26 January 2011
Shortly after we published our article, China Continues the Flow-through Treatment for FIVCIEs, the State Administration of Taxation (the "SAT") released another public notice (SAT Notice No. 2 of 2011, "Notice 2") on its website. Notice 2 reversed its position in SAT Notice No. 26 ("Notice 26"), which was the basis of our last article, and revoked the flow-through treatment of foreign-invested venture capital investment enterprises ("FIVCIEs").
The flow-through treatment of a FIVCIE was provided for in the Notice on Certain Questions Regarding Payment of Income Tax by Foreign Invested Venture Capital Companies (GuoShuiFa  No. 61, "Circular 61"). Notice 26 included Circular 61 as one of the SAT documents that were still valid. However, shortly after the publication of Notice 26, Notice 2 listed Circular 61 as one of the SAT documents that were completely abolished or partly invalidated.
Pursuant to Notice 2, Article 1, Article 2, the first paragraph of Article 3, the first sentence of the second paragraph of Article 3 have become invalid. A copy of Circular 61 is attached to this article (see Appendix 1).
Paragraph 1 of Article 3 is the most critical portion of Circular 61. According to this paragraph, a non-legal-person FIVCIE can either pay PRC enterprise income tax by itself (as a taxpayer), or be regarded as a flow-through entity and have its investors pay their respective enterprise income taxes. This flow-through treatment became uncertain under the unified income tax law in 2008. The invalidation of paragraph 1 of Article 3 means that an FICVIE, even if organised as a non-legal person from a corporate perspective, will be a taxable entity.
An interesting point to note is that, while the first sentence in paragraph 2 of Article 3 is invalidated by Notice 2, the second sentence is kept valid. Paragraph 2 of Article 3 addresses how foreign investors in a flow-through FIVCIE should pay enterprise income tax in China. The first sentence of paragraph 2 provides a general rule: a foreign investor in a flow-through FIVCIE should pay PRC enterprise income tax as a foreign enterprise with an establishment (a P.R.C. tax term equivalent to the tax treaty concept of a permanent establishment). This means that the foreign investor should pay enterprise income tax at the standard enterprise income tax rate, which was 33% under the old tax law and 25% under the unified income tax law. The second sentence of paragraph 2 creates an exception to the general rule and is another crucial part of Circular 61. According to the second sentence, foreign investors in a flow-through FIVCIE that has entrusted all of its investment activities to a separate fund manager will be treated as foreign enterprises without establishment in China. This means that these foreign investors will be subject to withholding tax at a rate of 10 percent or a lower treaty rate on their respective shares of the income from the FIVCIE.
The preservation of the second sentence in paragraph 2 of Article 3 is unnecessary and may even have an adverse effect on foreign investors. A foreign investor in a taxable FIVICIE will be treated separately from the FIVCIE. As long as the foreign investor itself does not have a taxable presence in China through its own activities, it should be treated as a foreign enterprise without establishment in China. Whether the FIVCIE engages in investment activities by itself or entrusts its investment activities to a separate fund manager should be irrelevant. Therefore, the preservation of the second sentence of paragraph 2 is unnecessary. Further, the preservation of the second sentence of paragraph 2 may be interpreted to mean that a foreign investor in a FIVCIE that does not entrust its investment activities to a separate fund manager should be treated as having an establishment in China. This interpretation would be contrary to China’s own tax law as well as to the international tax norm .
To conclude, Notice 2 overturned the position in Notice 26 and essentially abolished the flow-through treatment of a non-legal person FIVCIE. While part of Circular 62 has been kept valid, the remaining portion does not appear to be meaningful.
Prior to the issuance of Notice 2, local tax authorities in some cities had continued to treat non-legal person FIVCIEs as pass-through entities. The new and clear position in Notice 2 will have a profound impact on the funds industry in China.
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