Alibaba Group Holding Ltd., which bills itself as the largest online and mobile commerce company in the world, filed its registration statement with the U.S. Securities and Exchange Commission May 6 in anticipation of what could be the largest IPO in U.S. history. It is estimated that the offering could raise as much as $20 billion, an amount that would surpass the IPOs of Visa, Facebook, and General Motors.
Alibaba maintains headquarters in Hangzhou, China, conducts most of its operations there, and derives more than 80 percent of its revenue from Chinese commerce, but the company isn't Chinese -- at least not from a tax standpoint. It's incorporated in the Cayman Islands and conducts its Chinese operations through its subsidiaries and VIEs there.
The company's effective tax rate for the nine months ending December 31, 2013, was 9.9 percent. That rate is expected to increase in 2014, however, as some subsidiaries are phased out of China's preferential tax regime for high-technology and software enterprises.
According to the prospectus, Alibaba's major Chinese subsidiaries have been subject to VAT on the provision of services since 2013 under a national VAT pilot program to replace the business tax regime in China.
Heightened VAT enforcement of e-commerce transactions, including the imposition of VAT withholding obligations, "could have a material adverse effect on our business, financial condition, and results of operations," the prospectus says.
That likelihood may be more than a hypothetical concern in light of the attention on VAT related to digital transactions in the OECD's base erosion and profit-shifting project.
According to the prospectus, a significant number of small businesses and sole proprietors operating through Alibaba's shopping website, Taobao Marketplace, may not have completed the required tax filings. Those sellers could be made subject to more stringent tax compliance requirements, in which case their businesses, as well as Alibaba's, could suffer, particularly if the vendors decide to leave the marketplace rather than comply.
China's tax authorities may also ask Alibaba for assistance with the enforcement of registration requirements for small businesses and sole proprietors and could ask the company to provide information about its sellers. Alibaba's participation could have a chilling effect on the entry of new vendors into the marketplace.
China's Enterprise Income Tax Law has a management and control concept whereby a non-Chinese company with a place of effective management in China is considered to be resident for enterprise income tax purposes.
Circular 82, which provides guidance on the place of effective management, establishes factors to be considered in determining whether a Chinese-controlled offshore company is a Chinese tax resident, including the location of its day-to-day management and its primary assets.
Notwithstanding Alibaba's position that Circular 82 does not apply to it because the company is not a Chinese-controlled offshore enterprise, the prospectus concludes that Alibaba would not be a Chinese resident under the Circular 82 test.
While the company said it currently generates only a small portion of its revenues offshore, the cost of being wrong about its residence status could be quite high. Dividends paid by the company to nonresident shareholders and capital gains realized on the transfer of shares could be characterized as Chinese-source income subject to withholding tax. Further, those dividends and capital gains could subject overseas shareholders to individual income tax in China in the absence of an applicable income tax treaty.
Alibaba declined to comment on whether it has been approached by the Chinese authorities regarding its residence status.
The contractual arrangements between Alibaba and its VIEs, which hold Internet content provider licenses, domain names, and trademarks and operate websites for Alibaba's online businesses, enable the company to exercise control over the VIEs, realizing the economic benefits and bearing the burdens arising therefrom. However, the VIEs are majority-owned not by the company, but by Alibaba's founder, executive chair, and principal shareholder, Jack Ma, according to the registration statement.
Because the arrangements between Alibaba and its VIEs involve transfer pricing, the tax liabilities of the relevant parties could be subject to adjustments if the tax authorities determine that the arrangements were not conducted at arm's length.
A tax partner with a major international firm questioned the stability of contractual arrangements between parent companies and VIEs because the legality and enforceability of those arrangements have not been well tested. "It's a lot of money resting on an uncertain legal arrangement," the partner said.
Alibaba said that while it doesn't expect to become a passive foreign investment company for U.S. purposes, it may be treated as a PFIC if it is not considered to own stock of the VIEs for U.S. tax purposes (for example, because China does not acknowledge the arrangements between Alibaba and the VIEs).
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