In 2009, income taxes collected from non-resident enterprises (defined in the Enterprise Income Tax Law of China as “an enterprise incorporated in a foreign country or region with its actual management organization located outside China”) reached Renminbi 41.611 billion, a 55% increase in comparison with 2008. The State General Administration of Taxation has realized the potential tax revenue growth in this area. It passed more than 10 new tax regulations in 2009 alone to reinforce its related tax collection administration. Local tax bureaus also have geared up their collection efforts. Most of these new tax regulations are retrospective with the effective date tracing back to January 1, 2008, to be in line with the effective date of the Enterprise Income Tax Law. The new regulations cover tax collections with respect to provision of services, contracting engineering projects, equity interest transfers and payment of interests, dividends and royalties, tax withholding at income sources and approval for tax treaty benefits.

A recently issued regulation is of particular interest. The Notice on Strengthening the Administration of Enterprise Income Taxes Related to Gains from Equity Interest Transfers Conducted by Non-resident Enterprises (“Tax Rule No. 698”) issued on December 10, 2009 specifically targets gains obtained by non-resident enterprises from selling the equity interest of their foreign-invested enterprises in China in equity interest transfer transactions (excluding only those transactions involving public purchase and sale of Chinese resident enterprises’ stock on the securities markets). This new tax regulation has an impact on merger and acquisition transactions and enterprise restructuring transactions done outside mainland China in which the ownership of the foreign-invested enterprises in China directly or indirectly is transferred. In the past, because this type of transactions was done overseas, tax collection was a challenge to the relevant Chinese tax bureaus due to lack of a strong legal base and, as a result, they did not actively pursue collection. Tax Rule No. 698 has provided that legal base. It will likely expose non-resident foreign sellers to more Chinese tax liabilities and/or more document production burdens in doing such types of transactions:

Filing Tax Return. A non-resident enterprise shall file a tax return with the tax authority where its foreign-invested enterprise is located within seven days after transfer of the relevant equity interest if the withholding obligor (generally, it will be the foreign-invested enterprise in China) fails to or cannot perform its withholding obligation.

Tax Obligation. The gain (the difference between the transfer price and the cost for the equity interest) shall be taxed. Tax Rule No. 698 further defines the transfer price and the cost for the equity interest. The normal tax rate is 10%. To obtain a more beneficial treaty rate, an approval may be required.

Burden on Document Production. A foreign investor (the actual controlling party) which indirectly transfers the equity interest of a foreign-invested enterprise in China must produce a series of documents to the relevant tax bureau with respect to the transfer and business relations and dealings (management, funds, sale, production, finance, etc.) among the foreign investor (the actual controlling party), the holding company to be transferred and the foreign-invested enterprise, if certain conditions are met.

Exception. One type of equity interest transfer transaction may be done tax free. This type applies only to an enterprise group internal restructuring: a non-resident enterprise transfers the equity interest of its foreign-invested enterprise to another non-resident enterprise 100% directly owned by such non-resident enterprise transferor, provided that some other conditions are also met. This requires production of documents to support the tax-free treatment. Tax Rule No. 59 issued in April 2009 provides the detailed conditions required.

Adjustment. Tax Rule No. 698 gives a relevant tax bureau the authority to adjust the transfer price if an affiliated equity interest transfer is not conducted at arm‘s length. Article 6 of Tax Rule No. 698 is of concern. It provides that if a foreign investor (the actual controlling party) indirectly transfers the equity interest of a Chinese-resident enterprise through abuse of organizational structures and similar arrangements with no reasonable business purposes and avoids its enterprise income tax payment obligation, the relevant local tax authority may, after reporting to the State General Tax Bureau and obtaining its approval, redefine the nature of the equity interest transfer transaction based on the principle of economic substances and disregard the existence of a foreign holding company that is used for the purpose of tax arrangements. However, the regulation does not go further to define what constitutes “abuse of organizational structures” or the meanings of “reasonable business purposes” or “economic substances”. Lack of clear legal definitions will give the relevant local tax bureaus more discretion to interpret them. How this clause will play out and how actively the relevant local tax bureaus will enforce this clause remain to be seen. Nevertheless, care should be exercised when the structure involving a foreign holding company with the sole purpose of tax arrangements is used because the foreign investor (the actual controlling party) may face extra Chinese tax burdens.

The newly issued tax regulations governing non-resident enterprises will subject these enterprises to the close scrutiny of Chinese tax authorities. Getting to know these regulations, seeking good advice and planning well in advance may help save unnecessary transaction costs and reduce non-compliance risks.