The Circular of the State Administration of Taxation on Strengthening the Administration of Corporate Income Tax on Incomes of Equity Transfers of Non-Resident Enterprises (“Circular 698”) was issued in 2009 to regulate tax treatment of indirect transfers of equity interest in a domestic Chinese company by non-residents. Circular 698 empowered Chinese tax authorities to look through an offshore holding company if they consider the company lacks reasonable commercial purpose as defined by the general principles set forth therein, and treat the indirect equity transfer transaction as a direct equity transfer transaction subject to Mainland Chinese capital gains tax liabilities.
On February 3, 2015, the China State Administration of Taxation (“SAT”) issued the Announcement on Several Issues concerning the Corporate Income Tax on the Indirect Transfers of Assets by Non-Resident Enterprises(“Announcement 7”), which expanded the scope of application, provided additional detailed guidelines and abolished certain provisions of Circular 698.
Application Scope of Announcement 7
While Circular 698 only applied to the indirect transfer of equity interest of a domestic Chinese company, Announcement 7 expanded the application scope to indirect transfer of Chinese taxable assets including:
- Assets owned by the establishments or places1 of non-resident enterprises in China;
- Real estate located in China; and
- Equity investments in Chinese resident enterprises (together, the “Chinese Taxable Assets”).
Reasonable Commercial Purpose
Circular 698 provided general principles on what will be considered as “lacking a reasonable commercial purpose,” which created uncertainties in practice. Announcement 7 provides a detailed list of factors which will be considered when determining if an indirect transfer of Chinese Taxable Assets will be regarded as lacking a reasonable commercial purpose, including:
- Whether the primary value of an offshore holding company is directly or indirectly attributable to Chinese Taxable Assets;
- Whether the assets of an offshore holding company are primarily comprised of, directly or indirectly, investment in China, or whether the income of an offshore holding company is mainly sourced, directly or indirectly, from China;
- Whether the actual functions performed and risks assumed by an offshore holding company and its subsidiaries which directly or indirectly hold Chinese Taxable Assets can demonstrate the economic substance of a relevant corporate structure;
- The duration of the shareholders of an offshore holding company, its business model and relevant corporate structure;
- Overseas income tax implications in respect of an indirect transfer of Chinese Taxable Assets;
- Whether an indirect investment or an indirect transfer of Chinese Taxable Assets can be substituted by a direct investment or a direct transfer of Chinese Taxable Assets; and
- The applicability of any double tax treaty or arrangement for the indirect transfer of Chinese Taxable Assets.
In particular, Announcement 7 specifies that any overall arrangement concurrently satisfying all of the following circumstances shall be regarded as “without any reasonable commercial purpose” without the necessity to go through the technical analysis above:
- More than 75% of the value of the offshore holding company’s equity is comprised of, directly or indirectly, Chinese Taxable Assets;
- At any time during the year preceding an indirect transfer of Chinese Taxable Assets, more than 90% of an offshore holding company’s total assets (exclusive of cash) are directly or indirectly comprised of investments in China; or more than 90% of an offshore holding company’s income is directly or indirectly derived from China;
- The offshore holding company and its subsidiaries, which directly or indirectly hold Chinese Taxable Assets, are registered in the jurisdiction (or region) where they are located to satisfy legal organization requirements but the limited actual functions performed and limited actual risks assumed cannot demonstrate their economic substance; and
- The overseas income tax payable under the indirect transfer of Chinese Taxable Assets is lower than the potential Chinese tax that would be payable under the direct transfer of Chinese Taxable Assets.
Safe Harbor Rules
Announcement 7 grants a safe harbor under certain conditions, including:
- Buying and selling shares of the same overseas listed company in a public securities market;
- Certain intragroup restructuring transactions; and
- Incomes resulting from transfers which are exempted from corporate income tax in China in accordance with applicable tax treaties.
The first safe harbor rule above will be applied if, and only if, both buying and selling of shares are in a public securities market. In other words, risk of re-characterization of an indirect transfer still exists for private equity investors who made an investment before the listing of the offshore holding company, or for investors who acquired shares through private placements after the listing of the offshore holding company. For example, the safe harbor rules may not apply to a private equity investor who made an investment before the listing of the offshore holding company holding Chinese Taxable Assets even if such private equity investor exists through an offshore public securities market later.
Under Circular 698, an offshore transferor/seller was required to report a transaction to the tax authorities if the tax burden in the country or region of the transferred foreign enterprise fell under the threshold of 12.5%. Under Announcement 7, there is no longer such mandatory reporting obligation, and a broader scope of transaction parties, either the offshore transferor, the transferee or the domestic Chinese company whose equity interest is indirectly transferred, may report the transaction to the tax authorities at their own discretion. Announcement 7 also clarifies that for tax liabilities cases, penalties may be waived or eliminated if voluntary report has been made within 30 days after the execution date of a share transfer agreement – therefore encouraging transaction parties to report voluntarily. In particular, a buyer will have more incentives to make such voluntary report as it has a withholding obligation under Announcement 7. If it becomes a “seller” in a subsequent transaction the share transfer price in the first transaction will be regarded as allowable deductions in the calculation of PRC taxes payable for such subsequent transaction.
On May 13, 2015, SAT issued the Work Rules and Procedures on Corporate Income Tax on Indirect Transfer of Assets by Non-Resident Enterprises (Tentative) (“Procedures”) to all local tax bureaus, which not only aims at implementing Announcement 7 but also specifying responsibilities of each level of tax bureaus and work procedures in practice. According to the Procedures, the general procedures to re-characterize an indirect transfer transaction as a direct one and re-adjust tax payable are as follows:
- If a responsible tax bureau considers that an indirect transfer transaction lacks reasonable commercial purpose and requires investigation and adjustment, such responsible tax bureau shall submit the case filing report together with its opinion and relevant supporting documents to the provincial tax bureau for review which will further forward the aforesaid documents to SAT for application of case filing;
- The responsible tax bureau shall complete all investigation work within 9 months following the date of SAT granting the consent on case filing, and formulate its opinion and grounds for a non-adjustment plan or an initial adjustment plan on the case to the provincial tax bureau for review which will further forward the aforesaid documents to SAT for application of case closing;
- The responsible tax bureau shall proceed with the case by (i) issuing a Notice Letter of Conclusion on Special Tax Collection Investigation if SAT agrees with its non-adjustment plan and case closing; or (ii) issuing a Notice Letter of Initial Adjustment on Special Tax Collection Investigation (“Initial Adjustment Letter”) if SAT agrees with its initial adjustment plan and case closing; or (iii) revise its submission materials and resubmit to SAT for approval if SAT does not agree with its case closing application; and
- A Notice Letter of Adjustment on Special Tax Collection Investigation (“Adjustment Letter”) shall be issued by the responsible tax bureau if the enterprise being investigated does not raise objections within 7 days following the receipt of the Initial Adjustment Letter. According to the Procedures, even if the enterprise being investigated raises objections within the said 7 days, the responsible tax bureau still retains a discretion to ignore such objections and issue the Adjustment Letter.
In general, compared with Circular 698, Announcement 7 provides more specific and detailed guidelines on whether an indirect transfer of Chinese Taxable Assets will be subject to Mainland Chinese capital gains tax liabilities and clarifies uncertainties such as commercial purpose and reporting obligations under Circular 698. In addition, Announcement 7 clarifies areas that can qualify under the safe harbor rules which were unclear under the old Circular 698.