New rules for indirect transfers by offshore parties
Changes bring greater clarity to reporting and taxation requirements when offshore parties indirectly transfer Chinese entities.
China’s State Administration of Taxation (SAT) has released Announcement 7 Matters of Corporate Income Tax on Indirect Transfer of Properties by Non-Resident Enterprises, which took effect in February 2015. These new measures replace those of Circular 698. The announcement details the “substance over form” approach to the determination of tax liability and also expands on the types of transferred Chinese entities affected by the rules. Least attractive in the new measures is the introduction of a tax-withholding scheme that potentially increases the offshore buyer’s liability, while also increasing the offshore seller’s risk of incurring tax-related penalties.
Affected transactions in Announcement 7
In contrast to Circular 698, Announcement 7 applies to the indirect transfer of “properties of an establishment or place in China, immovable properties in China, equity investments in Chinese tax-resident enterprises, and other properties” which collectively are referred to as Taxable Properties in China (TPC). As illustrated below, the measures specifically apply to any transaction in which a Non-Resident Enterprise (NRE) transfers all or part of its equity or similar interests in another overseas enterprise, and this Transferred Overseas Enterprise (TOE) in turn directly or indirectly owns TPC.
The language of Announcement 7 extends the rules beyond the mere purchase and sale of equity or interest in a TOE that holds TPC. Now any indirect transfer that has a similar result to that of a direct transfer transaction is captured. This includes any corporate reorganisation through which a change of TOE shareholders occurs.
Example of indirect transfers affected by Announcement 7
Reasonable commercial purpose
Unlike Circular 698, Announcement 7 goes into great detail as to what does and does not constitute “reasonable commercial purpose”.
Firstly, tax officials must examine in detail several key aspects of the TOE, such as its location, organisational structure and the portion of TOE assets or value directly or indirectly attributable to the TPC. In cases where a high percentage of TOE assets are derived from the TPC, or where the TOE functions and risks are inconsistent with the organisational structure, the transaction is automatically considered to lack reasonable commercial purpose.
Conversely, an indirect transfer of TPC is automatically deemed as having reasonable commercial purpose if the NRE and the buyer of the TOE have certain shareholding relationships, such as the NRE owning all or most of the buyer, or vice versa, and if 100% of the consideration in the indirect transfer is in the form of equity. Other conditions may also apply, depending on circumstances.
Certain safe harbor transactions are also listed, for example when the NRE transfers TOE shares on a public securities exchange (excluding IPOs), where an NRE group reorganisation meets certain criteria, or where a direct transfer treatment renders eligibility for relief under provisions of a tax treaty.
Withholding tax and reporting requirements
In cases where an indirect transfer involves TPC that is a tax-resident establishment or a place subject to Chinese Enterprise Income Tax (EIT), the establishment or place must include the income from the transfer in its current EIT filing. This requirement not only ensures payment of relevant taxes by the tax-resident TPC, but also forces further reporting about the transaction, especially if the overseas parties wish to argue that the transaction should benefit from tax deferral, reduction or exemption.
Where the transfer involves TPC that is subject to EIT only under these new measures, the buyer (or other party that is obligated to pay the NRE) must act as the withholding agent and immediately remit the tax payment to the in-charge tax authority in China. If the buyer fails to withhold the tax from its payment to the NRE, the NRE must report the transaction and pay the tax within seven days. Relief from late payment penalties may apply if proper documentation is immediately submitted.
Regardless of the type of transaction, the parties must submit substantial documentation if making a claim that Announcement 7 taxation does not apply. The documents should evidence the transaction’s reasonable commercial purpose, the planning and decision-making process of the NRC and/or group, TOE financial statements, TOE and TPC assets valuation reports and so on.
Announcement 7 has a double-edged sword effect. On one side the comprehensive definitions and instructions provide significant clarity as to how Chinese tax authorities will examine indirect transfers of TPC. This should assist all transaction parties to prepare appropriate documentation in advance, to support their tax positions. On the other side, the new withholding tax and EIT filing regulations will often result in taxes being paid before the parties have had an opportunity to argue a case for reduction or exemption.
Even with the clarity offered in Announcement 7, it remains to be seen how the rules will play out in practice. For example, most tax bureaus in the country currently have no mechanism for direct payment of taxes by overseas parties, thus the deadlines for remittance may frequently be exceeded. Also, while early filing of documentation may exempt transaction parties from penalties when tax payments are overdue, an excessive burden of responsibility may rest with the buyer. Certainly during the planning stages for an indirect transfer of TPC, the transaction parties should seek the assistance of an experienced tax consultant in China.
For more information, contact:
Nexia TS, China
T (86) 156 1833 1281
Nexia TS, China
T (86) 6390 6000 (ext. 217)