On December 14, 2010, the State Administration of Taxation (SAT) released the Announcement on the Verification and Determination of the Tax Basis for Individual Income Tax on Income from Equity Transfers (Announcement) to clarify the verification and determination of the tax basis in relation to the individual income tax payable by individuals who receive income from transferring equity interests in enterprises. The equity transfer referred to in the Announcement expressly excludes the transfer of shares of listed companies. This Announcement took effect as of January 13, 2011.
Before the issuance of the Announcement, SAT published the Notice on Further Strengthening the Collection of Individual Income Tax (Circular 285) in 2009, which requires the pricing of the equity transfer to comply with the arms-length principle. Where the equity transfer price is apparently low without justifiable causes, Circular 285 authorizes the tax authority to adjust the tax determination basis with reference to the per share net asset value or net asset value allocable to the shares transferred. However, Circular 285 fails to define “apparently low” and “justifiable causes.” It seems that SAT issued the Announcement just to further clarify these issues.
- Definition of “Apparently Low”
The Announcement specifies that the income by an individual from equity transfer shall be determined according to the fair market value. The income gained by an individual from equity transfer may be deemed as “apparently low” under the following circumstances:
- the declared equity transfer price is lower than the original investment cost or the original rice plus tax paid for acquiring such equity;
- the declared equity transfer price is lower than the value of corresponding net assets;
- the declared equity transfer price is lower than the transfer price by this or othershareholders for the equity of the same enterprises under the same or similarcircumstances;
- the declared equity transfer price is lower than the transfer price for the equity of another
- enterprise in the same industry under the same or similar conditions; or
- other circumstances as so determined by the tax authority.
- Definition of “Justifiable Causes”
The Announcement clarifies that “justified causes” shall include the following:
- the underlying enterprise is in the red for at least three constructive years;
- the equity is transferred at a low price due to state policy adjustment;
- the equity-holder transfers the equity to their spouse, parents, children, grandparent, randchild, sibling, or any other person whom the transferee is legally obliged to provide conomic support; or
- other justified causes as so determined by the tax authority.
- Reassessment Methods
According to the Announcement, where the declared tax verification and determination basis is apparently low without justifiable causes, the tax authorities may use the following methods to reassess the tax basis.
- By reference to the net per share asset value or the net asset value allocable to the ransferred equity. Where more than 50% of the total investment of an enterprise consists of intellectual property, land use rights, real estate, exploration rights, mining rights, equity ownership, etc., the net asset value shall be assessed by a third-party appraiser.
- By reference to the share transfer price of the same enterprises by this or other shareholders.
- By reference to the share transfer price for other enterprises in the same industry under the same or similar conditions.
- When tax payers have objection to the reassessment methods adopted by the tax authority in-charge, they shall provide evidence to support their objection. Upon good cause shown by the tax payers, the tax authority may adopt other reasonable and equitable reassessment methods for reassessing the taxation basis.
The Announcement was published to provide clear standards for taxation basis reassessment with regard to individual income tax derived from income gained through equity transfer. However, certain clauses still need further explanation in practice. For example, how to define the “same industry” and under “similar circumstances”; and whether “three consecutive years” in Section 2 above shall be immediately before the year of the equity transfer or any three consecutive years in the enterprise’s history, which losses incurred result in the equity value lower than the original investment for acquiring such equity.