China recently extended the reach of its tax on the indirect transfer of China-related assets. The new approach, effective as of 3 February 2015, will particularly impact the disposal of assets in China through the sale of non-China holding companies. With China’s new anti-avoidance rules also now effective, the new approach may well come with greater enforcement.
The new approach to taxing indirect transfers was set out by China’s State Administration of Taxation (SAT) in the Notice regarding the Corporate Income Tax Treatment of Indirect Asset Transfers by Non-Tax Resident Enterprises (Notice) on 6 February 2015. The Notice both clarifies and substantively changes key provisions of SAT’s Circular 698 of 2009 and Circular 24 of 2011 on the tax treatment of indirect equity transfers. The Notice applies to unsettled tax matters as of 3 February 2015. Accordingly, both existing and future offshore transactions involving China-related interests may be affected.
Following are various key points arising out of the Notice:
Scope extended to “China Taxable Property”
Circular 698 focused only on indirect equity transfers. The Notice now expands the scope of taxation to indirect transfers of “China Taxable Property” structured without a “reasonable commercial purpose” and resulting in the avoidance of PRC corporate income tax. For the purpose of the Notice, “China Taxable Property” includes:
- property held by a Chinese establishment or place of business (E&P);
- real estate in China; and
- equity investments in Chinese tax-resident enterprises.
The indirect transfer of these types of property by a non-tax resident enterprise (non-TRE) which does not have an E&P in China with which the relevant income is connected will be taxable in China under the Notice if:
- the non-TRE transfers the equity or similar rights in an offshore structure (Offshore Company) which directly or indirectly owns the China Taxable Property generating the same, or a substantively similar, outcome as a direct transfer of the China Taxable Property;
- such a direct transfer of the China Taxable Property would be subject to corporate income tax in China; and
- the structure of the holding is deemed to be without a reasonable commercial purpose.
If these conditions are met, then the indirect transfer will be re-characterised as a direct transfer of the China Taxable Property, and the portion of the consideration for the transfer of the Offshore Company attributable to the China Taxable Property will be subject to withholding tax at the appropriate rate.
The transferee is obliged to act as the withholding agent to withhold the PRC tax if the indirect transfer of the China Taxable Property is taxable in China. Alternatively, if the transferee fails to withhold such tax, the non-TRE transferor (as the tax payer) must make the tax declaration by itself and pay the tax within seven days of completion.
“Reasonable Commercial Purpose”
The Notice sets out a number of factors that may be used to determine whether a particular structure has or does not have a reasonable commercial purpose. It also sets out black-listed circumstances in which a structure will be deemed to have no reasonable commercial purpose.
Except in black-listed circumstances (see below), the following factors must be comprehensively considered to determine whether a structure has a "reasonable commercial purpose":
- Whether the value, assets or income of the Offshore Company is mainly derived, directly or indirectly, from China Taxable Property;
- Whether the actual functions performed and the risks assumed by the Offshore Company or its subsidiaries directly or indirectly holding China Taxable Property can justify the economic substance of the group structure;
- The length of holding by the shareholder(s) in the Offshore Company, its business model and the organizational structure of the group;
- Whether and how much income tax is payable in an offshore jurisdiction on the transfer of the Offshore Company;
- Whether a direct transfer arrangement could be substituted for the indirect transfer arrangement; and
- Whether any tax treaty or arrangement is applicable to the transfer of the Offshore Company.
This list of factors is not exhaustive. The tax authorities may consider any other factor they deem appropriate.
2. Black-listed circumstances
Any structure or transaction that meets all the following conditions will be automatically deemed to have no reasonable commercial purpose and will be subject to PRC tax:
- 75% or more of the equity value of the Offshore Company derives, directly or indirectly, from China Taxable Property;
- at any time within the one-year period immediately preceding the indirect transfer of China Taxable Property, 90% or more of the asset value of the Offshore Company (not including cash) consisted, directly or indirectly, of investments in China or 90% or more of its income was derived, directly or indirectly, from China;
- the functions performed and the risks assumed by the Offshore Company or its subsidiaries directly or indirectly holding China Taxable Property are limited and cannot justify the economic substance of the group structure; and
- the income tax payable offshore on an indirect transfer arrangement is lower than the possible tax payable on a direct transfer arrangement.
The Notice specifies certain scenarios in which PRC tax need not be withheld or paid, including:
- the on market buying and selling of shares of an offshore listed company;
- transactions that would be exempted under applicable treaties or arrangements if a non-TRE directly transferred the China Taxable Property; and
- a share-for-share transfer under a qualifying group reorganization between members connected as to at least 80% (subject to conditions).
Unlike Circular 698, the Notice no longer imposes a mandatory reporting requirement on the transferor. Instead, the transferor, the transferee and the ultimate Chinese target company may decide between themselves whether a transaction should be reported to the tax authority and, if so, who will be the reporting party.
Penalty interest rates will be imposed under the Notice if the tax authority subsequently finds outstanding tax that should have been paid in relation to a transaction that was not reported and paid. The penalty interest rates payable by the non-TRE transferor, or the administrative sanction on the withholding agent, may be reduced or exempted if it reported the transaction to the tax authority within 30 days from the signing of the transaction documents.
The Notice demonstrates China’s determination to expand its tax base and combat tax avoidance activities, and brings an element of clarity to arrangements where Circular 698 had been unclear. It also brings challenges to both the seller and the buyer in a China-related offshore M&A transaction. Both parties should carefully assess the commercial purpose of the transaction structure against the guidelines specified in the Notice and consider whether a PRC tax obligation will arise. A definitive conclusion as to whether tax is payable may not, however, always be possible.
If a tax obligation will clearly arise, then the withholding obligations of the buyer should be reflected in the transaction documents. Also, the seller may consider requesting an indemnification from the buyer for a failure of the latter to pay over the withholding tax to the tax authority. From a buyer’s perspective, it will want to ensure that it only needs to pay the purchase price net of withholding tax.
If it is not certain, after careful assessment, whether there is a tax obligation, both parties need to work together to decide whether the transaction should be reported to the tax authorities. If the parties decide to report, further consideration should be given to the allocation of the reporting obligation and the inclusion of relevant protective clauses in the transaction documents.
The SAT is not obliged to issue a tax assessment notice within a certain time of its receipt of the tax filing. This may create uncertainty as to the actual tax liability even if the transaction is reported to the tax authority. In situations where the tax liability is not obvious, it might be difficult for the transferee or the non-TRE transferor to withhold or pay PRC withholding tax within seven days of completion.
Given the increasing complexity of China-related offshore transactions brought about by the Notice, we recommend that foreign investors consult their professional advisers to thoroughly review their existing or proposed deal structures. Transaction documents should also be carefully drafted or amended to lawfully limit potential tax exposures