Tax treatment of indirect transfer has remained prominent and controversial since the issuance of Guoshuihan  No. 698 (“Circular 698”). On December 10, 2009, the State Administration of Taxation (“SAT”) issued Circular 698 to strengthen the administration on indirect equity transfer made by nonresident enterprises. Subsequently, the SAT issued Announcement  No. 24 (“Announcement 24”) on March 28, 2011 to clarify on the application of Circular 698.
On February 3, 2015, the SAT eventually released Announcement  No. 7 (“Announcement 7”) to replace Circular 698 and Announcement 24. Indeed, the scope of Announcement 7’s target goes beyond indirect equity transfer and expands to indirect transfer of real estate in China as well as assets of establishment in China. Thus, nonresident enterprises engaged in such indirect transfer could potentially be subject to review and tax in China. Again, indirect transfer will be recharacterized as direct transfer, thus resulting in Chinese enterprise income tax (“EIT”) on capital gains. Announcement 7 became effective upon issuance. The key points of Announcement 7 are as follows.
Scope of Indirect Transfer
While Circular 698 was limited to indirect transfer of equity, Announcement 7 covers indirect transfer of real estate and establishment assets as well. All of them are labeled as the underlying Chinese property. Since Circular 698 was able to catch indirect equity transfer of Chinese resident enterprises holding real estate in China, Announcement 7 appears to set sight on indirect equity transfer of foreign companies directly holding real estate in China.
Further, the term “establishment” generally refers to a fixed place of business, which is essentially a fixed physical presence with a degree of duration for business purposes. The examples of establishment could be a representative office, a branch office, a place of management, a factory, a workshop, a project site, and a service
setup. Since there is no equity relationship between establishment and its foreign owner, an establishment itself is considered an asset. In any event, direct transfer of establishment is rare. So is indirect transfer of establishment.
Applicable double taxation agreements (“DTAs”) will prevail over Announcement 7 with respect to tax treatment of indirect transfer, if there is any conflict.
Reasonable Business Purpose
Announcement 7 sticks to a legal standard of reasonable business purpose, with a special focus on economic substance and comparable tax effect. Section 3 of Announcement 7 lists the followings factors in determining reasonable business purpose.
- Whether most of a concerned offshore holding company (“Holdco”)’s value is directly or indirectly derived from the underlying Chinese property;
- Whether most of Holdco’s assets are composed of its direct or indirect Chinese investment;
- Whether most of Holdco’s revenue is directly or indirectly sourced from China;
- Whether economic substance of corporate structure could be substantiated by the business functions and risks of Holdco and its subsidiaries directly or indirectly holding the underlying Chinese property;
- Holdco’s shareholders and business model, as well as the duration of Holdco’s organizational structure;
- Foreign income tax of indirect transfer;
- Whether indirect transfer of the underlying Chinese property could be substituted by a hypothetical direct transfer;
- Applicability of DTAs to indirect transfer; and
- Other unspecified factors.
While Section 3 does not provide definitive answer on reasonable business purpose, Sections 4 and 5 seek to draw a clearer line on certain indirect transfers. Under Section 4, an indirect transfer will have no reasonable business purpose, if it meets with all the following elements.
- Holdco derives directly and indirectly more than 75% of its value from the underlying Chinese property;
- During the one-year period prior to indirect transfer, either more than 90% of Holdco’s assets (excluding cash) are composed of its direct or indirect Chinese investment, or more than 90% of Holdco’s revenue is sourced from China;
- Economic substance is not sufficiently substantiated by the business functions and risk of Holdco and its subsidiaries directly or indirectly holding the underlying Chinese property, despite respective foreign legal registrations; and
- Foreign income tax of indirect transfer is lower than Chinese income tax of a hypothetical direct transfer.
On the other hand, Section 5 precludes any of the following indirect transfer circumstances from the radar screen of Announcement 7.
- Nonresident enterprises are engaged in indirect transfer by buying and selling shares of a publicly traded Holdco directly or indirectly holding the underlying Chinese property; or
- A hypothetical direct transfer is otherwise exempt from Chinese EIT.
Safe Harbor on Corporate Intragroup Reorganizations
Amid longstanding call for reasonableness, Announcement 7 provides a limited safe harbor on corporate intragroup reorganizations. Under Section 6, a corporate intragroup reorganization will have reasonable business purpose, if it meets with all the following elements.
- Both buyer and seller are directly or indirectly related in terms of 80% ownership interest;
- This indirect transfer does not reduce Chinese income tax of potential subsequent indirect transfer; and
- Buyer pays a consideration exclusively in the form of its equity or its related party’s equity, excluding equity of a publicly traded company.
To the extent that Holdco derives directly and indirectly more than 50% (exclusive) of its value from real estate in China, the ownership link threshold must be adjusted upwards to 100%.
While Announcement 7 eliminates mandatory filing requirements as initially mandated by Circular 698, it comes up with a different set of enforcement rules. Buyer, seller, and the underlying Chinese resident enterprise can decide on their own whether to report an indirect transfer with the Chinese tax authorities, regardless whether any party is certain about Chinese tax treatment of indirect transfer. On the other hand, the Chinese tax authorities can always proactively launch an investigation and adjustment of indirect transfer under the general anti-avoidance rules. In such investigation, the Chinese tax authorities are authorized to demand various transaction documents from buyer, seller, advisors, and the underlying Chinese resident enterprise.
Under Section 13, failure to pay tax timely will lead to interest on tax underpayment on the part of seller. The default interest rate is the central bank benchmark loan rate plus 5%. To the extent that seller has voluntarily reported indirect transfer to the Chinese tax authorities, the interest rate will be lowered to the central bank benchmark loan rate only. It is unclear whether seller will be subject to a standard penalty up to five times of tax underpayment. Previously there was no reporting of any such penalty.
In an unprecedented move, Announcement 7 expressly designates buyer (entity or individual) as withholding agent for seller. Failure to withhold properly will lead to a penalty up to three times of tax underpayment. Under Section 8, the Chinese tax authorities have discretion to eliminate or reduce penalty, if buyer as withholding agent has voluntarily reported indirect transfer. Apparently, Announcement 7 is shifting the compliance burden more heavily on buyer as withholding agent, rather than seller. It is true that buyer and seller have different interest over indirect transfer. This is why Announcement 7 is seeking to exploit this difference.
Indirect transfer of establishment assets will trigger a 25% EIT on capital gains as a part of income effectively connected with the establishment. On the other hand, indirect transfer of equity or real estate in China will trigger a 10% withholding tax on capital gains derived.
Announcement 7 is the latest step to tax indirect transfer by the SAT. Compared to Circular 698, Announcement 7 modestly improves the guidance on reasonable business purpose and deliberately provides limited blessing to corporate intragroup reorganizations. The designation of foreign buyer as withholding agent over an offshore transaction is expected to remain controversial. It remains unclear whether there will be a rush to report indirect equity by any party to indirect transfer, especially among foreign investment funds. In practice, however, both parties to indirect transfer are advised to closely review their positions and Chinese tax exposures with respect to indirect transfer.