Scope

On December 10, 2009, the Chinese Ministry of Finance (“MOF”) Tax Policy Department announced a new international tax enforcement initiative targeting offshore indirect transfers of Chinese equity interests.

The covered transaction involves the indirect transfer of an equity interest in a Chinese Enterprise through the sale of stock in a Nonresident Holding Company that holds the equity interest of the Chinese Enterprise.

Deriving its authority from China’s general avoidance rule (“GAAR”) under the Enterprise Income Tax Law (“EIT Law”), Notice 698 creates new reporting standards for offshore indirect transfers. The Notice also allows Chinese tax authorities to ignore the interposition of the Nonresident Holding Company and treat the transaction as a direct sale of the equity of the Chinese Enterprise if it is determined that the primary purpose of the transaction is Chinese tax avoidance. The Notice is retroactive, effective as of January 1, 2008, and therefore may apply to past transactions.

Notice 698 requires the Original Shareholder of the Nonresident Holding Company to disclose whether the Nonresident Holding Company is located in a “Tax Haven” jurisdiction. A “Tax Haven” is defined as a jurisdiction that does not tax foreign source income or taxes such income at a rate below 12.5 percent.

If Chinese tax authorities determine that the Nonresident Holding Company operates in such a jurisdiction, taxes will be assessed against the Original Shareholder of the Nonresident Holding Company based upon the economic substance of the transaction.  

Disclosure Requirements

Disclosure is triggered when an “actual controlling” Original Shareholder makes an indirect transfer. Within 30 days after the signing of the transfer agreement, the Original Shareholder must file a statement with the local PRC tax authority overseeing the Chinese Enterprise if either (1) the actual tax burden in the jurisdiction of residence of the Nonresident Holding Company is less than 12.5 percent; or if (2) the jurisdiction of residence of the Nonresident Holding Company does not tax foreign-source income. The 12.5 percent. “actual tax burden” rule is problematic in itself, as in certain jurisdictions it may be difficult to calculate the actual tax burden of a transaction due to the interplay of various tax treaties and foreign tax credits.

If a condition applies, the Original Shareholder must provide a copy of the equity transfer contract along with the following materials:

  • Documentation reflecting the relationship between the Original Shareholder and the Nonresident Holding Company with regard to funding, operations, etc.;  
  • Documentation of the Nonresident Holding Company’s operations, personnel, assets, etc.;  
  • Documentation of the Nonresident Holding Company’s relationship with the resident enterprise; and  
  • A statement affirming that the Nonresident Holding Company was established by the Original Shareholder for reasonable business purposes.  

Note that the establishment and use of a Nonresident Holding Company may have a variety of legitimate business purposes. As such, disclosure under Notice 698 is not tantamount to an admission of guilt. The use of such an entity may, for instance, be based upon legitimate operational and foreign exchange concerns. It is therefore imperative that parties utilizing Nonresident Holding Companies in their Chinese businesses take action, if necessary, to ensure the commercial substance of these structures is evident.  

Open Issues

As enforcement of Notice 698 is still in its infancy, a number of important issues remain unclear. There has been no clarification as to the operation of Notice 698’s retroactive application to transactions occurring between January 1, 2008 and present.  

Further, the MOF has not defined what will constitute an acceptable business purpose to justify offshore indirect transfers of Chinese equity interests.  

Finally, the MOF has yet to establish the penalties for non-compliance with Notice 698 reporting requirements. Shareholders of Nonresident Holding Companies with Chinese assets should, therefore, proceed with caution.  

Conclusions  

With Notice 698, China has joined the ranks of other major economies in the pursuit of tax revenue previously insulated by the use of offshore transactions.

The impact of Notice 698 has substantial reach, as it applies even where a transaction occurs between nonresident parties, entirely outside of China. Current holding company structures must be reviewed and careful attention must be paid to issues raised by the Notice in future China-related M&A and restructuring activity.

Parties contemplating transactions via holding companies located in jurisdictions with low foreign source income tax rates, must carefully consider that Chinese tax authorities may ignore the Nonresident Holding Company and treat the transaction as a direct sale, taxing the Original Shareholder as if the transaction occurred in China. One likely result of this recharacterization may be the double-taxation of certain transactions.