Jurisdiction - China
Reports and Analysis
China – New Indirect Transfer Rules Superseding Circular 698 Issued.

3 March, 2015

 

Legal News & Analysis – Asia Pacific – China – Tax

 

On February 6, 2015, the State Administration of Taxation (the “SAT”) released the State Administration of Taxation’s Bulletin on Several Issues Concerning Enterprise Income Tax on Income Arising from Indirect Transfers of Property by Non-resident Enterprises (SAT Bulletin [2015] No. 7, “Bulletin 7”). Bulletin 7 took effect on the date of its issuance, i.e., February 3, 2015 (the “Effective Date”); it also retrospectively applies to indirect transfers which took place before the Effective Date and in respect of which the PRC tax authorities have not assessed if capital gains tax must be paid.

 

Bulletin 7 was formulated and issued based on the experience of, and outstanding issues faced by, the tax authorities in implementing Circular 698 over the past 5 years. It has also repealed the relevant indirect transfer provisions in Circular 698 and SAT Bulletin [2011] No. 24, and contains more detailed rules for tax treatment of indirect transfer of equity interest in PRC resident enterprises and other assets situated in China. Bulletin 7 will have significant impact on future and past indirect transfer transactions involving China.

 

Highlight

 

We have set forth below our interpretations and analysis of the key provisions of Bulletin 7.

 

I. Broadened Scope Of Indirect Transfer

 

According to Article 1 of Bulletin 7, where a non-resident enterprise transfers indirectly equity interest in PRC resident companies and other assets situated in China to avoid enterprise income tax (“EIT”) through arrangements lacking reasonable commercial purposes, the indirect transfer shall be re-characterized as a direct transfer.

 

While Circular 698 only covered the indirect transfer of equity interest in Chinese resident enterprises, Bulletin 7 broadened the scope of indirect transfer to encompass non-resident enterprises’ indirect transfer of (i) the assets of an “establishment or place” situated in China; (ii) real property situated in China; and (iii) equity interest in Chinese resident enterprises (collectively, “Chinese Taxable Assets”).

 

Under Bulletin 7, an indirect transfer of Chinese Taxable Assets refers to a transaction where a non-resident enterprise transfers its equity interest and other similar interest in an offshore holding company, which directly or indirectly holds Chinese Taxable Assets, thereby in substance achieving the effect of directly transferring the Chinese Taxable Assets. Such indirect transfer also includes the reorganization of nonresident enterprises resulting in the change of offshoreshareholders of PRC resident enterprise(s).

 

Notably, Bulletin 7 for the first time covers the transfer of other similar interest than equity interest. What exactly the term “other similar interest” covers is still subject to further interpretation by the SAT.

 

II. Determining Reasonableness Of Commercial Purpose(s)

 

1. Factors In Determining The Reasonable Commercial Purpose

 

Circular 698 did not specify how to determine if reasonable commercial purposes exist, while Bulletin 7 provides detailed guidance in this regard. Article 3 of Bulletin 7 adopts a “totality of circumstances” approach for determining reasonable commercial purposes for the indirect transfer of Chinese Taxable Assets, and stipulates the following circumstances which need to be taken into consideration:

 

  • whether all or most of the value of the offshore holding company’s equity is directly or indirectly derived from Chinese Taxable Assets;

 

  • whether all or most of the assets of the offshore holding company comprises of direct or indirect equity investments in China; or whether all or most of the revenue of the offshore holding company is sourced from China;

 

  • whether the functions performed and risks assumed respectively by the offshore holding company and its direct or indirect subsidiaries which hold Chinese Taxable Assets can justify the economic substance of their respective corporate structure;

 

  • how long the shareholders, business model and relevant organizational structure of the offshore holding company(ies) are in existence;

 

  • whether income tax has been imposed in a foreign jurisdiction, including the jurisdiction where the offshore transferor is a resident and the jurisdiction where the holding company whose equity interest is transferred by the transferor, on the gains derived from the indirect transfer of Chinese Taxable Assets;

 

  • whether (A) the indirect investment in, indirect transfer of, Chinese Taxable Asset and (B) direct investment in, direct transfer of, Chinese Taxable Assets are interchangeable;

 

  • whether there is an applicable tax treaty or arrangement in respect of indirect transfer of Chinese Taxable Assets;

 

  • whether other relevant factors are present.

 

2. Blacklisted Indirect Transfers

 

Certain indirect transfer of Chinese Taxable Assets shall be deemed to lack a reasonable commercial purpose per se, if all of the following conditions are met, without going through the above-mentioned analysis of reasonable commercial purposes:

 

  • 75% or more of the value of the offshore holding company’s equity is derived from Chinese Taxable Assets;

 

  • anytime in the year prior to the occurrence of the indirect transfer of Chinese Taxable Assets, 90% or more of the total assets (excluding cash) of the offshore holding company are direct or indirect investments in China, or 90% ormore of the revenue of the offshore holding company was sourced from China;

 

  • the functions performed and risks assumed by the offshore holding company(ies), although incorporated in an offshore jurisdiction to conform to the corporate law requirements there, are insufficient to substantiate their corporate existence; and

 

  • the foreign income tax payable in respect of the indirect transfer is lower than the Chinese tax which would otherwise be payable in respect of the direct transfer if such transfer were treated as a direct transfer.

 

III. Safe Harbors

 

Bulletin 7 provides a safe harbor for indirect transfer of China Taxable Assets resulting from a qualified intra-group reorganization; in other words, if all of the following three conditions are satisfied, the intra-group reorganization would be deemed to have a reasonable commercial purpose, and therefore will be exempted from EIT:

 

  • the shareholding relationship between the transferor and the transferee meets any of the following:
    • the non-resident transferor holds directly or indirectly 80% or more of the equity of the transferee;
    • the transferee holds directly or indirectly 80% or more of the equity of the non-resident transferor; or
    • the same party holds directly or indirectly 80% or more of the equity of the non-resident transferor and transferee;

 

And in cases where more than 50% of the value of shares of the offshore holding companies comes directly or indirectly from real property situated in China, the above-mentioned shareholding percentage must be 100% instead of 80%.

 

  • the China tax burden of any subsequent indirect transfer conducted after the indirect transfer in question would not be less than the China tax burden on an identical or a similar indirect transfer as if the indirect transfer in question had not occurred; and

 

  • the transferee paid all consideration in the form of equity interest in the transferee itself or in its controlled enterprises (shares of listed companies excluded) .

 

The introduction of the safe harbor rule for qualified intra-group reorganizations reduces the risk for indirect transfer of China Taxable Assets resulting from offshore intra-group reorganization being subject to Chinese capital gains tax. However, the high shareholding percentage requirement and the requirement that payment of all consideration must be in the form of equity interest will put some restraints on companies intending to utilize this safe harbor. Also, it is not clear whether the merger of a subsidiary into its parent without any consideration will qualify for the safe harbor treatment under Bulletin 7.

 

Additionally, Article 5 of Bulletin 7 provides de facto safe harbors in either of the following two situations:

 

  • A non-resident enterprise buys and then sells, in the public securities markets, the shares of the same foreign listed company, which holds equity interest in a PRC resident enterprise, thereby realizingcapital gains1 ;

 

  • Where the offshore transferor who directly holds Chinese Taxable Assets directly transfers such assets, and such transfer would otherwise be exempted from EIT in China pursuant to an applicable tax treaty.

 

IV. Change In Reporting Obligations

 

Bulletin 7 has substantially changed the reporting obligations under Circular 698. For ease of reference, we have summarized these changes as follows:

 

  • Bulletin 7 has done away with the mandatory reporting under Circular 698, and provides that the parties to an indirect transfer transaction have the option to decide whether to report the indirect transfer to the competent tax authorities. However, where the indirect transfer is taxable in China, Bulletin 7 provides for different legal consequences depending on whether such indirect transfer has been voluntarily reported for the purposes of encouraging voluntary reporting by offshore sellers and buyers. Circular 698 only imposed on the offshore transferor the obligation to report the indirect transfer transaction to the competent tax authorities; but it did not specify the legal consequences if the transferor failed to report or was late in reporting to the tax authorities the transaction.

 

  • Bulletin 7 extends the reporting party to all parties associated with the offshore transaction, including the offshore transferor and transferee, as well as the Chinese resident enterprise whose equity interest was transferred. According to the SAT’s interpretation of Bulletin 7, the expansion of reporting parties gives the parties associated with the transaction the option to choose the appropriate reporting party among themselves.

 

  • The reporting procedure is simplified under Bulletin 7 and the documents to be submitted through a voluntary reporting procedure for an indirect transfer includes: (i) equity transfer agreement, (ii) corporate ownership structure charts before and after the indirect equity transfer, (iii) two years of financial and accounting statements for all intermediate holding companies, and (iv) a statement explaining the reasons why the indirect transfer of the Chinese Taxable Assets should not be deemed as a direct transfer. However, Bulletin 7 makes it clear that the competent tax authority may request further information on the indirect transfer from the offshore transferor, offshore transferee, the Target Company, or the tax advisors who participated in the planning of the indirect transfer.

 

V. Legal Consequences For Failing To Withhold And Pay Tax

 

1. Withholding Liability For Offshore Transferees

 

Circular 698 is silent on whether the non-resident offshore buyer has the legal obligation to withhold tax on capital gains (deemed to be) derived by the offshore seller. Bulletin 7 specifies that the payor, regardless of whether it is a resident enterprise, is required to withhold tax on capital gains realized from an indirect transfer of real property situated in China or equity interest in Chinese resident enterprises. In most indirect transfer transactions, the transferee would be the payor; therefore, if the transaction in question is taxable,generally the transferee has the withholding obligation.

 

According to Bulletin 7, where neither the transferor pays the taxes on capital gains realized from its indirect transfer, nor has the withholding agent withheld and transmitted to the competent tax authority the said taxes, the competent PRC tax authority may impose a penalty ranging from 50% to three times the amount of the unpaid taxes on the withholding agent for its failure to withhold the capital gains tax. However, Bulletin 7 provides that the penalty may be reduced or waived if the withholding agent has reported to the tax authorities by submitting the required documents within 30 days after the equity transfer agreement is executed.

 

It remains to be seen how in practice how the PRC tax authorities will enforce the withholding obligation against non-resident transferees/ withholding agents, as (A) the offshore transferees which do not have any assets in China are generally not subject to Chinese jurisdiction, and (B) there is not a matured mechanism under which non-resident enterprises could withhold EIT and remit such EIT to Chinese tax authorities. Another obstacle is that offshore buyers usually are not able or in a position to determine whether the indirect transfer is taxable in China unless the indirect transfer is a blacklisted indirect transfer transaction under Bulletin 7.

 

It is foreseeable that in order to minimize its potential tax exposure, buyers will attempt to include in the offshore share transfer agreement a clause requiring the seller to put in escrow an amount equal to the potential tax exposure.

 

2. Liability For Offshore Transferors To Make Tax Payments

 

Under Bulletin 7, offshore sellers are required to file a tax return and pay taxes within seven days after the tax liability arises if the withholding agent fails to withhold the taxes from the capital gains realized from the indirect transfer. If the offshore seller fails to pay taxes due within the prescribed time limit, the offshore seller is subject to a daily interest rate equal to the benchmark rate published by the People’s Bank of China plus 5%. The additional 5% punitive interest charge will be waived if the offshore seller voluntarily reports to the tax authorities as described above.

 

No doubt that the above provision would give the offshore transferor some incentive to evaluate whether its contemplated indirect transfer would be subject to EIT in China.

 

VI. Administrative Measures On GAAR

 

On December 2, 2014, the SAT issued the (Trial) Measures on the Application of General Anti-Avoidance Rules (GAAR) (“GAAR Measures”). Since Circular 698 and Bulletin 7 are an application of the GAAR, Bulletin 7 provides that GAAR Measures should be followed when the competent tax authorities initiate an investigation of an indirect transfer of China Taxable Assets.

 

Further Analysis and Comments

 

In comparison with Circular 698, Bulletin 7 provides more specific and detailed guidance on whether an indirect transfer of China Taxable Assets is subject to EIT in China and clarifies the confusion and uncertainties arising out of the implementation of Circular 698. In addition, Bulletin 7 has introduced more rigorous and stricter provisions on scrutinizing indirect transfer of China Taxable Assets.

 

Although it does not stipulate that the reporting obligation is mandatory, Bulletin 7 provides different legal consequences, depending onwhether the indirect transfer has been voluntarily reported. For indirect transfer of equity interest which took place before the release of Bulletin 7 and for which no Circular 698 reporting was made by the offshore transferor, the transferee may be subject to penalties for failure to withhold capital gains tax pursuant to Bulletin 7. If such penalties will indeed be imposed, the legal interest of the buyer to such historical indirect transfer transaction will be severely harmed. Circular 698 did not impose the withholding obligation on the buyers to the indirect transfer transactions. Retroactively imposing such penalties on the buyers would be an extremely unfair practice. Like the interested parties, we are anxiously waiting to see if the Chinese tax authorities will actually impose such penalties on the buyers for their failure to withhold capital gains tax in respect of indirect share transfer transactions which occurred prior to the issuance of Bulletin 7.

 

We strongly recommend the parties associated with the indirect transfer transactions, be it going-on, future or pre- Bulletin 7 indirect transfer in respect of which the tax authorities have not assessed if it was taxable, to carefully study Bulletin 7, and analyze and evaluate the potential tax risks they may face.

 

End Notes:

 

1. However, in order for the safe harbor treatment to apply, both of the purchase and sale shall be conducted on the public securities markets so as to preclude market manipulation; moreover, the equity interest purchased and sold shall be those of the same enterprise. Where the shares sold on public securities markets were purchased before such shares were listed on a stock exchange or through non-public market, or where the shares were bought on public markets but sold on non-public markets, the safe harbor treatment would not be applicable.

 

Jun He 4

 

For further information, please contact:

 

Liu (David) Dingfa, Partner, Jun He

liudf@junhe.com

 

Cheng (Julie) Hong, Partner, Jun He

chengh@junhe.com

 

Xiang (Lori) Fangfang, Jun He

xiangff@junhe.com

 

Jun He Tax Practice Profile in China

 

Homegrown Tax Law Firms in China

 

Comments are closed.