China updates tax regime for sale of offshore holding companies | Practical Law

China updates tax regime for sale of offshore holding companies | Practical Law

The State Administration of Taxation issued its seventh tax bulletin of 2015 on February 3 2015. The new bulletin, which expands upon Tax Circular 698/2009, affects the circumstances in which the sale of shares or other equity interests in a non-resident enterprise that indirectly holds certain types of assets in China will trigger Chinese enterprise income tax liability and changes buyers and sellers' reporting and withholding obligations. 

China updates tax regime for sale of offshore holding companies

Practical Law UK Legal Update 2-601-8045 (Approx. 9 pages)

China updates tax regime for sale of offshore holding companies

by Practical Law China
Published on 02 Mar 2015 • China
The State Administration of Taxation issued its seventh tax bulletin of 2015 on February 3 2015. The new bulletin, which expands upon Tax Circular 698/2009, affects the circumstances in which the sale of shares or other equity interests in a non-resident enterprise that indirectly holds certain types of assets in China will trigger Chinese enterprise income tax liability and changes buyers and sellers' reporting and withholding obligations.
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On 3 February 2015, the State Administration of Taxation (SAT) (国家税务总局) published the Announcement of the State Administration of Taxation on Several Issues concerning the Enterprise Income Tax on Indirect Property Transfer by Non-Resident Enterprises 2015 (Tax Bulletin 7/2015). Tax Bulletin 7/2015 clarifies when enterprise income tax (EIT) will be payable in China on the effective transfer of China taxable assets as a result of a change in the ownership of an offshore company that owns those assets, either directly or indirectly through a chain of holding companies.
Under the tax regime created under Tax Bulletin 7/2015, where the sale of a non-resident enterprise (NRE) results in a transfer of China taxable assets and was carried out with the aim of avoiding paying EIT on the transfer of those assets, the transaction will be subject to EIT as if the assets had been transferred to the buyer of the NRE directly. The test for determining avoidance is whether the transaction had a "reasonable commercial purpose". Under the previous regime, EIT could only arise on such a transfer if it resulted in a change in ownership of shares or equity in a Chinese subsidiary, but under the new regime EIT can also arise where there is no Chinese subsidiary but the sale results in a change of the ultimate ownership of real estate in China or assets attributable to an NRE that has a permanent establishment in China.
The new bulletin also replaces the mandatory obligation on sellers (but only sellers) to report transactions with voluntary reporting by any party to the transaction and clarifies how to assess whether an indirect transfer should be re-classified as a direct transfer, including the assessment factors, blacklisted transactions (that is, those that will definitely incur EIT liability), safe harbours and withholding duties.

Tax Bulletin 7/2015 overhauls the regime for offshore transfer taxes under Tax Circular 698/2009

On 3 February 2015, the State Administration of Taxation (SAT) (国家税务总局) published the Announcement of the State Administration of Taxation on Several Issues concerning the Enterprise Income Tax on Indirect Property Transfer by Non-Resident Enterprises 2015 (Tax Bulletin 7/2015). Under Tax Bulletin 7/2015, where a non-resident enterprise (NRE) (非居民企业) indirectly transfers China taxable assets with the aim of avoiding paying enterprise income tax (EIT) (企业所得税) through an arrangement that does not have a reasonable commercial purpose, the indirect transfer will be classified as a direct transfer of China taxable assets, and therefore will be subject to EIT as if it were a direct transfer (Article 1, Tax Bulletin 7/2015).
Prior to Tax Bulletin 7/2015, EIT was only chargeable on indirect transfers where the asset in question was shares in a domestic Chinese enterprise, as detailed in the Notice of the State Administration of Taxation on Strengthening the Administration of Enterprise Income Tax on Gain Derived from Equity Transfer Made by Non-Resident Enterprise 2009 (Tax Circular 698/2009).
Tax Bulletin 7/2015 expands on Tax Circular 698/2009 and provides additional guidance on a number of issues, including:

What is a China taxable asset

China taxable assets are any of the following types of assets that are held, directly or indirectly, by an NRE:
(Article 1, Tax Bulletin 7/2015)
Under Tax Circular 698/2009, the SAT only exercised extraterritorial jurisdiction over indirect transfers by NREs of shares or other equity interests in an enterprise that was a Chinese RE. The expansion of the definition of China taxable assets to cover real estate and assets held by PEs means that potential EIT liability may arise when the ownership of a foreign company changes if there is an underlying business in China, even if there is no underlying China subsidiary.

EIT tax treatment

The EIT tax treatment of an indirect transfer of China taxable assets without a reasonable commercial purpose varies depending on the type of assets involved:
Asset class
Applicable rate of EIT
Shares or other equity interest in an RE
10%
Real estate located in China
10%
Assets attributed to a PE
25%
(Article 2, Tax Bulletin 7/2015)
For information on the EIT that applies to the direct transfer of China assets by NREs, see Country Q&A, Tax on corporate transactions in China: overview: Main taxes on corporate transactions.

Demonstrating a reasonable commercial purpose for a transaction

Tax Bulletin 7/2015 gives more detailed guidance than Tax Circular 698/2009 on how to ascertain whether or not an indirect transfer structure has a reasonable commercial purpose.
The SAT will consider:
  • Value. Whether the main value of the shares of the intermediary NRE is directly or indirectly derived from China taxable assets.
  • Assets or revenue. Whether the assets of the intermediary NRE are mainly composed of investments made in China and whether the income of the intermediary NRE is mainly sourced from China, whether directly or indirectly.
  • Functions and risks. Whether the functions actually performed and the risks assumed by the intermediary NRE and its subsidiaries that directly or indirectly hold China taxable assets can justify the economic substance of the organisational structure.
  • Duration. The length of time the shareholders, business model and relevant organisational structure of the intermediary NRE has been in existence.
  • Foreign taxes payable. What foreign taxes are payable on the indirect transfer of China taxable assets.
  • Investment substitutability. Whether it would have been possible for the seller to directly invest in and transfer China taxable assets rather than indirectly invest in and transfer them.
  • Tax treaties. Whether there is any tax treaty or arrangement applicable to the indirect transfer of China taxable assets.
  • Others. This is a catch-all provision for other relevant factors that the SAT might reasonably consider from time to time.
(Article 3, Tax Bulletin 7/2015)
The SAT will follow the principle of substance over form and conduct a comprehensive analysis of all factors of the transaction when assessing whether there is a reasonable commercial purpose for an indirect transfer. Although no single factor is decisive, if any of these factors indicates the absence of a reasonable commercial purpose (for example, if the structure has been set up immediately prior to the transfer, the intermediary NRE has no substantive assets other than the China taxable assets and there is no obvious reason other than eliminating EIT to have carried out the transfer at the offshore level), there is a substantial risk that EIT will apply to the transaction..

What transactions are automatically subject to EIT?

A transaction will be directly deemed to lack a reasonable commercial purpose, and therefore be subject to EIT, if all of the following conditions are met:
  • Value. 75% or more of the value of the shares of the intermediary NRE derives directly or indirectly from China taxable assets.
  • Assets or revenue. At any time during the year immediately before the transfer date of the China taxable assets, 90% or more of the value of the non-cash assets of the intermediary NRE are composed of direct or indirect investments in China, or 90% or more of the intermediary NRE's income is directly or indirectly sourced from China.
  • Functions and risks. The functions performed and risks assumed by the intermediary NRE and any of its subsidiaries that directly or indirectly holdi China taxable assets are limited and are insufficient to prove their economic substance.
  • Foreign taxes payable. The foreign tax payable on the gain derived from the indirect transfer of China taxable assets is lower than the potential Chinese tax on the direct transfer of such property.
(Article 4, Tax Bulletin 7/2015).
If the parties can demonstrate that any of these conditions has not been met, the transaction will not necessarily be subject to EIT, although the onus would remain on the parties to demonstrate a reasonable commercial purpose for the transaction.

What transactions are automatically exempt from EIT (Safe harbours)?

The Tax Bulletin 7/2015 sets out three types of transactions which fall outside of the extraterritorial taxation jurisdiction of the Chinese tax authority:
  • Qualified group reorganisations.
  • Normal public trading exception.
  • Tax treaty exemption exception.

Qualified group reorganisation

A transaction will be deemed to be exempt from EIT on the grounds that it is a qualified group reorganisation if all of the following conditions are met:
  • The equity shareholding relationship of the seller and the buyer meets one of the following criteria:
    • The seller directly or indirectly owns 80% or more of the shares of the buyer;
    • The buyer directly or indirectly owns 80% or more of the shares of the seller; or
    • 80% or more of the shares of both the buyer and the seller are directly or indirectly owned by the same shareholder.
  • The consideration is entirely made up of shares in the buyer or a related enterprise with which the buyer has a control relationship (excluding shares in any listed company).
  • The indirect transfer will not reduce the tax payable in China on any potential future indirect transfer of the same assets.
(Article 6, Tax Bulletin 7/2015)
If more than half of the value of the shares in the intermediary NRE derives, directly or indirectly, from real estate located in China, the shareholding requirement to take advantage of this exemption rises from 80% to 100%.
When seeking to rely on this exemption, carefully consider the final point (that is, whether the transaction will reduce the future tax payable to China on a change of ownership of the underlying assets). For example, if the transaction would involve transferring indirect ownership of the China taxable assets from a company established in a jurisdiction that has no preferential tax treaty with China to a company established in a jurisdiction that has a preferential tax treaty with China, the qualified group reorganisation exemption would not be available.

Normal public trading and tax treaty exemptions

Article 6, Tax Bulletin 7/2015 also includes two generally available exceptions:
  • Trading in listed shares. This applies to where an NRE derives income from an indirect transfer of China taxable assets by buying and selling shares in a single company that is listed on a public stock exchange outside China.
  • Transactions exempt under a tax treaty. This applies to a situation where had the non-resident enterprise transferred China taxable assets directly, the transfer would have been exempt from EIT in China under an applicable tax treaty or arrangement.

Reporting and withholding obligations

Voluntary reporting

Under Tax Circular 698/2009, the seller in an offshore transaction that was potentially subject to EIT was obligated to report the transaction within 30 days upon the date of execution of the sale and purchase agreement. This has changed. Under Tax Bulletin 7/2015, there is no longer any general obligation to report offshore transfers that are potentially subject to EIT. However, the offshore seller, offshore buyer or a Chinese RE whose ultimate equity ownership will change as a result of the transaction may now voluntarily report the indirect transfer of China taxable assets to the competent tax authority (Article 6, Tax Bulletin 7/2015).
When voluntarily reporting a transaction, the person reporting the transaction must give the tax authority:
  • A copy of the executed sale and purchase agreement for the relevant transaction (together with a translation into the Chinese language if the agreement is written in a foreign language).
  • A Group organisational chart showing the position before and after the transfer.
  • The financial and accounting statements in the previous two years of the intermediary NRE and its subsidiaries that directly or indirectly hold China taxable assets.
Although reporting is not a mandatory obligation, buyers and sellers may choose to report transactions to avoid facing unplanned-for penalties and mitigate the consequences of failure to pay any EIT that is ultimately assessed on the transaction (see Consequences of non-compliance).

Withholding duty

When China taxable assets are transferred indirectly, whoever is directly obliged to pay the seller must also act as the withholding agent for any EIT payable on the transfer (Article 8, Tax Bulletin 7/2015). The obligation arises on completion of the offshore transfer of shares (Article 13, Tax Bulletin 7/2015).
If the withholding agent fails to withhold the tax, the seller must declare and pay the unpaid tax to the competent tax authority within 7 days after the payment obligation fell due (Article 8, Tax Bulletin 7/2015).

Consequences of non-compliance

If EIT is due on an indirect transfer of China taxable assets under Tax Bulletin 7/2015 but is not paid (or withheld) as required, the competent tax authority may impose a number of penalties:
  • Against the withholding agent. A penalty of 50% to 300% of the unpaid tax (Article 69, Law of the People's Republic of China on the Administration of Tax Collection 2013). This penalty may be reduced or waived if the withholding agent reported the transaction within 30 days after the date on which the sale and purchase agreement was executed.
  • Against the seller. Interest on the unpaid tax. The interest period starts to run on 1 June of the year following the year that the tax is due and continues until the date on which the tax is paid. The interest rate will be:
    • The benchmark interest rate, if the seller reported the transaction within 30 days of the date of execution of the sale and purchase agreement or has paid the tax in a timely manner.
    • The benchmark interest rate plus five percentage points, if the seller fails to report and pay the tax on time.

Implications for M&A transactions

Overall, the new regime will make life easier for those acquiring offshore holding companies with an underlying business in China.
Under the previous regime, only sellers had formal standing to report a potentially affected transaction (buyers could request that sellers do so, but not all sellers would agree). If a seller refused to do so, the buyer would lose the ability to step up the tax base of the underlying assets the next time they were sold, effectively transferring the tax liability from the seller to the buyer. This led to a situation in which buyers typically sought to negotiate a covenant from the seller to report the transaction and pay any tax if required, and an indemnity from the seller against any potential adverse tax consequences. Although in most cases buyers would obtain this, sometimes a seller with a strong bargaining position would refuse; even when buyers could obtain these protections, the time spent in negotiations and drafting added to the overall transaction cost.
The addition of a clear duty on the buyer to withhold EIT, together with clear penalties for a seller that fails to report the transaction, gives buyers a firm basis for withholding EIT and empowers them to report the transaction if the seller is reluctant. Taken together, these changes reduce the incentive for sellers to refuse to report potentially liable transactions and reduce the need for buyers to spend time and money negotiating extensive EIT protection in offshore sale and purchase agreements.