Stricter Provisions, More Detailed Guidance, Broader Scope:
Five years ago, Notice 698 came into effect. It reached certain sales outside China by non-Chinese companies (e.g., Delaware) of interests in other non-Chinese companies (e.g., Cayman Islands or Hong Kong) that hold property in a subsidiary in China. And it subjected capital gains realized from such sales (which would not otherwise be subject to Chinese income tax ) to tax as if the sale were a direct transfer of Chinese assets.
In a number cases, some widely publicized, the State Administration of Taxation (SAT) and local tax bureaus have collected substantial tax revenue from such indirect sale of Chinese assets. Based on these experiences, SAT issued Bulletin on Several Issues Concerning Enterprise Income Tax on Income from Non-Resident Enterprise Indirect Transfers of Property, Guoshuiju Gonggao  No. 7 (Bulletin 7), effective February 15, 2015, to replace the indirect transfer provisions of Notice 698.
With regard to the applicable tax, if the transfer of a non-Chinese company is treated as a direct transfer of assets in China, the part of the resulting capital gains attributable to such assets is subject to Chinese enterprise income tax. If the gains are effectively connected to an establishment or place of business in China, they will be included in the taxable income of that establishment or place. Otherwise, they will be subject to Chinese withholding tax on the gains, currently at the rate of 10%.
SAT’s new rules came into effect on February 15, 2015. A summary follows:
- The scope of Bulletin 7 includes transfers of both equity and similar interests in the offshore holding company, and is also expanded from indirect transfers of equity interests in China to include:
- assets of an establishment in China,
- real property in China, and
- equity interests of a Chinese resident enterprise (which may be established under the laws of another jurisdiction but resident in China).
- If the transfer lacks a reasonable business purpose, SAT may disregard intermediate subsidiaries and, if conditions in Bulletin 7 are met, tax the transfer as if it were the direct transfer of assets in China, i.e. SAT may subject the transfer to Chinese tax.
- Bulletin 7 lists factors to determine whether the transfer has a reasonable business purpose, all of which should be considered. In summary, they are:
- does the equity value derive mainly from Chinese assets?
- are the assets of the holding company mainly from equity in a company in or income from China?
- do the functions and risks of the non-Chinese holding companies justify their organizational structure’s economic substance,
- how long have the model and structure of the holding companies and the companies themselves existed?
- will foreign countries tax the transfer?
- is any tax treaty applicable?
- are other relevant factors present?
- Bulletin 7 includes several safe harbors. Transfers are assumed to have a reasonable commercial purpose if:
- the holding company is a foreign listed company and the transfer is made through the purchase and sale of shares on the market;
- the transfer would have been exempted from enterprise income tax in China if made directly; or
- they carry out a reorganization within a group where a) member of the group are related through at least 80% equity ownership (100% if more than 50% of assets are directly or indirectly owned real property in China), b) the China tax burden on a transfer that might occur after the reorganization is not reduced; and c) consideration consists solely of stock of the transferee or its parent company (not including a listed company).
- If a safe harbor rule does not apply, a transaction will be deemed to lack a reasonable commercial purpose if all of the following apply:
- 75% or more of the directly transferred company’s equity value is from the Chinese assets;
- at anytime within the 12 months preceding transfer, 90% of the directly transferred company’s investments (excluding cash) are in China or 90% or more of its income comes from China sources,
- although established outside of China, the functions and risks of the holding companies do not evidence sufficient economic substance; and
- the foreign income tax burden on the transfer is less than the Chinese enterprise income tax burden would be if the Chinese assets were directly transferred.
- Under Bulletin 7, the parties are no longer required to report the transfer, but they may do so. The transferee, transferor and indirectly transferred Chinese enterprise are all reporting parties.
- The transferee (payor) has a withholding obligation. Failure to withhold and pay tax on capital gains may result in penalties of 50% to 300% of the withholding amount. However, if the withholding agent submits the transfer documents to the relevant tax authority within 30 days following the transaction, the penalties may be reduced or waived.
- The transferor is directly liable to pay any taxes due that are not withheld and remitted to the tax authority by the transferee as withholding agent. If the taxes are not paid within seven days when due, the transferor must pay interest at the benchmark rate published by the People’s Bank of China plus five percent. If paid prior to that date, the five percent premium does not apply.
Bulletin 7 is well received to the extent it clarifies the parties’ rights and obligations and provides a detailed test for “reasonable business interest” and other terms. It does expand the scope of offshore transfers potentially subject to Chinese tax. It’s reach can come as a surprise to companies who hold equity in a wholly-owned subsidiary or joint venture for other purposes, such as limitation of liability or flexibility for financing or cooperation with other parties.
Questions? Please contact Allan Marson at firstname.lastname@example.org or +1 408-738-0592 #719 for a complimentary consultation on investing through a holding company in China, or buying or selling an indirect interest.