Is China Creating A New Business Order? Rationalizing China's Extraterritorial Attempt to Expand the Veil-Piercing Doctrine

Countries are increasingly using tax policy as an instrument to navigate through the recent global financial difficulties, and China is no exception. In an effort to avoid the loss of tax revenue resulting from the utilization of foreign holding companies, the Chinese tax authority issued Circular 698 granting itself the authority to tax transactions between foreign entities taking place outside of China if the transactions effectively transfer interest in a domestic enterprise. The phrase “denying the existence of an offshore holding company which is used for tax planning purposes” in Circular 698 appears to share similarities with the veil-piercing doctrine, a long established doctrine of corporate law existing independent of tax regulations, which disregards the separate legal personality of a company. This article addresses the legitimacy and policy objectives behind Circular 698 and its implementation, and the article compares the Chinese policy to the application of a similar policy in India. The article then examines how the expansive and extraterritorial veil-piercing scenario created by Circular 698 compares with traditional veil-piercing justifications and the three veil-piercing scenarios listed in China’s Company Law. The article interprets Circular 698 in a global context, which underscores the legitimacy of Circular 698 and suggests how foreign experiences can improve the enforcement mechanism for Circular 698. By drawing a global picture this article also enhances the proposition that there is a need to have a uniform approach to dealing with the loopholes that Circular 698 tries to fill at the global level. * KoGuan Chair Professor of Law, Shanghai Jiao Tong University KoGuan Law School; PhD (London School of Economics); LLM (Cambridge); LLM (Michigan); LLM & LLB (East China University of Politics and Law); Attorney-at-Law, New York, FHKIArb. ** Attorney-at-Law, California; JD (University of California, Hastings College of the Law); Adjunct Lecturer, Shanghai Jiao Tong University KoGuan Law School.The authors thank valuable comments made by Roberta Romano, Henry Hansmann, Aaron Joslin, Frank Upham, Jacques DeLisle, Marshall W. Meyer, Erica Gorga, Jamie Horsley, Robert Williams, Leonard P. Goldberger, Iris H.Y. Chiu, Natalya Shnitser, and the participants of the workshop held at Columbia Law School on October 16, 2013, the New York University–Shanghai Jiao Tong University Joint Conference: “Business Beyond Borders: Law, Firms and Markets in the US and China” held at Westin Hotel on January 17 and 18 in Shanghai, the workshop held at Yale Law School on February 19, 2014, the workshop held at the University of Pennsylvania Law School on March 26, 2014, and the workshop held at the New York University School of Law on April 14, 2014. The authors thank Xu Mengshan, Zhang Jieying and Yang Lilong for their research assistance on data collection. Errors and omissions remain with the authors. The authors thank China’s National Social Sciences Foundation for a research grant (Project No.: 15BFX100). 1SHEN_WATTERS -NEEDS FFC (DO NOT DELETE) 10/21/2015 7:42 PM Northwestern Journal of International Law & Business 35:469 (2015) 470 TABLE OF CONTENTS Introduction ............................................................................................... 472 I. Circular 698 and its Implications for the Veil-Piercing Doctrine .......... 473 A. Circular 698: Scope and Application ........................................ 473 B. Circular 698 and the Veil-Piercing Doctrine ............................. 476 C. Overview of the Common Law Veil-Piercing Doctrine ............ 479 1. Modern British Approach to Piercing the Corporate Veil .. 479 2. The American Approach to the Veil-Piercing Doctrine ..... 480 3. Domination and Control ..................................................... 480 (a) Corporate Formalities. ................................................. 480 (b) Adequate Capitalization .............................................. 481 (c) Intercompany Transactions and Commingling of Assets .......................................................................... 482 (d) Overlap in Officers and Directors ............................... 482 (e) Other Miscellaneous Factors ....................................... 482 4. Fraud and Misuse of Corporate Form ................................. 483 II. Legitimacy of Circular 698 .................................................................. 484 A. Why Are Corporations Provided Limited Liability Protection? .............................................................................. 484 B. Is Circular 698 a Specific Application of the Veil-Piercing Doctrine Under the Company Law? ....................................... 486 1. Agency ................................................................................ 489 2. Single Economic Unit ......................................................... 491 3. Avoiding Legal Obligations/Fraud ..................................... 492 C. Is the New Veil-Lifting Rule in Line With the PRC Legislation Law? ..................................................................... 493 III. Is Circular 698 Creating a New Veil-Piercing Doctrine? ................... 496 A. China’s Adoption of the Veil-Piercing Doctrine ....................... 496 B. Circular 698 and Veil-Piercing Policy Objectives..................... 499 1. Preventing Abuse of the Corporate Form Contrary to the Intentions of Corporate Law ............................................. 499 2. Preventing Fraud or Intentional Misuse of the Corporate Form .................................................................................. 499 3. Preventing Harm to Involuntary Creditors.......................... 500 4. Anti-avoidance Measures Against the Systematization of Tax Avoidance .................................................................. 500 C. Administrative Enforcement of Circular 698 ............................ 501 1. Chongqing Case and Circular 698 ...................................... 503 2. Xinjiang Case and Circular 698 .......................................... 503 3. Yangzhou Case and Circular 698 ....................................... 504 IV. The Ramsay Principle: An Equitable Solution to Improve Circular 1SHEN_WATTERS -NEEDS FFC (DO NOT DELETE) 10/21/2015 7:42 PM China’s Extraterritorial Veil-Piercing Attempt 35:469 (2015) 471 698 .................................................................................................. 509 A. Circular 698 and Ramsay Principle: A Comparative Approach ................................................................................. 509 1. Policies Underlying the Ramsay Principle .......................... 509 2. The Aftermath of the Ramsay Principle ............................. 512 B. Circular 698 and the Ramsay Principle ..................................... 512 C. Vodafone Case in India .............................................................. 513 D. The Ramsay Principle and Circular 698: Policy Concerns ....... 517 V. A New Global Tax Order? – “Rationalizing” Circular 698 from an International Dimension ................................................................. 519 A. Round-Trip Investment Model ............................................... 520 B. Regulatory Measures to the “Round-trip Investment” Model ... 530 1. Foreign Exchange Control Rules in 2005 ........................... 530 2. Mergers and Acquisitions Rules in 2006 ............................ 532 3. Tax Notice 82 in 2009......................................................... 533 4. National Security Review Rules in 2011 ............................ 535 C. Global Emphasis on Increased Tax Revenue and AntiAvoidance ............................................................................... 540 1. European Approach to Cracking Down on Aggressive Tax Planning ..................................................................... 544 2. The United States Approach ............................................... 546 3. The G8, G20 and OECD – Global Tax Reform .................. 551 Conclusion ................................................................................................ 554 1SHEN_WATTERS -NEEDS FFC (DO NOT DELETE) 10/21/2015 7:42 PM Northwestern Journal of International Law & Business 35:469 (2015)