On 13 December 2010, the State Administration of Taxation (SAT) granted a big gift to the private equity industry by confirming the flow-through treatment of RMB fund in the form of FIVCIEs (Foreign Invested Venture Capital Investment Enterprises).

FIVCIEs as investment vehicles were introduced by the Ministry of Commerce in 2001 and modified in 2003. In 2003, the SAT issued a tax circular —  the “Notice on Certain Questions Regarding Payment of Income Tax by Foreign Invested Venture Capital Companies” (GuoShuiFa [2003] No. 61, “Circular 61”), which provided for flow-through treatment of FIVCIEs formed as non-legal-person cooperative joint ventures (CJVs).

The tax transparency of FIVCIEs became uncertain in 2008 when China unified its income tax law. The new income tax law no longer has the provision in the old foreign income tax law that granted the flow-through treatment of non-legal-person CJVs. This lack of guidance caused great uncertainty in the private equity industry, which had frequently relied on FIVCIEs to make investments in China.

After continuous lobbying efforts by the interested parties, the SAT finally confirmed on 13 December 2010 that Circular 61 remained effective under the new tax law. This confirmation was given by a public notice (SAT Notice No. 26 of 2010, “Notice 26”), which addresses the effectiveness of tax circulars issued under the old tax law. Besides Circular 61, there are 1841 other circulars remaining effective under the new law.

Without Circular 61, a FIVCIE would be a taxable entity in China and its foreign investors would need to pay an additional level of withholding income tax on dividends distributed by FIVCIEs. Circular 61 eliminates this double taxation. It provides that FIVCIEs can be considered transparent for tax purposes, i.e., the FIVCIE itself does not need to pay income tax; instead, each investor of the FIVCIE will pay income tax for its allocated share of the income. In addition, if a FIVCIE entrusts all of its investment activities to a separate fund manager, the foreign investors in the FIVCIE will be treated as foreign enterprises without establishment (a PRC tax term equivalent to the tax treaty concept of a permanent establishment) in China. This means that the foreign investors will be subject to withholding tax (at a rate of 10 percent, as compared to 25 percent normal corporate income rate) only for PRC-sourced income, mainly from dividends of portfolio companies or capital gains on the disposal of portfolio companies. Those withholding taxes can be reduced or even avoided by foreign investors through careful planning, including the use of tax treaties, which may offer withholding tax rates lower than 10 percent.

Notice 26 will likely revive FIVCIEs as a vehicle for foreign investment in RMB funds. Compared with the new vehicle of limited partnerships, an FIVCIE is a tested one with certainty in approval procedures, foreign exchange conversions, deal execution and now tax treatment. Foreign investors may consider going back to using FIVCIEs for RMB fund formation.