Editor's Note: Affiliated transactions are common transactions between group companies, and business transactions such as equity transfer, capital lending and borrowing, and purchase and sale of goods or services between affiliated enterprises are relatively common. At present, China's legislation on anti-avoidance procedures between related enterprises is mainly based on the field of cross-border related transactions, and has already formed a more professional and complete methodology as well as handling procedures, but how to investigate and adjust related transactions of domestic enterprises has not yet been formed into clear provisions. In practice, there are certain disputes on whether the special tax adjustment procedures can be applied to domestic connected transactions, and there are different views on whether the transactions between connected entities with the same effective tax burden in China can not be adjusted. Based on the recent case of a listed company's subsidiaries being adjusted to pay back tax, the author analyzes the common controversial issues of domestic connected transactions and puts forward risk prevention suggestions.

I. Case: The tax bureau determined that the tax basis of connected transactions between subsidiaries of a listed company was on the low side, and required the enterprise to pay nearly 480 million yuan of retroactive taxes and late payment fees.

Recently, a listed company issued "Announcement on Subsidiary's Receipt of <Notice of Tax Matters>", stating that Company A, a wholly-owned subsidiary of the listed company, received the "Notice of Tax Matters" issued by the Tax Bureau on April 9, which reads as follows: Company A and Company B, a wholly-owned subsidiary of the listed company, are related enterprises, and Company A sells brine to Company B from 2021 to 2023, which is significantly lower than the sales price of brine to other taxpayers in the region. Compared with the sales price of brine of other taxpayers in the region, the sales price of brine of Company A was obviously low. According to Article 35 of the Tax Collection and Administration Law, Article 7 of the Provisional Regulations on Value-added Tax, Article 16 of the Rules for the Implementation of the Provisional Regulations on Value-added Tax and the Announcement of the Ministry of Finance and the General Administration of Taxation on the Caliber of Execution of Relevant Issues on Resource Taxation (Announcement of the Ministry of Finance and the General Administration of Taxation No. 34 of 2020), Company A shall adjust the sales amount of the brine within 15 days after receipt of the Notice on Tax Matters and pay the VAT, resource tax and other taxes and late payment fees into the treasury in a timely manner.

According to the ''Notice on Tax Matters'', the listed company initially estimated that Company A was required to pay back VAT, resource tax, enterprise income tax and other related taxes and fees totaling RMB398,052,264.46 and late payment fees totaling RMB81,719,609.52, totaling RMB479,771,873.98 for the years from 2021 to 2023. After Company A sells brine matters to Company B and pays back the tax, Company B will generate VAT tax credit refund of RMB123,160,118.18 and enterprise income tax refund of RMB142,143,436.46, totaling offsetting tax refund of RMB265,303,554.64.

Connected transactions often appear together with related concepts such as transfer pricing and special tax adjustments. In this case, the tax authorities did not initiate special tax adjustment procedures for the obviously low pricing of the connected transaction between Company A and Company B. Instead, Company A was required to adjust the back tax in accordance with Article 35 of the Law on Administration of Tax Collection, which stipulates that the tax basis is obviously low. The treatment of the tax authorities in this case is also a common way for the tax authorities to request the related enterprises to adjust the back tax in the current practice. Whether the general inspection procedure or the special tax adjustment procedure should be applied to the domestic related transactions, and whether the taxpayer can claim not to adjust the tax on the ground that the related transactions have not caused the overall tax loss of the country, will be analyzed in the following paragraphs.

II. Whether general inspection procedures or special tax adjustments should be applied to domestic connected transactions?

(I) In practice, domestic connected transactions are mostly subject to self-inspection or tax inspection for tax reimbursement.

In practice, some tax authorities believe that special tax adjustment is a procedure for adjusting foreign-related connected transactions and is only limited to the regulation of income tax, which is not applicable to connected transactions in most cases in the territory, and it can be seen from the public cases that few special tax investigations have been formally filed in respect of the transactions between connected parties in the territory. Some tax authorities require enterprises to self-examine and pay back taxes based on the idea of special tax adjustment, which avoids the initiation of complicated and long special tax adjustment procedures and at the same time ensures the full collection of taxes; while most of the tax authorities deal with the case as in the previous section, according to Article 35 of the Law on Administration of Taxation Collection, "If a taxpayer has any of the following circumstances, the tax authorities shall have the right to approve its Taxable amount: (6) the taxpayer declares the tax basis is obviously low, and there is no justifiable reason," the provisions of the associated enterprises required to make up the tax, the application of this provision is not limited to the adjustment of the income tax, and thus in practice the application of the more common, such as the case, in addition to the enterprise income tax, Company A is also faced with the problem of making up for the payment of value-added tax, resource tax.

(II) The existing regulations do not specify that the special tax adjustment is not applicable to domestic connected transactions.

Article 36 of the Law on Administration of Tax Collection stipulates that "the business transactions between an enterprise or a foreign enterprise that is engaged in production or operation of an organization or a place established in China and its affiliated enterprises shall be charged or paid in accordance with the business transactions between the independent enterprises; and if an enterprise or a foreign enterprise does not charge or pay in accordance with the business transactions between the independent enterprises and reduces its taxable income or income, it shall not be subject to special tax adjustments. If the taxable revenue or income is not charged or paid in accordance with the business transactions between independent enterprises, which reduces the taxable revenue or income, the tax authorities have the right to make reasonable adjustments". That is to say, it is clear that the tax authorities have the right to make tax adjustments for domestic and foreign related transactions. The Measures for the Implementation of Special Tax Adjustments (for Trial Implementation) (Guo Shui Fa [2009] No. 2) and the Measures for the Administration of Procedures for Adjustment and Mutual Negotiation of Special Tax Investigations (Announcement of the State Administration of Taxation No. 6 of 2017) stipulate that special tax adjustments are applicable to the special tax adjustments made by the tax authorities to transfer pricing, appointment pricing arrangements, cost-sharing agreements, controlled foreign enterprises, capital weakening, as well as general anti-avoidance matters of the enterprises. Among them, the management of transfer pricing refers to the general term for the work of tax authorities in auditing, assessing and investigating whether the business dealings between an enterprise and its related parties comply with the principle of independent transactions in accordance with Chapter 6 of the Income Tax Law and Article 36 of the Law on the Administration of Taxes. The Measures for the Management of Tax Audit Case Sources (for Trial Implementation) (No. 71 of the General Administration of Taxation [2016]) stipulates that "if the information of the case sources involves matters of special tax adjustments, it shall be transferred to the anti-avoidance department for processing upon the approval of the head of the tax bureau".

As can be seen from the foregoing provisions, the existing laws and regulations do not limit the application of special tax adjustment procedures to foreign-related connected transactions, and cases of special tax adjustments for equity transfers between domestic connected enterprises have also appeared in practice. There are differences between the general tax inspection procedure and the special tax adjustment procedure in terms of the recovery period and the treatment results. In terms of the recovery period, the tax inspection procedure can be retrospective for transactions occurring within five years, or indefinitely in cases constituting tax evasion, while the retrospective period is ten years for the special tax adjustment procedure; in terms of the treatment results, the taxpayer may face the risk of paying back tax, paying tax on a daily basis, or being subjected to a tax penalty. In terms of the outcome, after the tax authority initiates the inspection procedure, the taxpayer may face the risk of paying back the tax, charging a late payment fee of five ten thousandths of a percent per day, and in case of tax evasion, etc., the taxpayer will also be fined, whereas in the Special Tax Adjustment Procedure, the taxpayer may be required to pay back the tax and to pay interest on a daily basis at an interest rate of the People's Bank of China's published benchmark interest rate for RMB loans in the year to which the tax belongs, plus five percentage points. Therefore, when taxpayers are faced with the issue of back tax on connected transactions, they may consider the time of occurrence of the connected matters, the possible characterization and the different back tax liabilities, and strive to apply the more favorable treatment procedures.

III. Can it be argued that no adjustment of back taxes should be made on the grounds that the related transactions have not resulted in a loss of the overall tax revenue of the State?

Article 38 of the Administrative Measures for Special Tax Survey Adjustment and Mutual Negotiation Procedures stipulates that "as long as a transaction between domestic related parties with the same actual tax liability does not directly or indirectly lead to the reduction of the overall tax revenue of the State, no special tax adjustment shall be made in principle". In practice, some taxpayers believe that the domestic related transactions will not lead to the loss of national tax revenue and the tax risk is low. In fact, this view is a one-sided interpretation of the above provision: on the one hand, this provision originates from the special tax adjustment procedure, and it is controversial whether it can be applied to the general tax inspection procedure. For example, in this case, can Company A and B claim that this provision is applicable without causing the loss of the overall national tax revenue and that they do not need to pay the back tax? On the other hand, one of the prerequisites for the application of this provision is the same actual tax liability, and what is the same actual tax liability is also worth exploring.

(I) Transactions between domestic related parties with the same actual tax burden shall not be subject to tax adjustment if they do not result in tax loss.

In practice, some tax authorities based on the consideration of local tax sources, for the foreign related transactions, a blanket tax adjustment, requiring enterprises to make up taxes. In the author's opinion, in the general tax inspection procedures, if the actual tax burden is the same between the related parties in the territory of the transaction, does not cause the loss of the overall national tax, should also be referred to deal with, not adjusted to make up for the tax. The provisions of Article 38 of the Administrative Measures for Special Tax Investigation Adjustment and Mutual Consultation Procedures mainly take into account that in the domestic related transactions, if the actual tax burden of both parties is the same, one purchase and one sale will not result in loss of tax, e.g., in the domestic purchase and sale of goods transactions, one of the related parties sells the goods at low price and declares the tax at low taxable price, which results in a reduction of tax, whereas the other related party obtains the goods at a low price and the cost deduction is also reduced accordingly. The other party obtains the goods at a lower price and the cost deduction is reduced accordingly. As a result, such domestic connected transactions will not result in a loss of tax when the actual tax burden of both parties is the same. There are similar provisions in some of the domestic connected transactions: for example, the Circular of the Ministry of Finance and the State Administration of Taxation on Tax Policy Issues Relating to the Pre-Tax Deduction Standard for Interest Expenditures of Enterprises' Domestic Connected Parties (Cai Shui [2008] No. 121) stipulates that, "If an enterprise can provide relevant information in accordance with the relevant provisions of the Tax Law and its implementing regulations and prove that the relevant transaction activities are in line with the principle of independent transaction; or If the enterprise can provide relevant information in accordance with the tax law and its implementing regulations, and prove that the relevant transactions are in line with the principle of independent transactions; or the actual tax burden of the enterprise is not higher than that of the domestic related party, the interest expenses actually paid to the domestic related party shall be allowed to be deducted when calculating the taxable income", which also reflects the principle of "if the transactions between the domestic related parties with the same actual tax burden have not caused any loss of tax revenue, the tax adjustments shall not be made". This provision also reflects the principle of "if the transactions between domestic related parties with the same actual tax burden do not cause tax loss, no tax adjustment shall be made".

(II) What is effective tax liability?

What is the effective tax liability is quite controversial in practice. Taking enterprise income tax as an example, the effective tax liability is usually the ratio of the actual amount of income tax payable by the enterprise divided by the taxable income. There is a view that if the nominal tax rate of both parties to a transaction is the same and one party does not have any tax deduction or exemption, then the effective tax burden is the same; while there is a view that whether one party to a transaction has any unrecovered losses should also be considered. In the author's view, under the premise of protecting the overall tax revenue of the country, judging "the same actual tax burden" according to the condition of the same nominal tax rate and no unilateral tax incentives is conducive to reducing the enforcement cost of the tax authorities, and also helps to maintain the stability of the connected transactions and improve the efficiency of the market operation.

IV. Suggestions for the Prevention of Tax-Related Risks of Enterprises' Domestic Connected Transactions

(I) Strengthening the management of daily connected transactions

Before carrying out connected transactions, it is recommended that the connected enterprises form a reasonable scheme of connected transaction arrangement in respect of the process and pricing policy of connected transactions, with full consideration of the substance of the transaction, the risk assumption of each party and the sharing of costs, etc., and keep relevant written materials in the process of concrete implementation to prove that the relevant transaction arrangement is carried out in accordance with the principle of independent transaction, so that they can respond to the review of the tax authorities in a more effective manner when tax-related risks arise. (ii) Paying attention to the actual tax burden of the related parties.

(II) Paying attention to the actual tax burden level of the related parties to improve the reasonableness of related pricing

Transactions between related enterprises shall be based on business authenticity, especially when one of the related parties has a large uncompensated loss for enterprise income tax or enjoys the fiscal rebate policy provided by the local government, etc., the actual tax burden of the related party is usually significantly lower than that of the other related parties in the transaction. Related transactions under such circumstances may easily give rise to the suspicion of transferring profits through related purchases and sales without paying or underpaying taxes. Therefore, before carrying out the related transactions, the related enterprises should pay attention to whether both parties to the transaction have tax rates, tax base tax incentives, and should ensure the authenticity of the related transactions and the reasonableness of the pricing.

(III) Strengthen consultation with tax authorities

China's legislation on special tax adjustment procedures are mainly based on the international anti-avoidance field, and have formed a more professional and complete methodology as well as handling procedures. However, no clear regulations have been formed on how to investigate and adjust the connected transactions of domestic enterprises. Article 42 in Chapter 6 of the Special Tax Adjustment Procedures of the Enterprise Income Tax Law stipulates that "an enterprise may propose to the tax authorities the pricing principles and calculation methods for the business transactions between the enterprise and its related parties, and the tax authorities shall reach an appointment pricing arrangement after consulting and confirming with the enterprise". In the author's opinion, enterprises can actively communicate with the tax authorities before making arrangements for related transactions within the country, and strive for a prior ruling on the reasonableness of the transaction pricing, so as to prevent the risk of subsequent tax adjustments and back-taxation.