Tax Incentives to Entity Partners of VC Firms

The economic slowdown has exerted huge pressure on the government to take actions, big or small. One message of the government is to encourage venture capital investment by adopting or reaffirming stimulus policies. On November 16, 2015, the State Administration of Taxation (“SAT”) released the SAT Announcement [2015] No. 81 (“Announcement 81”). Announcement 81 essentially restates the key element of tax incentives as offered by Guoshuifa [2009] No. 87 (“Circular 87”). Announcement 81 became retroactively effective on October 1, 2015.

Deduction of Allocated Investment Amount

Under Announcement 81, entity partners of a qualified limited partnership venture capital (“VC”) firm is allowed to deduct a 70% of allocated investment amount in qualified private high technology startup companies against income received from such VC firm, as long as the following conditions are met:

  1. Entity partners are subject to enterprise income tax (“EIT”) in China under the actual income method;
  2. The VC firm must be a limited partnership specialized in VC investment and exceeding certain thresholds in accordance with various laws;
  3. The holding period with respect to qualified private high technology startup companies is more than 2 years (or 24 months), starting October 1, 2015; and
  4. Entities partners have paid up capital into the VC firm for more than 2 years, since October 1, 2015.

Qualifications of VC Firms

Not every VC firm in the form of limited partnership is qualified for this tax incentive. Announcement 81 refers to qualifications as mandated by the 2005 Interim Measures on Venture Capital Enterprises and the 2003 Foreign-Invested Venture Capital Enterprises Regulations. For instance, domestic VC firms must have paid-in capital in excess of RMB 30 million, while foreign-invested VC firms generally need to commit capital no less than USD 10 million.

Qualifications of Private High Technology Startups

While Announcement 81 does not expressly outline criteria, Circular 87 continues to provide the detailed requirements on private high technology startups: status of a private company which is  not yet publicly listed; receipt of high technology certification; number of employees no more than 500; annual sales revenue no more than RMB 200 million; and amount of assets no more than RMB 200 million.

Allocated Investment Amount

The investment amount allocated to an entity partner is equal to the total amount invested into a private high technology startup by a VC firm, multiplied by capital contribution ratio of such entity partner in the VC firm. For instance, if a VC firm invests RMB 50 million into a startup and an entity partner contributes a 10% capital of the firm, then the allocated investment amount is RMB 5 million to this entity partner. Any amount or ratio is only measured by paid-in capital.

Mechanism of Deduction

The deduction amount is equal to the allocated investment amount, multiplied by 70%. To the extent that an entity partner only invests in one VC firm, the deduction amount could be more than income received from such VC firm. Announcement 81 allows a carryover of excess deduction amount. To the extent that an entity partner invests in multiple VC firms, the entity partner is entitled to aggregate both the deduction amount originated and income received from multiple VC firms. The total excess deduction amount could be carried over, while the total net income is generally subject to a 25% EIT.

Our Observations

Despite some excitement, Announcement 81 is not a brand new idea. From 2009 until 2016, however, the landscape of VC investment has greatly changed. Hundreds of, if not in thousands, new VC firms have been established since 2009. Thus, it is highly likely that Announcement 81 would be far widely applied than Circular 87.