By Stephen Nelson, Partner and Head of King & Wood’s Taxation Practice

It is not uncommon for foreign investors to sell the shares of intermediate holding companies that hold the equity in Chinese companies as a way to exit their investments in China, in order to get around government approval procedures, as well as to avoid PRC tax on their capital gains. It certainly appears that these offshore transfers may be examined by the China tax authorities going forward, and may no longer escape the Chinese tax net. Recently, the State Administration of Taxation (the “SAT”) issued the circular Guoshuihan [2009] No. 698, “Strengthening the Tax Administration of Equity Transfers by Non-resident Enterprises” ("Circular 698”), which, for the first time, explicitly requires disclosure to the tax authorities of offshore indirect transfers of equity in PRC companies. The tax authorities may then examine the transferred offshore holding company in order to ascertain whether the structure has a reasonable commercial purpose – if not, the offshore gain could be held subject to Chinese tax.

1. Scope and effective date

Circular 698 stipulates the tax position and administrative treatment on capital gains of non-resident enterprises generated from their disposals of equities in resident enterprises. However, the tax issues for gains from transfers of H-shares, Chinese tax resident listed red chip companies and B-shares are not addressed by the circular. The circular was promulgated by the SAT on 10 December 2009, with retroactive effect starting from 1 January 2008.

2. Calculation of gains of equity transfer

Under Circular 698, the income of an equity transfer is equal to the amount of equity transfer proceeds minus the original investment/acquisition cost, which would be normally subject to withholding tax at 10%, unless the relevant tax treaty provision stipulates a lower rate. Particularly, retained earnings and after-tax reserves (if applicable) attributed to the transferor’s equity may not be deducted from the transfer price for the purpose of calculating capital gains. This is the first time that the SAT officially clarified the treatment of reserves and retained earnings. In addition, where the original shareholder acquires the equity through multiple investments or purchases, the equity transfer cost should be determined on a weighted average basis.

3. Indirect transfer

“Indirect transfers” refers to the situation where foreign investors indirectly transfer the equity in resident enterprises by disposing of the shares of offshore holding companies. According to Circular 698, if foreign investors (de facto controlling parties) indirectly transfer their equity in a resident enterprise, and the transferred offshore holding company is located in a country (or territory) with effective tax rate less than 12.5% or no income taxation on residents’ foreign sourced income, then they should, within 30 days upon the conclusion of equity transfer contract, submit relevant materials to the in-charge tax bureau where Chinese resident enterprise is located. These documents include the equity transfer contract; a report addressing any reasonable business purpose for establishing the offshore holding company, information on the operating activities, personnel, finance and properties of the offshore holding company, and its relationships with resident enterprises, etc. In case the indirect transfer transaction is viewed by the tax authorities as having no reasonable business purpose or abusive use of treaties or forms of investment vehicles, the local tax bureau may report the case up to the SAT for further assessment. If confirmed, the tax authorities may re-characterize the equity transfer based on economic substance or even deny the existence of offshore holding company in the transaction.

4. Group transfer of equity in multiple companies

Circular 698 also addresses the scenario where foreign investors (de facto controlling parties) transfer equities of several onshore and/or offshore companies in one transaction. In this case, the resident target enterprise shall submit to the competent tax bureau the master transfer contract and sub-contract concerning the resident target enterprise. If no sub-contract is available, then the resident target enterprise shall furnish detailed materials/methodology for the purpose of accurate allocation of transfer proceeds among companies involved. Otherwise, the tax authority may deem the respective transaction consideration by reasonable means.

5. Election of tax treatment for special reorganization

Where an equity transfer covered by Circular 698 qualifies for a tax-deferred special reorganization, as stipulated by the circular No. 59 “Notice on Enterprise Income Tax Issues for Corporate Restructuring” and the company elects to enjoy special tax treatment, it shall obtain approval from tax authorities at the provincial level.

K&W Observations:

Circular 698 remains silent on the issue as to whether capital gains on H-shares and B-shares (as well as tax-resident red chip companies listed on a stock exchange), are subject to tax. Some have expressed the view that Circular 698 deliberately sets aside the issue of transferring publically listed shares and it is more likely than not that the gains for trading public shares will not be taxed in China. However, it may be premature to reach that conclusion as it is expected that the SAT may issue a separate ruling to clarify the issue.

Circular 698 now formally clarifies the method for calculating the taxable income from an equity transfer. Even though undistributed profits and after-tax reserves may no longer be deducted from equity transfer consideration, for tax planning purposes, some structures are still viable to decrease the tax cost including the distribution of existing dividends, and allowing the transferor to retain the right to current-year dividends.

The most significant development is that indirect transfers are now officially under the scrutiny of the PRC tax authorities, which will significantly impact offshore holding company structures. Circular 698 sets forth substantial disclosure and compliance obligations, and offshore equity transfer arrangements without a sufficient business purpose may be taxed in China. China tax authorities have sent strong signals to attack tax avoidance arrangements in the form of overseas transactions or holding structures. It will be interesting to see how the tax authorities will in reality enforce the circulars.

Finally, it remains unclear whether the reporting requirements of Circular 698 will apply to indirect equity transfers that have already been consummated prior to the issuance of the notice.

We will closely monitor further developments with respect to Circular 698’s implementation and local enforcement, as well as any further clarification on listed company shares and follow up with future blogs as soon as information is available.