Tax treatment is critical to the planning and execution of corporate reorganizations. On April 30, 2009, the Ministry of Finance and the State Administration of Taxation (“SAT”) jointly issued Caishui  No. 59 (“Circular 59”) to set out the income tax treatment of corporate reorganizations. On July 26, 2010, the SAT released Announcement  No. 4 to clarify certain terms and provide procedural guidance on the application of Circular 59. On December 25, 2014, the SAT issued Caishui  No. 109 (“Circular 109”) to offer additional oxygen to the practical use of Circular 59. Circular 109 becomes retroactively effective on January 1, 2014.
Percentage Threshold of Shares or Assets to Be Acquired
Under Circular 59, a tax free treatment will apply to a corporate reorganization, if all of the following conditions are met:
- The reorganization must have reasonable business purposes and the main purpose is not to reduce, avoid or defer tax;
- The shares or assets being acquired must not be less than 75% of the total shares or assets of the target;
- No less than 85% of the total consideration must be in equity;
- The substantive operation of the target must not change within 12 consecutive months after the reorganization; and
- The main shareholders of the target receiving equity as consideration must not transfer such equity within 12 consecutive months after the reorganization.
To facilitate more tax-free reorganizations, Circular 109 lowers the minimum percentage threshold of shares or assets to be acquired from 75% to 50%.
Gratuitous Transfer of Shares or Assets
Circular 109 goes on to address gratuitous transfer in the corporate reorganization context. Under Circular 109, resident enterprises can make a gratuitous transfer of shares or assets at net book value, free from income tax, as long as the following elements are met:
- These resident enterprises are either 100% direct parent-subsidiary, or have common 100% direct parent company or companies;
- The transfer must have reasonable business purposes and the main purpose is not to reduce, avoid or defer tax;
- The shares or assets being acquired must not change its substantive operation within 12 consecutive months after the transfer; and
- Both transferor and transferee resident enterprises involved recognize no income or loss for the accounting purposes.
A tax-free gratuitous transfer will have clear tax implications. Both transferor and transferee resident enterprises will recognize no taxable income on the transaction. Further, the tax basis of shares or assets in the hands of the transferee will be equal to original net book value of shares or assets transferred. If applicable, the transferee is entitled to take a depreciation deduction in assets at original net book value.
Circular 109 clearly demonstrates the SAT’s growing flexibility towards corporate reorganizations. This is certainly a helpful step in the right direction. Unfortunately, a tax-free gratuitous transfer will continue to remain unavailable to nonresident enterprises for foreseeable future. We expect the SAT to revisit this area again before long.