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By Kenneth J. Krupsky, Esq.
Jones Day, Washington, DC
On December 10, 2009, China's State Administration of Taxation issued a "Notice on Strengthening the Administration of Corporate Income Tax Concerning Equity Transfer for Nonresident Enterprises," Guo Shui Han  No. 698 (the "Notice"). As explained by Fuli Cao in Jones Day's Beijing office, the Notice provides a new interpretation of Chinese income tax law, which may have significant implications for direct and indirect transfers of shares of Chinese companies by nonresident companies. Avoiding Chinese tax on capital gain sales of non-Chinese intermediate holding company shares may not be as effective as was thought. Significantly, the Notice is effective retroactively to January 1, 2008. Accordingly, foreign investors should review relevant transactions undertaken since that date. It is unclear how the Chinese tax authorities intend to enforce the new interpretation retroactively.
Computation of Capital Gain
When a nonresident enterprise transfers an equity interest in a Chinese resident enterprise, the nonresident enterprise generally is liable for China's corporate income tax at a tax rate of 10% of the gain, if any, realized on the transfer. The gain is the amount of the transfer price in excess of the cost of investment in the equity. If the nonresident enterprise originally directly invested in the Chinese resident enterprise, the cost of the investment is the amount of actual contributions made by the nonresident enterprise; if the nonresident enterprise acquired the equity from other investors, the cost is the consideration actually paid for the equity. At the time of transfer, if the Chinese resident enterprise has undistributed retained earnings and various reserves allocated from its after-tax profits, the nonresident transferor cannot deduct such retained earnings and reserves in computing capital gain. This provision is consistent with the general rule of withholding tax on dividends paid to nonresident enterprises.
However, the Notice does not distinguish pre-2008 earnings from post-2007 earnings. According to the current tax law and regulations, a nonresident shareholder is subject to 10% withholding tax on dividends paid by a resident enterprise. However, if the dividends are distributed out of the earnings generated prior to January 1, 2008, such withholding tax is exempted. If this nondeduction rule provided in the Notice applies to pre-2008 earnings, such application would be inconsistent with the exception to the general rule of withholding tax on dividends concerning pre-2008 earnings and so may result in additional tax on the transfer of equity.
For example, suppose a nonresident enterprise (N) contributed 100 as registered capital to its wholly owned Chinese subsidiary (S). S has 20 of pre-2008 retained earnings. If N sells shares of S for 180, N would have a capital gain of 80 (180 – 100). However, if N distributes a dividend of 20 before the share transfer and then sells the shares for 160, N would have a gain of only 60 (160 – 100) and would not be subject to withholding tax on the dividend of 20.
Indirect Transfer of a Chinese Company
According to Article 7 of the Implementation Rules for the Corporate Income Tax Law, income from the transfer of an equity investment should be sourced to the location of the invested enterprise. Based on this sourcing rule, if a nonresident enterprise owns an overseas holding company that is also a nonresident enterprise, which in turn invests in a Chinese company, the gain on the sale of shares of the overseas holding company should be sourced to the location of the overseas holding company and generally should not be taxable in China. According to the Notice, however, if the overseas holding company is located in a jurisdiction where the effective tax burden is less than 12.5% or where offshore income is not taxed, the nonresident transferor will be required to provide the Chinese tax authorities in charge, within 30 days of the execution of the share transfer agreement, the following information:
The share transfer agreement;
Information on the relationship between the nonresident transferor/investor and the overseas holding company transferred, in the areas of capital, business, purchase and sales, etc.;
Information on the production, business, personnel, accounting, property, etc., of the overseas holding company transferred;
Information on the relationship between the overseas holding company transferred and the Chinese resident enterprise, in the areas of capital, business, purchase and sales, etc.;
An explanation of the reasonable commercial purpose for the establishment of the overseas holding company transferred; and
Other information that may be required by the tax authorities.
If the tax authorities in charge believe that the indirect transfer of the equity interest in the Chinese resident enterprise was undertaken to avoid Chinese tax by abusing the organizational form and that it lacks a reasonable commercial purpose, the tax authorities may recharacterize the equity transfer based on "economic substance" and disregard the overseas holding company. Such redetermination of the nature of the transfer must be reported by the tax authorities in charge to, and confirmed by, the State Administration of Taxation.
The Notice does not apply to direct or indirect transfers of shares of Chinese resident enterprises that are bought and sold on stock exchanges. It appears that this exception is not available to a foreign investor that directly or indirectly invests in a Chinese resident enterprise before the Chinese enterprise is listed on a stock exchange and subsequently directly or indirectly sells the shares of the Chinese enterprise on the stock exchange after the Chinese company is listed.
This commentary also will appear in the March 2010 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Nee, 957 T.M., Business Operations in the People's Republic of China.
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