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Abe Zhao Baker McKenzie FenXun (FTZ) Joint Operation, China
Abe Zhao is International Tax Director at Baker McKenzie FenXun (FTZ) Joint Operation, China
The Beijing state tax bureau has recently collected approximately 100 million dollars in corporate income tax (“CIT”) in a major indirect transfer case. The case drew to a close after 18 months of intense negotiations between the tax authorities and the taxpayer. It was significant not only due to the size of the transaction, but, more importantly, because it highlighted how documentation planning is key.
The case originally started from a Chinese new media report in early 2016 that a well-known real estate developer invested close to 10 billion renminbi into Shunyi, Beijing, through its newly acquired local operation, China Co.
China Co was a local taxpayer in the Shunyi district and had extensive land ownership in China. The Beijing Shunyi State Tax bureau noticed the news report and interviewed personnel from China Co.
During the process, the Chinese tax investigators learned that China Co was wholly owned by Target Co, a company incorporated in the BVI (“British Virgin Islands”). Although Target Co's direct ownership in China Co did not change, the ownership of Target Co was recently transferred in an equity transaction (“the transaction”), when the original owner (“seller” or “the taxpayer”) sold 100 percent of the shares in Target Co to a new owner (“buyer”).
The considerations in the transaction were paid by installment. As a result of the transaction, the indirect ownership in China Co was shifted from the seller to the buyer. The seller and buyer were unrelated and both of them were BVI companies.
The tax officials confirmed that the primary assets and revenues of Target Co came from its equity ownership in China Co. Target Co did not have employees. It didn't have any fixed assets or intangible properties that were used in direct business operations, and conducted no substantive activities.
The corporate functions of Target Co were outsourced to external vendors. Following SAT Bulletin 2015-7, the tax authorities ruled that the transfer of Target Co, which led to an indirect transfer of China Co, lacked reasonable business purpose from a China CIT perspective and was structured to avoid China CIT.
As a result, the tax authorities pierced the corporate veil of Target Co and recast the indirect transfer into a direct transfer of China Co. Under the recast, the seller was deemed to sell the equity interest in China Co to the buyer, even though it never owned China Co directly from a legal standpoint.
Under the China CIT law, the seller was obligated to pay 10 percent China CIT on gains realized from the deemed direct transfer. Gains were equal to the excess of the transaction price corresponding to the equity value of China Co over the seller's deemed PRC tax basis in China Co.
The taxpayer did not appear to have strongly challenged the tax authorities' decision to tax the transaction, but the two sides had significant disagreements over the details of the tax computation. Both parties agreed that the deemed PRC tax basis in China Co should be its registered capital. However, dispute arose with respect to the transaction price that should be used in calculating the gains.
The tax authorities recognized that there was no transfer pricing issue in this case because the seller and the buyer were unrelated.
The beginning of the negotiation was the overall transaction price in the Equity Transfer Agreement (“EPA”). The seller argued that the overall transaction price in the EPA should be adjusted downward by 300 million dollars for the following reasons.
First, the EPA contained post-closing price adjustment items whose amounts were not determined yet as of the time of the tax investigation. The final transaction price was expected to be significantly lower than the overall transaction price stated in the EPA.
Second, it appears that the seller had lent money to China Co before the transaction and was a creditor of China Co. As a part of the transaction, the seller transferred its debt to the buyer for consideration, and such consideration was blended into the overall transaction price. The seller argued that the consideration for the debt transfer should be carved out of the transaction price when computing the taxable gains.
Third, due to the installment payment provision in the EPA, there was to be a significant lapse of time between the contract signing date and the date of the final installment. The seller argued that a part of the overall transaction price in the EPA was interest in nature rather than equity value, and should be removed.
After extensive negotiations between the parties, the tax authorities agreed that the seller should deduct an estimated amount of post-closing adjustment from the transaction price. The seller should file an amended return to either make up for any tax deficiency or seek a tax refund when the final amount of the post-closing adjustment was known.
Furthermore, the tax authorities agreed to deduct the value of the debt from the overall transaction price for computing the Chinese CIT. However, the tax authority disallowed any deduction for imputed interest, citing that the EPA did not contain a specific provision on the computation of interest and there was no document explicitly reflecting a consensus between the transacting parties that a part of the consideration was intended to be compensation for the time value of money. Therefore, the tax authorities considered that any separation of the interest element from the overall transaction price, due to the installment feature, would be arbitrary.
SAT bulletin 2015-7 prescribes a blacklisted scenario under which an indirect transfer will automatically be recast as a direct transfer for Chinese CIT purposes. The blacklisted scenario refers to the situation where the seller is located in a low tax jurisdiction, the foreign target has no physical substance in its own jurisdiction, most of the foreign target's revenue originates from its investment in China, and most of the foreign target's assets and equity value are derived from its investment in China, etc. The transaction above fell right into the blacklisted scenario, so the fact that it was taxed in China should not come as a surprise.
The case shows that even if an indirect transfer will likely be subject to Chinese CIT, there are still opportunities to reduce the amount of tax liability through planning and preparation of documentation.
The reason that the Chinese tax authorities agreed to split the value of the debt instrument from the overall transaction price was that the EPA clearly differentiated the transfers of the equity and debt and assigned separate values to them. An offshore transfer of creditor rights in a standard debt instrument with a Chinese borrower by a nonresident taxpayer usually does not trigger material Chinese CIT liabilities.
This is because even if any China-sourced gains are realized (there is a potential technical argument that such gains are not China-sourced), such a debt instrument likely has limited appreciation potential so the amount of the gains would probably be immaterial. Meanwhile, the value of the debt instrument can be substantial and if it can be reduced from the overall transaction price, this can decrease considerably the amount of the Chinese tax obligations from the indirect transfer. To achieve such a result, the taxpayer needs to present documentation to substantiate the mutual intentions of the parties as to what value should be used for the equity transfer portion of the transaction.
On the flipside, due to a lack of sufficient documentation, the tax authorities disallowed the reduction of the overall transaction price by an imputed interest element. Although the argument from the taxpayer was commercially reasonable, it couldn't present legal documents to prove that both parties agreed for a portion of the consideration to be treated as interest and what the amount should be. This provided the tax authorities an argument to deny the request. Had the seller built this potential position into a specific provision in the EPA, it would have a better chance to win this position and reduce the overall transaction price further.
It was a breakthrough for the taxpayer that it persuaded the tax authorities to accept a lower transfer value by incorporating an estimated downward post-closing adjustment into the computation. This way the taxpayer reduced the chance of overpaying tax first and asking for a refund later. Although seeking a tax refund was allowed in this case once the exact amount of post-closing adjustment was available, getting tax payment back in China is usually a long process for taxpayers. It's better to reduce the tax payable amount up front through negotiation than to apply for money back afterwards. In some previous direct equity transfer transactions with post-closing price adjustment mechanisms, the local tax authorities would insist upon the seller using the transaction price as stated in the EPA to compute the Chinese CIT due, and were reluctant to accept tax refund requests when the final transaction price turned out to be lower than reported in the initial tax returns.
The fact that the Chinese tax authorities in this case agreed to post-closing price adjustment suggested that unreasonable tax authority practices are not fixed, and good tax results can be obtained through active negotiation based on the law.
Interestingly, the case did not address the role of the buyer as withholding agent in the transaction. Under SAT bulletin 2015-7, if an indirect transfer is subject to Chinese CIT, the buyer of the transaction, Chinese or foreign, has a withholding obligation. The Chinese Tax Collection and Administration law potentially imposes an administrative penalty of up to 300 percent of the Chinese CIT due onto the buyer if:
The buyer can reduce or eliminate this penalty if, within 30 days of signing the EPA, it voluntarily files a reporting package to the relevant Chinese tax authorities and discloses the transaction.
In the case above the transaction was discovered by the tax authorities through a news article and subsequent on-site interviews. Therefore apparently neither the buyer nor the seller voluntarily reported the transaction to the tax authorities. The buyer wasn't penalized for its failure to withhold pursuant to Article 8 of SAT bulletin 2015-7, likely because the tax authorities ultimately collected the tax from the seller. However, if, for whatever reason, the tax authorities were unable to recover the tax, the buyer would run the risk of receiving a penalty.
It's important that both parties take the Chinese indirect transfer rules seriously, and craft the provisions in the EPA carefully to ensure cooperation from the other party and protect themselves in all scenarios.
Abe Zhao is International Tax Director at Baker McKenzie FenXun (FTZ) Joint Operation, China.He can be contacted at Abe.Zhao@bakermckenziefenxun.com.
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