On August 27, 2014, China Taxation News12 reported that the Qidong State Tax Bureau (“QSTB”) of Jiangsu province collected RMB30 million of EIT on the indirect transfer of two Chinese resident enterprises in Qidong city of Jiangsu province. Tax officials became interested in the indirect transfer when the deal was disclosed to the public by the buyer’s listed parent company (“ListCo”).
The target company (“BVI Target”) wholly owned a Hong Kong company (“HK Co.”), which in turn had 100 percent direct ownership interests in the two Chinese resident enterprises. Before the indirect transfer deal, the BVI Buyer held 51 percent of the BVI Target while the BVI Seller held 49 percent of the BVI Target. After acquiring 49 percent for US$550 million, the BVI Buyer became the sole shareholder of the BVI Target. The corporate structure before the indirect transfer is depicted in Diagram Two below.
Corporate Structure before the Transaction in Qidong Case
According to the China Taxation News, the QSTB found that the intermediate holding companies had no employees, no substantive business activities, and no assets other than the ownership interest in the two Chinese resident enterprises. Consequently, according to Article 6 of Guo Shui Han  No. 698 (“Notice 698”), the QSTB recharacterized the indirect transfer as a direct transfer of the two Chinese resident enterprises. The 49 percent interest in the BVI Target was acquired by theTherefore, the QSTB only assessed capital gains of US$50 million at a 10% EIT rate on this indirect transfer.
One noteworthy point of this case is that the QSTB recognized the purchase price (US$500 million) paid by the BVI Seller in a previous indirect transfer as the tax basis for calculating the capital gains of this indirect transfer. For more information of the previous indirect transfer, please refer to the February 2012 issue of our China Tax Monthly.
Another noteworthy point of this case is that the QSTB appeared to disregard the reasonable commercial purpose of the indirect transfer and instead focused on the economic substance of the intermediate holding companies. In doing so, the QSTB ignored plausible arguments for reasonable commercial purpose, including: (i) as a minority shareholder of the BVI Target, the BVI Seller had no authority to compel the HK Co. to sell the two Chinese resident enterprises to the BVI Buyer via a direct transfer; and (ii) the BVI Seller was not involved in establishing the BVI Target or the HK Co and did not establish the current corporate structure, which the BVI Seller merely inherited in 2012 when it acquired the 49 percent interest in the BVI Target in the previous indirect transfer deal.
The final noteworthy point of this case is that even without a formal withholding obligation, the BVI Buyer was asked by the QSTB to assist in collecting EIT from the BVI Seller. At last, upon the BVI Seller’s delegation, the BVI Buyer withheld and remit EIT to the QSTB. Therefore, prudent buyers may feel the need to protect themselves and guard against withholding risk by requiring a certain degree of Notice 698-related compliance from sellers.