Anti-avoidance rules for offshore share disposals in China

Published 18 January 2011

The State Administration of Tax (“SAT”) has recently issued the circular Guoshuihan [2009] No.698 (“Circular 698”) addressing various tax issues for equity transfers by Non-China Tax Resident Enterprises (“Non-TREs”). One of the most important issues arising from Circular 698 is the indirect equity transfer undertaken by Non-TREs outside China (“indirect transfer”). Circular 698 takes retroactive effect from 1 January 2008 and covers taxation of Non-TREs which transfer non-listed shares of China Tax Resident Enterprise (“TRE”) or specific overseas intermediate holding vehicles with underlying TREs.

Submission of information on indirect transfer

Within 30 days of the signing of the equity transfer contract in relation to an indirect transfer transaction, Non-TRE(A) shall be obliged to submit the relevant information including the equity transfer contract and the relationship between Non-TRE(A) and SPV(B) to the Chinese local-level tax bureau in charge of TRE(C), provided that SPV(B)
is located in a country (or territory):
- where the effective tax rate is lower than 12.5%; or
- where the foreign income of TREs is not taxable.

Re-characterisation of equity transfer

If Non-TRE-A is considered as abusing the organisation form (i.e. establishing SPV(B) with no reasonable commercial purposes) in order to indirectly transfer the equity in TRE(C) for avoidance of PRC tax liabilities, the Chinese tax authorities may re-characterise the transaction under the principle of “substance over form”. Upon
successful challenge, the existence of SPV(B) in the transaction can be disregarded, and thus the offshore transfer could effectively be treated as a transfer of TRE(C)’s equity, the gains of which could be subject to PRC tax.

Observations

• Foreign investors shoulder a heavier tax compliance burden in relation to the equity transfers in China. The amount of information to be submitted to the Chinese tax authorities in relation to indirect transfers will likely be extensive.

• Foreign investors face greater exposure to the anti-avoidance rules and uncertainties in relation to indirect transfers. It is unclear how the Chinese tax authorities will administer taxation of such offshore transfers in practice. Where
transactions involve a large group of companies in a global merger and acquisition, the requirement to disclose all the information concerning the entire transaction may create an overwhelming administrative burden and could involve the submission of information that will be irrelevant to TREs. From the buyer’s point of view, the impact
and consequences of a seller’s non-compliance are not very clear.

Possible Actions

In view of the above challenges, foreign investors may wish to take the following actions:

•Review their past (i.e. after 2007), existing and contemplated investment structures, assess the potential tax exposures, take appropriate steps to mitigate the tax risks, get prepared for reasonable commercial reasons to substantiate the arrangements, etc.

•Clarify and discuss, directly or through intermediaries, with the Chinese tax authorities on uncertain areas in relation to the interpretation and implementation of Circular 698.

Having said the above, it is indeed a challenge to do so due to the lack of clear rules and the complexity of the issue.