China: China Taxes Private Equity Fund on Indirect Transfer of PRC Company

Originally published 22 June 2010

Keywords: China, taxes, private equity, indirect transfer, PRC company

On 18 May 2010, a well-known multinational investment group paid RMB173 million (approximately US$25.4 million) in taxes to the tax authority in the city of Jiangdu in the Jiangsu Province of China. The investment group (the "Seller") owned a subsidiary in Hong Kong ("HoldCo"), and HoldCo owned 49% interest in a joint venture in Jiangdu. In January, 2010, the Seller transferred its interest in HoldCo to the subsidiary of a US company (the "Buyer"), and the PRC tax was levied on the transfer of HoldCo.

This tax is the largest amount collected from a single, indirect transfer of a PRC enterprise, and the case represents a landmark win for the Chinese tax authority, who started their nationwide efforts to levy PRC taxes on indirect transfers of Chinese companies since the issuance of Circular 698 — Notice on Strengthening the Administration of Corporate Income Tax Concerning Equity Transfers by Non-resident Enterprises (GuoShuiHan [2009] No. 698) ("Circular 698").

Background on Circular 698

China imposes a 10% withholding tax on capital gains derived by non-resident enterprises from the transfer of equity interest in Chinese resident enterprises. A traditional tax planning strategy is to use an offshore holding company to invest into China and exit from China by transferring the offshore holding company without paying any PRC withholding tax. One purpose of Circular 698, among others, is to attack such planning strategy (for a more detailed discussion of Circular 698, please refer to our previous legal update at http://www.mayerbrown.com/publications/article.asp?id=8352&nid=6).

If a non-resident enterprise transfers an offshore holding company with an underlying PRC resident enterprise and the jurisdiction of the offshore holding company has an effective tax rate lower than 12.5% (half of China's 25% income tax rate) or does not tax its residents on overseas income, Circular 698 requires the non-resident transferor to provide certain documents and information to the tax authority responsible for the area where the underlying PRC resident enterprise is located. If the transferor is regarded as abusing the business structure (i.e. setting up holding companies without a business purpose) so as to indirectly transfer the PRC underlying enterprise to avoid PRC tax liabilities, the tax authorities may ignore the existence of the offshore holding company, treat the offshore transfer as a transfer of the underlying PRC resident enterprise, and impose withholding tax accordingly.

Circular 698 received lots of criticisms, and a major concern expressed is whether the Chinese government has the jurisdiction to tax non-resident enterprises in transactions that take place outside China. Many taxpayers adopted a strategy of "wait and see", and the case in Jiangsu set an important precedent.

The Jiangsu Case

The local authority in Jiangdu learned of the Seller's intention to transfer its interest in the joint venture company as early as the beginning of 2009 and formed a team of experts to keep track of the potential transfer. At the beginning of this year, the local tax authority found out that an indirect transfer had occurred outside China and requested information about the transaction from the Buyer and the Seller, including the share transfer agreement. The authority even went on the website of the US parent company of the Buyer to find out more information about the transaction.

Based on the information collected, the local authority concluded that HoldCo had no employees, no assets, no liabilities, no other investments and no other business operations and thus HoldCo did not have any economic substance. Therefore, the tax authority asserted that the transfer of HoldCo was in substance a transfer of the PRC joint venture company and should be subject to PRC withholding tax. The Seller argued that the Seller should have no obligation to pay PRC tax since the Buyer, the Seller and the immediate target company i.e. Holdco were all located outside of China, but such argument was rejected by the tax authority. Upon approval of the China's State Administration of Taxation, the local authority served a notice, requiring the Seller to pay PRC withholding tax on the transfer. After multiple rounds of negotiation, the Seller filed a tax return on 29 April 2010 and settled the payment on 18 May 2010.

Remarks

According to a provincial tax official in the Jiangsu Province, the significance of the Jiangsu case was not that China collected more taxes but, more importantly, was the message sent to multinationals that have made huge profits in China but tried to avoid PRC tax through the use of offshore special purpose vehicles. The way in which the local tax authority in Jiangdu actively pursued the case indicates a strong resolution on the part of the PRC tax authorities to scrutinise indirect transfers of PRC companies on the basis of Circular 698.

In 2008, the PRC tax law introduced a general anti-avoidance rule ("GAAR") for the first time, and the issuance of Circular 698 is just one of the applications of GAAR. GAAR has manifested itself in many other areas of PRC tax law, including the new tax rules on mergers and acquisitions and the new beneficial ownership requirement regarding the use of holding companies to benefit from lower withholding tax rates under treaties. It is therefore necessary to re-evaluate traditional tax planning techniques, many of which are no longer workable or need to be adjusted under the new regulatory regime.

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