Investment Into China Needs Careful Exit Planning Upfront

Circular 698 issued in December 2009 and the subsequent clarification Public Announcement 24 issued in March 2011 address the reporting and taxation of gains arising from transfers of China-resident companies. They have wide reaching implications for anyone investing in China, but in particular they have a huge impact on the private equity sector.

Circular 698 has been widely reported but it is worth recapping on the scope of the Circular and considering the landmark case where the State Administration of Taxation (SAT) in China has successfully challenged and collected tax in relation to indirect share transfers.

In the past and especially in a private equity scenario, investments were often structured into China via a special purpose vehicle (SPV) where the SPV was sold rather than the Chinese entity itself. As there was no direct disposal of a Chinese entity no tax arose on any capital gain.

There are two main issues in relation to indirect share transfers:

1) Reporting obligation

If a non-resident disposes of a China-resident enterprise via an indirect transfer of an offshore holding vehicle, the seller is obliged to report the matter to the SAT within 30 days of signing the equity transfer agreement, provided:

the offshore holding vehicle is located in a jurisdiction with an effective tax rate lower than 12.5%; overseas income derived by the offshore holding vehicle is not subject to income tax within its jurisdiction.

The seller is required to provide various documentation, including:

the equity transfer agreement ;the relationship between the offshore investor and the offshore holding company being transferred, with respect to capital, operational and sales and purchase activities; the business operation, personnel, accounts and assets of the offshore holding company; the relationship between the offshore holding company and China-resident enterprise, with respect to capital, operational and sales and purchase activities; and a reasonable explanation (with commercial substance) regarding the establishment of the offshore holding company that is being transferred.

It should be noted that the Circular 698 reporting requirement applies to ALL foreign investors who have indirectly transferred a Chinese resident enterprise. Therefore, even a small indirect ownership in the Chinese resident enterprise would be subject to the reporting requirements of Circular 698.

2) Taxation

Just because there is a reporting obligation, this does not mean that there is necessarily a tax obligation.

The SAT will review the documentation provided to determine whether the tax anti-avoidance rules contained in Circular 698 apply. Basically, the authorities will consider whether the indirect share transfer has reasonable commercial/economic substance. If it does not, the authorities may ignore the existence of the offshore holding vehicle that is being transferred and tax will apply in the same manner as if the transfer was a direct transfer.

In general, the SAT will consider the following factors when evaluating an equity transfer transaction from an anti-avoidance perspective:

• its form and substance;
• the date of its conclusion and the execution period;
• the method of implementation;
• the relationship among each procedure or part of the procedure; and
• the tax effects.

Hence, transferors are advised to keep detailed documentation to support the economic/commercial substance of the transaction.

3) RMB Funds

Many private equity firms are utilizing RMB funds, basically the ability to establish a private equity fund in China that makes direct acquisitions in China.  It’s not within the scope of this article to go into any detail but anyone who has used RMB funds or a dual structure involving offshore investment and RMB funds needs to be aware of a potential tax if RMB fund investments are listed as there are rumors that such a tax will be imposed and the rate could be as high as 35%.

As with all investments in China, careful upfront planning needs to be done and the structure needs regular reviews to ensure the strategy is still valid.

Conclusion

Circular 698’s effective date was backdated to 1 January 2008.  Investors who intend to restructure or make new investments in China should seek professional tax advice to ensure that their structure or transactions are tax-effective and are able to withstand any potential challenges by the SAT.

Companies who have entered into transactions during the last few years must review their details to ensure these past transactions do not fall foul of the new rules.

Those who intend to sell or acquire an offshore company with an underlying PRC subsidiary need to consider the risks associated with Circular 698 carefully.

Since the implementation of Circular 698, many multinational companies have raised concern that this may create uncertain tax exposure for companies aiming at undergoing genuine group restructuring for a valid business reason. The SAT is currently thinking of issuing clearer guidance to deal with the above situation.

Until the SAT has released that clarification, in consideration of other recent anti-avoidance announcements and the SAT’s efforts to improve enforcement, all companies need to review their existing structures as a matter of urgency.