As discussed in our previous legal update The Tax Man Cometh: Not Only Long Awaited “Safe Harbor”, Notice No.7 is set to present a different income tax regime for non-tax resident enterprises (“Non-TRE”).  In addition to the long awaited “Safe Harbor”, it is worth-noting that Notice No.7 has introduced new measures to strengthen administration of income tax collection on Non-TRE.

Case Study: Indirect Share Transfer

It was widely discussed whether Chinese tax authorities would take an intensive anti-avoidance action on offshore indirect share transfer when Notice No.698 was promulgated in late 2009. On June 8, 2010, a local counterpart of China’s State Administration of Taxation (“SAT”) in Jiangsu published on its official website a case of indirect share transfer with a total tax amount up to RMB 173 million (“Jiangsu Share Transfer Case”). There has been a heated discussion on Jiangsu Share Transfer Case. We would like to highlight the crucial points of the tax administration rules as set forth in Notice No.698 and Notice No.7 through this Case Study of the Jiangsu Share Transfer Case.

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The diagram above presents the deal of Jiangsu Share Transfer Case, which constitutes a currently popular transaction mode in cross-border investment and financing in China. For the convenience of discussion, we summarize the deal structure as follows:

  • Indirect Access: Non-TRE investors tend to establish holding companies in a country or region with loose tax environment and favorable tax planning opportunities as an intermediate access to China investment.  Hong Kong is one of the most popular intermediate region for holding companies due to its special geographic advantages and the nearly most favorable tax treatment provided by arrangement of avoidance of double taxation between the mainland China and Hong Kong.
  • Indirect Exit: Non-TRE investors may be levied on a 10% withholding tax if they exit via direct share transfer of China tax resident enterprises (“TRE”) (such as the JV presented in the diagram above). Comparatively, Non-TRE investors may tend to exit via indirect share transfer of intermediate holding companies, which always take place in “tax-friendly” regions such as Hong Kong and BVI.

It has caused a long-lasting controversy in tax administration practice of Chinese tax authorities as to whether the aforementioned popular indirect exit should fall into Chinese tax authorities’ jurisdiction. Chinese tax authorities have strengthened their law enforcement on Non-TRE ever since the implementation of “Enterprise Income Tax Law” (“EIT Law”) and its implementing regulations in 2008. Notice No.698 and Jiangsu Share Transfer Case did echo the SAT’s stringent tax approach on Non-TRE.

A New Regime of Tax Collection with Consistency and Innovation

With Jiangsu Share Transfer Case as an example, we set forth below the salient points of the tax regime provided under Notice No. 7 compared with that in Notice No.698.

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SAT has set up a new regime of tax collection on Non-TRE via Notice No.7. It is reasonable for us to expect that Chinese tax authorities will further strengthen its administration on offshore transaction of indirect transfer of China Taxable Property. Participants in cross-border capital transactions should further note the relevant PRC tax compliance issues.