China amends its tax rules on indirect transfers of Chinese investments
As anticipated, on 6 February 2015, China's State Administration of Taxation (SAT) issued Public Notice  No. 7 ("Public Notice 7") dealing with indirect transfers of Chinese taxable assets. It substantially replaces Circular 698 and Bulletin 24 and introduces a new reporting regime which is significantly different from the previous rules. Public Notice 7 has retroactive effect to indirect transfers which have occurred since 1 January 2008 but have not yet been decided upon by the Chinese tax authorities.
What is this about?
If a foreign investor sells or reorganises shares (and equity-like interests) in another foreign company ("Foreign Company") which directly or indirectly holds Chinese taxable assets, and if this effectively has a similar effect to directly transferring these Chinese assets, then any gain attributable to the Chinese assets will be subject to Chinese income tax if manner in which the sale or reorganisation is conducted does not have reasonable bona fide commercial purpose. There will be no income tax liability if the manner in which the transfer is conducted has reasonable bona fide commercial purpose.
Chinese taxable assets now include (1) assets attributable to an establishment in China, (2) immovable property in China and (3) shares in Chinese resident companies.
What happens if the indirect transfer lacks reasonable bona fide commercial purpose?
- The gain from an indirect transfer of the property of an "establishment or place" situated in China will be treated as income that is effectively connected with that "establishment or place" and subject to 25 percent Chinese income tax.
- The gain from an indirect transfer of real property situated in China and the gain from an indirect transfer of equity interests in Chinese resident companies will be treated as China-sourced income and is subject to 10 percent withholding tax.
The good news
- Unlike Circular 698, Public Notice 7 no longer imposes an obligation on the transferor to report the transfer to the Chinese tax authorities. However, if the transferor does not report the transfer and it turns out to be subject to income tax because it lacks sufficient bona fide commercial purpose, then the transferor or the transferee will be subject to severe penalties.
- Public Notice 7 exempts from income tax (1) a sale of shares of the Foreign Company if it occurs through normal trading on a stock exchange and (2) a sale of shares of the Foreign Company which would have been exempt from Chinese income tax under an applicable tax treaty if the transferor would have sold the Chinese assets directly.
- Public Notice provides more guidance as to what constitutes bona fide commercial purpose1.
- Public Notice 7 gives clarity when an indirect transfer will be deemed to lack sufficient bona fide commercial purpose.2
- Public Notice 7 contains a safe harbour for qualifying internal reorganisations3.
- Better protection for taxpayers and clarity on procedure if the Chinese tax authority wants to tax an indirect transfer: they must first obtain prior approval from the SAT on all major steps of an investigation and they must give the taxpayer an opportunity to appeal against an adjustment decision before this decision can be finalised.
The bad news
- The scope of situations affected by Public Notice 7 now includes Foreign Companies directly or indirectly owning Chinese immovable assets and assets attributable to an establishment in China, whereas previously it only included the transfer of equity in a Foreign Company which directly or indirectly owns equity in a Chinese company.
- If the indirect transfer lacks reasonable bona fide commercial purpose, the transferor, the transferee and the Chinese company whose equity is indirectly being transferred have a reporting obligation4 within thirty days of the date of the transfer, failing which penalties will be due. Under the previous rules only the transferor had a reporting obligation. This raises a serious practical challenge for the purchaser, who is often unable to assess whether the transfer is subject to Chinese income tax and what the amount of the tax liability is.
- The party acquiring the equity in the Foreign Company or its paying agent is primarily responsible for paying the Chinese tax in the event the transaction lacks reasonable bona fide commercial purpose, failing which the transferor will be liable to pay the Chinese income tax. If the transferor fails to pay the income tax, the party acquiring the equity in the Foreign Company will be liable for the income tax due plus a penalty. The penalty could range between 50 percent and 300 percent of the income tax liability, subject to a waiver or reduction of the penalty if the acquirer reports the transaction within thirty days after the date of the transfer. The transferor will be liable for a penalty if neither the transferee nor the transferor have paid the income tax on the transfer. The offshore seller has an obligation to file a tax return and pay tax within seven days from the date when the tax liability arises if the purchaser (or its withholding agent) fails to withhold the tax. If the offshore seller fails to pay the income tax in full within the prescribed time limit, the offshore seller is subject to a daily interest rate equal to the benchmark RMB lending rate published by the People's Bank of China plus 5 percentage points. For the indirect transfer of the property of an "establishment or place" situated in China, the "establishment or place" must include the capital gains in its taxable income of the tax year.
- The SAT has no obligation to make a determination on taxability. In most cases the offshore seller and the "establishment or place" are not able to determine whether the indirect transfer is taxable in China within the prescribed time limit.
- As Public Notice 7 does not address this point, there is uncertainty to whether the tax authorities will recognise the tax paid prior to the indirect transfers when determining the subsequent tax basis direct or indirect transfers.
- If an indirect transfer of Chinese assets lacks sufficient bona fide commercial purpose, the seller is still liable for income tax liability on the sale, including reporting the same to the SAT, but the purchaser now has a withholding and reporting obligation and can be liable if the seller does not pay the tax. This is problematic as there will now need to be an overt discussion on the amount of the tax that is to be paid and therefore the amount that is withheld (or held in escrow), previously something that sellers in practice were generally very reluctant to discuss with purchasers.
- Purchasing parties will need to amend their Sale and Purchase Agreements (SPAs) to reflect the new withholding and reporting obligations in order to protect themselves when they acquire assets which are subject to Public Notice 7.
- Investors should keep sufficient evidence on record to substantiate the reasonable commercial purpose criteria, including minutes of board of directors meetings, shareholders meetings and correspondence with the SAT, if any.
1 While it says that one should consider all the facts of the case, it singles out the following criteria as being of special importance: (1) whether the equity value of the Foreign Company is mainly derived directly or indirectly from Chinese taxable assets, (2) whether the assets or income of the Foreign Company are mainly derived directly or indirectly from Chinese taxable assets, (3) whether the functions performed and risks assumed by the Foreign Company and its direct and indirect subsidiaries that hold Chinese taxable assets can justify the economic substance of the organisational structure, (4) whether foreign income tax is paid on the indirect transfer, (5) whether and how a tax treaty applies to the indirect transfer, (6) the length of time that the shareholders, business model and the organisational structure of the Foreign Company have been in existence, (7) whether it would have been possible for the transferor to directly invest in and directly transfer the Chinese taxable assets, instead of doing so indirectly.
2 If all the following criteria are satisfied: (1) 75 percent or more of the equity value of the Foreign Company is derived directly or indirectly from Chinese taxable assets, (2) 90 percent or more of the asset value (excluding cash) or the income of the Foreign Company is derived from investments in China during any moment within one year prior to the indirect transfer, (3) the functions performed and risks assumed by the Foreign Company and any of its direct or indirect subsidiaries are limited and insufficient to justify the economic substance of the organisational structure, (4) the income tax paid on the indirect transfer in both the country of the transferor and the country where the Foreign Company is established is lower than the Chinese income tax if a direct transfer of the Chinese taxable assets would have taken place.
3 The following three conditions must be satisfied: (1) the transferor and transferee are related companies, either because one owns at least 80 percent of the equity of the other or a third party owns at least 80 percent of both transferor or transferee (if it concerns immovable assets in China, the test is not 80 percent but 100 percent), (2) the new holding structure created after the reorganisation should not result in a lower Chinese income tax liability if the Foreign Company would be transferred, (3) the transferee acquires the equity of the Foreign Company by either issuing its own equity or equity of a company controlled by the transferee (this excludes publicly traded stock).
4 The documents required to voluntarily report the indirect transfer include: (i) equity transfer agreement, (ii) corporate ownership structure charts before and after the equity transfer, (iii) prior two years of financial and accounting statements for all intermediate holding companies, and (iv) a statement that the indirect transfer is not taxable.