China’s State Administration of Taxation (SAT) has imposed new challenges for international investors that wish to reduce Chinese government approval procedures and Chinese taxation of their capital gains through the use of offshore investment vehicles. Article 47 of China’s Enterprise Income Tax Law (EITL), which took effect on January 1, 2008, already granted the SAT a general right to tax transactions that have been structured to avoid taxation, where such structures have no reasonable business purpose. Lack of reasonable business purpose has generally been understood to mean lack of any purpose other than to avoid taxation. However, with no explicit requirements for nonresident investors to report such transactions to the Chinese authorities, it has remained unclear whether China’s tax authorities would in fact tax the income earned on indirect equity transfers in Chinese companies by non-residents.

On December 10, 2009, the SAT took a significant step toward enforcing its right to impose such a tax when it issued the Circular on Strengthening the Administration of Levying Enterprise Income Tax on Share Transfer by Nonresident Enterprises (Circular 698). Circular 698 supplements the EITL by explicitly requiring disclosure to the Chinese tax authorities of offshore transfers of equity in Chinese companies. In particular, this disclosure requirement subjects certain offshore indirect equity transfers of Chinese companies to the SAT’s determination of whether a reasonable business purposes existed for the transaction.


Effective retroactively to the January 1, 2008 effective date of the EITL, Circular 698 applies to both direct and indirect equity sales of Chinese enterprises. Under the EITL and its implementation rules, ten percent withholding tax will apply to gains from equity sales of Chinese resident companies by nonresident entities, unless such tax is reduced by an applicable tax treaty. Circular 698 specifies that gains on an equity transfer equal the equity transfer price minus the original price paid for the investment. Circular 698 specifies that such calculations of gains should not be reduced by retained earnings or any after-tax reserves, and that where the seller acquired their equity in more than one transaction, gains shall be calculated using a weighted average method.

Listed Shares

Circular 698 explicitly indicates that it does not apply to transfers of shares of Chinese resident entities purchased and sold on stock exchanges.

Direct Equity Sales

With respect to any direct equity transfer for which the withholding agent does not or cannot pay the Chinese capital gains tax on the transaction, Circular 698 requires that the nonresident seller declare and pay the tax within seven days of the equity transfer.

Indirect Equity Sales

“Indirect equity sales” refers to transfers of equity in Chinese companies via the sale of equity in offshore entities that hold equity in Chinese companies. Circular 698’s use of the language “foreign investor (actual controller)” suggests that the indirectness of such holding of equity applies ad infinitum, meaning that (for example) Circular 698 also applies to the transfer of equity in a company, A, that owns equity in a company, B, that owns equity in another company, C, that owns equity in a Chinese company. In cases where the transferred offshore entity is located in a tax jurisdiction that applies an effective income tax rate of less than 12.5 percent to such transactions, or that does not tax income on residents’ foreign-sourced income, Circular 698 stipulates that the selling entity must submit certain materials to the tax authority of the tax jurisdiction in which the Chinese entity is located.

In cases where Circular 698 requires submission, the tax authorities will use the materials required by Circular 698 to evaluate whether the structure of the entities’ investment and sale have a reasonable business purpose. Circular 698 requires submission of the following materials within 30 days of the equity transfer: (i) The equity transfer contract or agreement; (ii) explanation of the relationship between the transferring foreign entity and the transferred offshore entity with respect to capital, operations, purchases and sales, and so forth; (iii) explanation of the operations, personnel, financial affairs and assets of the transferred offshore entity; (iv) explanation of the relationship between the transferred offshore entity and the owned or invested Chinese entity with respect to capital, operations, purchases and sales, and so forth; and (v) other materials required by the tax authority.

Simultaneous Transfer of Equity in Several Entities

Simultaneous transfer of equity in several entities can result in complications regarding the calculations of capital gains on the aggregate transaction. In order to ensure the tax authorities’ adequate ability to examine such allocations, Circular 698 requires the provision of additional materials. In such cases, each of the Chinese entities whose equity is being transferred must submit to their local tax authorities the transfer contract as well as any sub-contract(s) specifically applicable to the submitting entity. If no sub-contract exists, then the resident entity must submit detailed information and an explanation regarding the calculations of the gains on its equity transfer. If an entity refrains from submitting such materials, the local tax authority may independently perform its own reasonable analysis of the transaction.

Transfers among Related Entities

In cases where the tax authorities determine that non-resident entities have transferred equity in Chinese entities to related parties, and that the consideration for such transfers was less than the arms-length or market price for such transaction, Circular 698 authorizes the tax authorities to adjust the gains calculations accordingly.

Election of Special Tax Treatment

When an equity transfer subject to Circular 698 also qualifies for, and elects to take advantage of, the special tax treatment under Circular 59 (the Notice regarding Certain Corporate Income Tax Treatments of Enterprise Restructuring) as a special entity undergoing restructuring, the entity must first submit the relevant application materials to the relevant tax authorities.


THE CHALLENGE OF ENFORCEMENT: Although not unusual in its extraterritorial reach, Circular 698 may pose some difficult enforcement issues, even if the SAT substantially expands its international monitoring resources. Many jurisdictions where investors commonly establish holding companies will not share information with the Chinese or any other government. Even for jurisdictions that will share relevant information, it would take an enormous amount of resources for the Chinese government to monitor even a small fraction of the many relevant transactions per year. Accordingly, some have speculated that the SAT will initially apply Circular 698 only to large or widely reported transactions. Nevertheless, since the enactment of the EITL, the SAT has become consistently more assertive about its intent to enforce such measures. Therefore, investors should consider the effects of Circular 698 on their existing investments and recent and planned transactions both large and small.

NOT THE END OF OFFSHORE HOLDING STRUCTURES FOR CHINESE INVESTMENTS: Chinese taxation of the above-described structures has not eliminated the usefulness of offshore structures for investment into Chinese entities. Among other reasons, investors might want to continue using offshore structures for reasons relating to expatriation of funds and even continued tax reduction. Offshore structures will also continue to provide many benefits for investors wishing to minimize certain regulatory or administrative procedures that apply to direct investment into China. For example, disposing of a non-resident entity that holds equity in a Chinese entity will still generally require far fewer disclosures and applications than direct disposal of the equity in the Chinese entity. Additionally, as mentioned above, some existing tax treaties do limit the applicability of Circular 698. Accordingly, investors should carefully consider the full body of applicable law when planning or changing their investments and investment structures.

When considering their investment structure options, investors and potential investors should also remember that China’s comparably low withholding tax 10 percent might mean they can reduce overall costs by refraining from establishing and maintaining certain traditional complex off-shore structures. However, opportunities still exist for many investors to employ similar structures to enjoy reduced tax rates under certain treaties with China. Additionally, investors should carefully weigh the cost benefits of each of their options along with the regulatory and other factors relevant to engaging in China-related investment whether on a direct or off-shore basis.


The enactment of Circular 698 should not surprise any serious and knowledgeable investors into China. However, Circular 698 could have a dramatic impact on investments and investment structures that reach into China. Therefore, investors holding or planning investments into China using offshore structures should carefully analyze their current or planned structures both immediately and before making any significant investment decisions going forward.