In a circular issued on 10 December 2009, the State Administration of Taxation (“SAT”) made clear its intention to target offshore transactions involving the indirect transfer of PRC enterprises (Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-Resident Enterprises Guoshuihan  No. 698) (“Circular 698”). Circular 698 has ushered in a new era in the China cross-border transactional landscape, and represents the most recent challenge for offshore holding companies or special purpose vehicle (“SPV”) structures in the PRC.
Circular 698 requires foreign (i.e. offshore) companies and funds, which are non-China Tax Resident Enterprises (“Non-TRE”), to pay taxes in the PRC when it sells or transfers equity of an intermediate offshore company , where the underlying intermediate offshore company directly or indirectly holds an interest (any assets, subsidiary, business operations) in the PRC.
Among the major criticisms of Circular 698 has been its perceived extra-territorial nature. The promulgation of Circular 698 is China’s first real effort at enforcing its jurisdictional “long-arm” tax scheme on Non-TREs, thus presenting a monumental new direction in policy. The SAT would be happy to point out that it is a generally accepted principle that a country may impose taxes on non-residents with regard to income that is sourced from that country. To date, few countries have had either the clout or the sufficient resources to vigorously enforce such a scheme (the United States being among the more successful).
Circular 698 contains an expansive retroactive provision, applying to any transfer after 1 January 2008, the implementation date of the new Enterprise Income Tax Law (“EIT”). All cross-border transactions involving PRC assets and operations using SPVs will have to comply with Circular 698, or at least be aware of the implications of any possible non-compliance.
In light of the challenges the SAT may face with regard to enforcement, as well as the dearth of SAT rulings on the extent of potential penalties, companies must ensure that their organizational structures or transactions are compliant with Circular 698. While Circular 698 is silent with regard to the consequences of non-compliance, PRC law provides, among other penalties, a general penalty of 0.05% of the amount of unpaid taxes due per day (or 18.25% per annum) and up to five times the unpaid tax.
On 10 December 2009 the SAT issued Circular 698, involving the taxation of gains arising from the direct or indirect transfer of the equity of a China Tax Resident Enterprise (“TRE”) by Non-TREs. Some experts consider Circular 698 to have sounded the death knell for the use of offshore intermediate holding structures in China.
Circular 698 applies in two scenarios namely, (i) a direct transfer of a TRE enterprise1 and (ii) an indirect transfer of such an enterprise by a Non-TRE.
Specifically excluded from the scope of Circular 698 are gains derived from the buying and selling of the shares of PRC enterprises listed on a public stock exchange. However, it is unlikely that this exception would apply to shares are listed on a stock exchange following their acquisition.
a. Indirect Transfer
An indirect transfer occurs when a Non-TRE transfers the shares of an offshore company that holds a subsidiary in the PRC. Given the beneficial tax treatment, it is very common for foreign investors to utilize intermediate offshore holding companies or SPVs to hold PRC subsidiaries.
For instance, where a SPV is established in a jurisdiction that has a favourable tax treaty with the PRC, the SPV may withhold taxes on dividends paid by the PRC subsidiary to the SPV, or the SPV may be exempt from capital gains tax when the SPV disposes of the PRC subsidiary. Further, by establishing an offshore SPV between the Non-TRE and the PRC subsidiary, at the time of its sale the PRC subsidiary would be a tax-free offshore sale.
There are many challenges in navigating China’s rather intricate and often administratively burdensome legal framework, including considerable registration requirements, approval processes and other complex procedures. As such, it is common for foreign investors to utilize SPVs as holding companies. Such SPVs are often situated in transparent and administratively straightforward jurisdictions. Further, certain such jurisdictions provide SPVs beneficial or even tax-free treatment.
II. Salient Points of Circular 698
a. Calculation of Equity Transfer Gain
Article 3 of Circular 698 defines “equity transfer gain” as the equity transfer price less the cost of equity investment. When calculating the gain on the equity transfer, the currency used by the Non-TRE seller when making the original equity investment in the PRC subsidiary will be adopted to determine the transfer price and cost of the equity investment. In the case of multiple original investments, the prices are calculated in the currency of the first investment of capital, and, for the cost of equity price, at a weighted average.
b. Reporting Obligation in Connection with an Indirect Transfer
Although Article 5 of Circular 698 places the reporting obligation2 on the Non-TRE seller, an earlier regulation, Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-Resident Enterprises Guoshuihan  No. 3. (“Notice 3”), imposes a reporting obligation on the PRC subsidiary if there is a direct transfer from the Non-TRE seller. If the equity transfer was re-classified as a direct transfer, the PRC subsidiary is required to file the offshore equity transfer agreement with the PRC tax authorities and to assist them in collecting the taxes due. The reporting obligations imposed on the PRC subsidiary will apply after the Non-TRE seller has reported the transfer and the PRC tax authorities have determined that the transaction will be treated as a direct transfer.
c. Taxation on Indirect Transfers
Article 6 of Circular 698 states that if a Non-TRE seller indirectly transfers a PRC enterprise using a business entity that lacks a reasonable commercial purpose, in an effort to evade paying PRC taxes, the PRC tax authorities can disregard the existence of the intermediate holding company for the purpose of calculating taxes. If the intermediate holding company is disregarded, the transaction is effectively treated as a direct transfer. The offshore seller’s capital gain (if any) from the sale will be treated as PRC-sourced income and will be subject to PRC income tax at a rate of 10%, or at a rate otherwise stipulated in an applicable tax treaty or arrangement.
In the interests of consistent enforcement, the determinations of local tax authorities are ultimately reported to progressively higher level authorities, then ultimately subject to the approval of SAT.
d. Retroactive Application
While Circular 698 was issued on 10 December 2009, it became effective on 1 January 2008, the implementation date of the EIT. As such, Circular 698 applies retroactively to any transfer after 1 January 2008.
While many may contend that the retroactive treatment is a draconian measure, the SAT would likely argue that Circular 698 is consistent with the spirit of Article 47 of the EIT (the general anti-avoidance rule (“GAAR”) provision) and, therefore, taxpayers were put on notice that such SPV arrangements are no longer lawful. Moreover, given the SAT’s strong signals throughout 2009 that it intends to aggressively target unlawful SPV arrangements, the SAT would challenge any assertions that Circular 698 is harsh or unfair.
Circular 698 does not address the consequences of non-compliance. However, the Law of the People’s Republic of China of Tax Administration and Collection specifies a significant penalty for the non-payment of tax, namely 0.05% of the amount due per day (or 18.25% per annum), plus a penalty of up to five times the unpaid tax. The law also stipulates a penalty ranging from RMB 2,000 to RMB 10,000 for failure to comply with tax reporting obligations.
Further, given that the underlying PRC interests (i.e., assets, subsidiaries or business operations) are in China, the SAT can then assess charges on such PRC interests to settle outstanding tax penalties.
PRC tax authorities have various methods through which to identify an unreported indirect equity transfer (as evidenced by the Jiangdu case below). Unreported cases can be discovered where there is a change of enterprise name, change in directors, or change in tax auditors. Companies that have been listed on international stock exchanges, subsequent to structuring, are more prone to detection. It may be the case that accounting firms may need to “provision” or footnote such potential tax liability and thus adversely impact the financial statement of the Non-TRE.
Given the breadth and scope of Circular 698, the SAT will face challenges with regard to enforcement. There is evidence of greater compliance by tax authorities worldwide to cooperate with one another with respect to information exchanges in taxation affairs. Presumably, the SAT recognizes the impossibility of policing all transactions, and perhaps it will instead focus its resources on targeting big-ticket transactions (in light of the Jiangdu case below). This does not however alleviate the need for all companies to assure that their structures or transactions are compliant with Circular 698.
III. The Jiangdu Case
Little information has been made public in relation to specific instances where penalties have been levied against companies in violation of Circular 698. One case, however, was made public on 8 June 2010, posted on the official website of a local-level state tax bureau. The case involved a Non-TRE that held a 49% share in a domestic PRC company through its wholly owned Hong Kong intermediate holding company. In January 2010, the Non-TRE disposed of its shares in the intermediate holding company, indirectly disposing of its shares in the PRC domestic company.
The PRC tax authorities first became aware of this transfer in the course of normal tax administration procedures for the PRC domestic companies. After reviewing the share purchase agreement and other documents of the intermediate holding company, the PRC tax authorities determined that the holding company had no employees, no assets (other than the shares of the PRC company), no liabilities, and no other investments or businesses. In this case, the PRC tax authorities regarded the above elements as evidence that the intermediate holding company was an SPV lacking substance for anti-tax avoidance purposes. Further, the PRC tax authorities made note of the fact that a public announcement was found on the website of the buyer, announcing the completion of the acquisition of the PRC company, but without mention of the intermediate holding company.
In the view of the PRC tax authorities, this was strong evidence that the holding company operated solely for the purpose of transferring the shares in the PRC company. After rounds of negotiation, the Non-TRE seller agreed to file a tax return and pay RMB 173 million (US$ 25 million) to the relevant tax authority.
IV. Issues and Concerns
Given Circular 698’s broad language and lack of detailed guidance, there has been a rise in concern on the part of foreign investors.
a. Reasonable Commercial Purpose
Pursuant to Article 6 of Circular 698, whether or not a transfer by way of a holding company is classified by PRC tax authorities as directly or indirectly holding an interest in a PRC entity is subject to whether the intermediate holding company has a “reasonable commercial purpose.” Circular 698 does not define “reasonable commercial purpose.” There is guidance in the form of the implementing regulations of the EIT, which provide that an arrangement will not be considered to have a reasonable commercial purpose if the main purpose of such arrangement is to reduce, exempt or defer tax.
There are many circumstances in which the transfer of an offshore intermediate holding company, instead of its PRC subsidiary, may have a reasonable commercial purpose. Nevertheless, it remains uncertain whether the breadth of the term “reasonable commercial purposes” has a wide or narrow meaning. Presumably, the SAT would adhere to a narrow meaning, contending that “business” requires the purpose to be reasonable in the context of the business operations of the PRC resident enterprise. A wider interpretation would favour the approach that any transaction that a company engages in will be conducive in furthering a commercial objective for the company or its shareholders (such as ease of foreign exchange, investor convenience, simplified approval requirements or business flexibility). Ultimately, any such determination will rest with the relevant PRC tax authorities.
It should be noted that Circular 698 should be read in conjunction with the Notice of the State Administration of Taxation on How to Understand and Determine “Beneficial Owner” in Tax Treaties Guoshuihan  No. 601 (“Circular 601”). Circular 601 stipulates several factors that are used to determine the eligibility of an overseas holding company to claim status as a “beneficial owner” pursuant to PRC tax treaties. The main factors listed are third party control over the income received by the holding company, lack of substantive operations, little or minimal amount of capital and no employees. When evaluating the legitimacy of a holding company, these factors make clear that a premium is placed on substance, not form.
It is possible that SPVs holding more than one PRC subsidiary can argue that there are good commercial reasons for their holding structure. Such explanations could include centralized administrative functions, non-PRC tax planning, cash management, re-investment efficiency and simplified transfer documents.
b. Purchase Price Allocation
Under Article 8, where a Non-TRE seller transfers multiple holding companies at the same time, the underlying PRC subsidiary must submit both the master transfer agreement and the local transfer agreement involving the PRC subsidiary to the PRC tax authorities. If the price allocation among the onshore and offshore subsidiaries are found to be unreasonable, the PRC tax authorities can adjust the purchase price allocation.
Further, where a Non-TRE transfers the shares of a PRC subsidiary to its related parties for a non-arm’s length price, the PRC tax authorities may make valuation adjustments as they deem appropriate.
It is unclear whether Article 8 applies to transactions involving indirect or direct transfers of PRC subsidiaries. It is argued that because Article 8 imposes a reporting obligation on the PRC subsidiary, and Notice 3 imposes reporting obligations on the PRC subsidiaries in cases involving direct transfers, it follows that Article 8 should apply only to simultaneous transfers of multiple holding companies involving the direct transfer of a PRC subsidiary. If Article 8 is interpreted broadly to cover both direct and indirect transfers, both the Non-TRE seller and the PRC subsidiary will be obligated to report to the PRC tax authorities.
c. Time Limit
Article 5 of Circular 698 states that the Non-TRE seller is required to disclose an indirect transfer of a PRC subsidiary to the PRC tax authorities within 30 days after signing any such agreement. It is quite likely that a deal will not have been completed within this time period. As a result, there are confidentiality concerns for situations in which a disclosure must be made before the closing date of a transaction.
Given that the effective date of Circular 698 is 1 January 2008, there are questions regarding whether of not the 30-day disclosure period implies that the reporting obligation is only applicable for transactions concluded after 10 December 2009, the issue date of Circular 698.
Some have expressed concern that the rules impart both an administrative burden and impractical timeline on Non-TRE sellers. Article 2 of the Notice stipulates that Non-TREs are responsible for filing income tax returns within seven days after the agreed equity transfer date.
V. Concluding Remarks And Solutions
Given the considerable discretion of PRC tax authorities and the recent uncertainties in the tax landscape, tax planning activities have inherited a new level of complexity.
For Non-TREs intending to transfer shares of a PRC subsidiary using an offshore intermediate holding company, ensuring the existence of economic substance in such holding structures (such as employees, assets, investments, revenue and expenses) will evidence the lawful utilization of such structures. This will help verify that such an intermediate holding structure possesses a “reasonable commercial purpose,” and would more likely mitigate the possibility of being subject to scrutiny when selling them off.
For those who are utilizing an offshore intermediate holding company in connection to their PRC transactions, it is imperative to undertake a review of its current structure, implement any necessary changes, and comply with Circular 698’s reporting obligations where necessary.
At present, few Circular 698 filings have been made. It is likely that follow-up guidance will be issued to provide a more structured framework as to how Circular 698 will be applied, and to shed light on many of the unresolved issues discussed in this memorandum.
Given that the penalties and other possible consequences for non-compliance can be severe, parties with tax issues pertaining to the equity transfer of Non-TREs cannot afford to neglect the implications of Circular 698 and should thoroughly familiarize themselves with its content. Further, with time, less sophisticated cross-border structuring techniques may cease, as the unfavourable tax implications of such structures may likely result in their futility. Un-remedied legal structures and transactions may likely be subject to a tax liability taint.
Structuring techniques such as the (i) the use of an option “slow-walk” or (ii) the use of a nonarm’s- length equity transfer to a foreign party (i.e. a “nominee arrangement”) and (iii) employment option earn-out (i.e. an “ESOP take-back”) are likely to come under greater scrutiny by PRC tax officials and regulators, as these structures are often used by over-thecounter listed companies and are thus disclosed.