From "Formal Compliance" to "Substantive Compliance" – A Shift in Regulatory Focus

Introduction

Against a backdrop of geopolitical volatility and fiscal pressure, "substance over form" and "reasonable commercial purpose" have become core principles across tax, accounting and legal regulation. This article traces their historical development and examines their practical implications.

Part I: Historical Origins

Substance Over Form originated in Anglo-American common law. It was formally established as a concept in 1970 by the US Accounting Principles Board, and later adopted by the International Accounting Standards Committee in 1975. China formally introduced it in the 2000 Enterprise Accounting System.

Reasonable Commercial Purpose stems from UK case law, most notably the Ramsay Principle established in IRC v. Ramsay. It holds that transactions arranged solely for tax avoidance should be assessed as a whole. China introduced this concept in the 2008 Enterprise Income Tax Law as a general anti-avoidance rule.

Part II: Tax – Anti-Avoidance and Look-Through Supervision

In tax, both principles form the pillars of anti-avoidance. US codified the economic substance doctrine in 2010. China's Enterprise Income Tax Law empowers tax authorities to adjust arrangements lacking reasonable commercial purpose.

The "reasonable commercial purpose" test serves two functions: protecting legitimate tax planning, and defining the boundary of tax authorities' adjustment powers.

Key disputes often centre on whether a transaction passes the "principal purpose test" (PPT) introduced by OECD.

Part III: Accounting – Foundation of Information Quality

Under the Enterprise Accounting System, substance over form requires that transactions be recorded according to their economic reality, not just legal form.

Typical applications include:

- Off-balance-sheet financing

- Special purpose entities

- Sale and leaseback transactions

When legal form conflicts with economic substance, the latter prevails.

Part IV: Law – From Judicial Precedents to Look-Through Adjudication

In US case law, Gregory v. Helvering (1935) established that economic substance prevails over legal form. In China, "look-through adjudication" has extended this principle from tax to commercial litigation.

A key challenge is balancing "substance over form" with the "commercial appearance doctrine" – particularly in cases involving corporate personality and related-party transactions.

Part V: Case Studies

Case 1 – Social Media Platform Cross-Border Structure

A social media group used a Hong Kong holding company to claim a 5% dividend withholding tax rate under the China-HK tax treaty. Tax authorities denied the "beneficial owner" status due to lack of substantive operations in Hong Kong, resulting in HK$547.9 million in additional tax.

Case 2 – Walmart's Acquisition of BCL

Walmart acquired BCL (a BVI holding company) to indirectly acquire China-based Trust-Mart. Courts disregarded BCL's legal form, treating it as a conduit, and held that Walmart was in substance acquiring the Chinese entities directly.

Case 3 – Software Company "Tax Holiday" Abuse

A Nanjing software company claimed preferential tax treatment without genuine business operations. Authorities proved its purpose was tax avoidance through employee records, bank flows and contracts. The company was required to pay back taxes and penalties.

Part VI: Making Compliance Work with Business

Three stages to integrate compliance into business:

Design Stage: Let commercial purpose drive tax structure. Consider commercial logic, alternative paths, and tax consequences before locking in a structure.

Implementation Stage: Support the structure with economic substance. Overseas entities should have physical offices, local employees, business records and risk-bearing capacity.

Ongoing Stage: Maintain a "compliance health file" – board minutes, business plans, employment contracts, lease agreements, and transfer pricing documentation.

Part VII: Conclusion – Converging Trends Across Three Domains

The three domains share a common origin but diverge in focus: accounting emphasises "true reflection", tax focuses on "anti-avoidance", and law pursues "fairness". They are now converging through the rise of "look-through" approaches across all three areas.

Under the BEPS framework, CRS and domestic anti-avoidance rules, purely formal compliance is no longer sufficient. Tax authorities increasingly examine whether transactions have real commercial substance and reasonable purpose.

The goal is not to eliminate legitimate tax planning, but to ensure that every transaction can withstand scrutiny on both form and substance – building a bridge between formal compliance and true substantive compliance.

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