On February 3, 2015, the State Administration of Taxation of China (“SAT”) promulgated, effective immediately, the Announcement on Several Issues Concerning the Enterprise Income Tax on Indirect Property Transfer by Non-Resident Enterprises (“Circular No. 7”). Circular No. 7 supersedes all previous SAT regulations regarding indirect property transfers by foreign investors (e.g., transfers of equity interests in Chinese companies through the transfer of a foreign holding company), including the well- known and controversial Notice on Strengthening the Administration of Enterprise Income Tax on Income from Transfers of Equity Interest by Non-Resident Enterprises (i.e., Circular No. 698).

General Background

In general, Circular No. 7 expands the scope of taxable income generated from transfers of stock or equity interests in a foreign holding company if the foreign holding company holds certain assets in China (e.g., stock or equity interests in Chinese companies, certain types of assets, or real property in China). Additionally, these types of transactions would be subject to the regulations of Circular 7 even if they are consummated outside of the jurisdictional province of China.

In an effort to promote compliance and avoid confusion with these new regulations, Circular No. 7 provides detailed guidance for determining what constitutes “reasonable commercial purpose” (which is a fundamental anti-tax avoidance principle that was originally introduced under China’s Enterprise Income Tax Law) for these types of transactions because of certain circumstances where these tax liabilities would either not apply or could be significantly reduced. Circular No. 7 also introduces a long-awaited “safe harbor” mechanism for granting tax exemptions that would apply under limited scenarios (e.g., intragroup reorganizations, etc., which are discussed further below).

New Developments

Below is a brief comparison highlighting the key differences between the regulatory framework in place prior to Circular No. 7 and the recently adopted Circular No. 7:

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Practical Uncertainties

Circular No. 7 is aimed to provide a more transparent regulatory framework for multinational companies engaging in transactions outside of China (e.g., cross-border M&A transactions and intragroup reorganizations) if they have Chinese subsidiaries or own properties/assets in China. However, the methodology to determine what constitutes “reasonable commercial purpose” in Circular No. 7 is still too general in many respects and, as a result, decisions made by local tax officials will likely carry more weight. For example, with respect to the factor referenced above regarding the shareholders and type of business of the foreign holding vehicles, and the period of existence of the relevant organizational structure, it is unclear what types of shareholders and businesses, including what period of existence, would fall within the scope of what constitutes a “reasonable commercial purpose.”

In conclusion, when foreign companies transfer their stock or equity interests but have subsidiaries that own Chinese properties or assets, they may encounter further obstacles on how to quantify their tax liabilities in China as a result of these new regulations. Also, since executed stock purchase agreements must be reported and are subject to review by Chinese tax authorities, early planning and consideration should be given to structuring transactions in an effort to mitigate the potential tax liabilities resulting from the recent adoption of Circular No. 7.