIT law.
Applicability of CFC rules
1) A foreign company that is owned by one or more China tax residents (individuals or entities) directly or indirectly, through holding more than 50% shares (with at least 10% or more shares of the voting rights); or
2) Effectively controlled by one or more China tax residents by virtue of share ownership, funding, operations, or purchase and sales etc.
3) Having an effective tax rate of less than 50% of the rate under China's CIT law; and
4) Profit of the CFC is not distributed back to China without reasonable operational needs for retaining it in the CFC.
The above assessment elements from the CIT Law are important references for resident individuals to properly fulfill their compliance obligations, until China state tax authority has made further provisions for "controlled foreign enterprises" under the IIT Law.
Exceptions for CFC rules
1) The CFC is registered in the UK, the USA, Canada, France, Germany, India, Italy, Japan, Norway, South Africa, Australia and New Zealand; or
2) The CFC’s income is mainly derived from active business operations; or
3) The annual pretax profits of the CFC are lower than RMB 5 million, or
4) An Overseas China-funded Enterprise identified as a Non-domestic Registered China Resident Enterprise.
Takeaway
The CFC rules are part of the general-anti avoidance rules that is being implemented in China to protect the national tax base. Comparing to transfer pricing audit cases, the number of successful CFC audit cases reported is quite few, as it is difficult for Chinese tax authorities to obtain information on taxable activities occurred outside China. However, with the introduction of the BEPS achievements and implementation of the CRS, the Chinese tax authorities have already started to pay more attention to the CFC rules as a powerful general-anti avoidance tool, both at the regulatory level and at the practical level.
Chinese companies or individuals that invest abroad via the offshore structure, especially with the intermedia holding companies registered in low-tax jurisdictions, such as BVI, Cayman Islands, will be exposed to higher CFC risks in China. Hence, it is suggested that Chinese taxpayers carefully review their offshore structure and operating arrangements, in order to mitigate the CFC risks.
