Key Point:

  • Sales of offshore holding companies may now be subject to PRC tax  

Offshore holding companies have been widely used by investors from outside the PRC to structure their investments in China, especially if the investor intends to dispose of its China interests in the near future. Rather than selling its interest in a China-based company, which will normally attract a 10% PRC capital gains tax, the outside investor has in the past been able to avoid the PRC capital gains tax by disposing of its interest in the offshore company, which directly holds the interest in the China-based company. In such case, the capital gains derived are considered to be foreign-sourced income received by a non-China tax resident and thus not be subject to any PRC tax.  

However, a recent ruling by Yuzhong District State Tax Bureau (a branch of the Chongqing State Tax Bureau) imposing PRC tax on an offshore equity transfer by an intermediate holding company may mean that using offshore holding companies to avoid PRC tax liability is no longer a viable tax planning structure for minimizing tax exposure.  

In May 2008 Yuzhong District State Tax Bureau examined an equity transfer transaction between Singapore Company A and Chinese Company A under which Singapore Company A transferred its 100% equity interest in Singapore Company B to China Company A. The transfer price was the equivalent of RMB63.38 million, representing a capital gain of about RMB9 million for Singapore Company A. Upon further investigation, the tax bureau discovered that the registered capital of Singapore Company B was only SGD100, and that it did not engage in any business activities other than holding a 31.6% interest in China Company B.

Please click here to view diagram.

After consulting the Chongqing State Tax Bureau and the State Administration of Taxation, the Yuzhong State District State Tax Bureau concluded that (a) the transfer of equity in Singapore Company B constituted, in substance, a transfer of equity in Chinese Company B, and (b) the capital gain so derived should be considered China sourced income subject to a 10% withholding tax under the Sino-Singapore Tax Treaty.  

This decision can be viewed as an application by the local tax bureau of a “commercial viability test” under the general anti-avoidance provisions in the new PRC Enterprise Income Tax Law. Under Article 47 of the Enterprise Income Tax Law, China’s tax authorities may make tax adjustments when business transactions are considered to lack a bona fide business purpose. Indeed, Article 120 of the Enterprise Income Tax Law Implementation Rules defines such transactions as those whose primary purpose is to reduce, avoid or defer tax payments. Although details of the subject transaction have not been disclosed, the tax bureau determined that the transaction failed the commercial viability test and elected to redefine the transfer based on two major findings: (a) nominal registered capital (i.e., SGD100) and (b) the lack of commercial activities for the holding company. Singapore Company A  

Although not expressly noted in the above case, the transfer of an equity interest in an offshore holding company with a PRC subsidiary or investment may also be subject to PRC tax under the new PRC tax resident rule. According to this rule, a company established outside China, but with its effective management in China, is deemed to be PRC tax resident and, therefore, subject to enterprise income tax on its worldwide income. A company is deemed to be effectively managed in China if its overall management and control, including management and control over production and business operations, employees, treasury and finance functions and property of the company, are in China.  

Through unofficial channels we have learned that some tax authorities in Southern China have adopted the position taken by the Chongqing State Tax Bureau and begun imposing tax on capital gains derived from similar offshore equity transfers. This ruling, which was also recognized by the State Administration of Taxation, represents a major step by China’s tax authorities in using the general anti-tax-avoidance principle against transactions deemed not to have a valid business tax purpose and structured only for tax avoidance purposes. Therefore, non-China investors relying on similar offshore holding structures should examine their current arrangements to analyze whether they can withstand potential challenges by China’s tax authorities. In addition, offshore holding companies should avoid engaging in de facto management and control from China and thus being labeled as China tax residents.