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BEPS-related Tax Law - CFC and PEM Rules

Josephine Peng/Leo Tsai/Judy Lo

Anti-tax-avoidance has become an important issue among tax authorities in almost every jurisdiction, not least of all in the Republic of China. The Ministry of Finance (MoF) has formed various task forces to study the 15 action plans published by the OECD for the Base Erosion and Profit Shifting Project ("BEPS"). In line with the international tax regime and to mitigate tax avoidance, the MoF has adopted certain measures including amending tax regulations and developing new taxation platforms that are recommended by the OECD. 
In early 2016, the MoF proposed amendments to Articles 43-3 and 43-4 of the Income Tax Act ("ITA") to include two important international tax rules: the Controlled Foreign Corporation ("CFC") rule, and the Place of Effective Management ("PEM") rule (jointly, the "BEPS-related Tax Law"), and submitted the BEPS-related Tax Law for the Legislative Yuan's review and approval. In light of the offshore corporate tax avoidance trends exposed by the Panama Papers scandal, the Legislative Yuan accelerated and completed the three readings of the BEPS-related Tax Law on 12 July 2016, and the President promulgated the BEPS-related Tax Law on 27 July 2016.
As the BEPS-related Tax Law only applies to profit-seeking enterprises and not individuals, to cope with the ROC individuals setting up CFCs to evade individual tax, the Executive Yuan proposed the amendment to the Alternative Minimum Tax Act for the Legislative Yuan's review and approval. Lee and Li may address this amendment in another tax bulletin once the Legislative Yuan completes the three readings procedure.
The key points of the BEPS-related Tax Law, including the background of the BEPS-related Tax Law, their impact on the ROC and non-ROC investors/profit-seeking enterprises, and the proposed effective date, are explained below.
      CFC Rule
1.    Background
Under the ROC's current tax system, income received by the ROC profit-seeking enterprises from their foreign affiliates is taxed when such income is repatriated to the ROC in the form of dividends, which often results in profit-seeking enterprises deferring repatriation of income generated by their foreign affiliates to the ROC. To stop the ROC profit-seeking enterprises from keeping their earnings in low-tax jurisdictions, the BEPS-related Tax Law incorporates the CFC rule into the ITA.
2.    Key Points of CFC Rule
   Definition of CFC
Offshore affiliates that are (i) more than 50% owned (directly or indirectly) or controlled by the ROC profit-seeking enterprises and its domestic affiliates, and (ii) established in low-tax jurisdictions (jurisdictions where the profit-seeking enterprises income tax rate is lower than 11.9% or taxes are levied only on domestic-sourced income) will be defined as CFCs of their ROC profit-seeking enterprises.
   Safe Harbors Rule
The CFC Rule will not apply to the following CFCs:
CFCs that have substantial overseas operations; and
CFCs that have earnings below a certain level (to be determined by the MoF).
    Taxation under CFC Rule
The ROC profit-seeking enterprises should declare their pro rata share of their CFCs' taxable profits as their investment income in their annual tax returns.
   Loss Carry Forward / Avoidance of Double Taxation
To correctly calculate earnings, a CFC's loss that is certified by a certified public accountant and assessed by the tax authorities can be carried forward for 10 years to deduct the CFC's earnings.
When the earnings of CFC are distributed to the ROC profit-seeking enterprises in the form of dividends, such dividends will not subject to the ROC income tax again. In other words, there will be no double taxation issue.
3.    Impact of CFC Rule
The adoption of the CFC rule into the ROC's ITA should eliminate the deferral of taxation on earnings generated by the offshore affiliates of the ROC profit-seeking enterprises and should encourage them to regularly distribute their retained earnings to the ROC profit-seeking enterprises.
In light of the tax impact under the CFC rule, investors (whether the ROC or non-ROC) whose current business structures involve the ROC profit-seeking enterprises with offshore affiliates should re-evaluate the necessity of having affiliates located in low-tax jurisdictions, and may need to consider adjusting their business structures accordingly.
     PEM Rule
Under the current tax laws, offshore profit-seeking enterprises are subject to the ROC income tax only on their ROC-sourced income. As such, some investors established offshore profit-seeking enterprises in low-tax jurisdictions, yet have their primary business operations in the ROC. In order to combat this tax-avoidance tactic, and to ensure that such offshore profit-seeking enterprises are properly subject to the ROC's tax system, the BEPS-related Tax Law incorporates the PEM rule into the ROC's ITA.
      Key Points of PEM Rule
   Definition of PEM
PEM refers to the place where the substantive management and commercial decisions of profit-seeking enterprises are made. More specifically, profit-seeking enterprises in the following situations will be deemed as having their PEM in the ROC:
(i)   profit-seeking enterprises whose major business/financial/human resource decision-makers are the ROC residents, whose head offices are located in the ROC, or whose major business/financial/human resource decisions are made in the ROC;
(ii)   profit-seeking enterprises whose financial statements, accounting books, board resolutions, and/or shareholder resolutions are produced and/or stored in the ROC; and
(iii) profit-seeking enterprises whose main business operations are in the ROC.
   Taxation under PEM Rule
Profit-seeking enterprises incorporated in low-tax jurisdictions with their PEM in the ROC will be regarded as the ROC profit-seeking enterprises for income tax purposes. Such corporations will be taxed in accordance with the ROC ITA and relevant tax regulations, making them subject to taxation on a worldwide income basis at the rate of 17%.
    PEM Rule supersedes CFC Rule
Offshore profit-seeking enterprises with their PEM in the ROC will be subject to the PEM rule instead of the CFC rule.
      Impact of PEM Rule
The PEM rule should discourage the ROC profit-seeking enterprises from forming affiliates in low-tax jurisdictions simply to avoid the ROC income tax.
It is also worth noting that the PEM rule will likely have a favorable impact on the profit-seeking enterprises to which it applies since such profit-seeking enterprises may be entitled to benefits under the treaties that the ROC has signed with other tax jurisdictions. The Cross Strait Agreement provides more favorable benefits than other tax treaties that China has signed with other countries. For those investors (whether the ROC or non-ROC) that formed an offshore affiliates as a vehicle for doing business with China, once the Cross-straits Agreement between the ROC and China takes effect (which is now pending the Legislative Yuan's approval), investors to which the PEM rule will apply will be able to enjoy the tax benefits under the Cross Strait Agreement. 
     Effective Date of the CFC and PEM Rules
In order to give profit-seeking enterprises time to make the necessary adjustments after the passage of the BEPS-related Tax Law, the lawmakers authorize the Executive Yuan to determine the effective date of the BEPS-related Tax Law. The Executive Yuan will take the following factors into consideration before setting the effective date of the CFC and PEM rules:
(i)  the effective date of the Cross-straits Agreement;
(ii)   the implementation date of the OECD's Common Reporting Standards, formally referred to as the Standards for the Automatic Exchange of Financial Account Information in Tax Matters; and
(iii) the establishment of rules for the enforcement of the CFC and PEM rules.
According to the MoF, the BEPS-related Tax Law would unlikely be enacted before 2018.