By: Mark Schaub and Luo Bin, King & Wood’s Corporate Group and Shanghai Office

On December 14, 2010, the State Administration of Taxation (“SAT”) promulgated an Announcement on Issues Concerning the Verification of Taxation Basis of Individual Income Tax Payable on Equity Transfer Income (“Announcement”). The Announcement will come into effect on January 14, 2010.

The Announcement only applies to sales of equity interest by individuals and seeks to combat situations in which companies are sold very cheaply on paper. Experience has shown that Chinese entrepreneurs are very strong in negotiating prices (i.e. selling foreigners the Chinese dream) and it is very rare for a company’s equity to be sold at a price below its net asset value unless there is some other transaction taking place outside of the share documentation (i.e. offshore payment, consulting fees etc.) which makes up for the shortfall.

Brief Overview

The Announcement provides that the income a PRC individual derives from selling equity (i.e. shares or registered capital) in an enterprise will not only be based on the contract price but shall also take into account its fair trade price. The term “fair trade price” is more specifically defined in the Announcement. If the tax authority determines that the transfer price is artificially low it may decide upon a “fair trade price” and tax the seller on such basis.

Main Contents

The Announcement provides details as to which factors they will take into consideration when determining whether the taxation basis (i.e. sales price) is artificially low:

  •  Transfer price is lower than the original investment, or lower than the combination of the price and taxes and fees paid for the equity;
  •  Transfer price is lower than the value of the target’s net assets;
  •  Transfer price is lower than the price at which the equity would normally be transferred in an arm’s length transaction;
  •  Transfer price is lower than the industry standard; or
  •  Other circumstances.

However, the Announcement also provides that there may be justifiable reasons for a low price. Examples given include:

  •  Target is loss making for more than three (inclusive) consecutive years; or
  •  The investor is selling equity at an artificially low price due to an adjustment in state policy; or
  •  As part of a family re-structuring ( i.e. where the equity-holder transfers equity to a spouse, parent, child, grandparent, grandchild, sibling or any relative that has a right to support or maintenance); or
  •  Other justifiable reasons as may be provided by the competent taxation authority.

In addition, the Announcement also provides some details as to possible verification methods that may be adopted:

  •  Comparing the transfer price against the value of net assets corresponding to the equity in the target held by the seller.
  •  If the aggregate of intellectual property rights, land use rights, real estate, right of prospecting, right of mining and equity accounts for more than 50% of the total assets of the target, then the value of net assets of the target should be assessed by a third-party valuer; or
  •  Benchmarking the transfer price against other deals in a similar industry.

If a seller objects to any of the above verification methods adopted by the tax authority, he or she will need to provide supporting evidence for the objection.

Impact

The Announcement illustrates that the PRC tax authorities are taking actions against taxes which are being evaded by Chinese entrepreneurs when they sell their companies. The direct consequence is that local sellers may face increased tax burdens when selling their equity interest. However, foreign buyers may also be indirectly affected. Although it is unlikely that the Announcement’s implementation would directly affect a transaction after its approval, there may be an indirect affect. We have seen increasing numbers of cases where the approval authorities will not approve a transaction if the price seems artificially low. In this case, the Announcement may be helpful in that it provides guidance as to which argument may support a price which at a first glance appears to be too low. As a suspiciously low price may impact approval it is in all Parties’ interests to consider such issue early or in the process.