China Tax/Business News Flash 

Circular 698 covers generally the taxation for gains arising from transfer of the equity of a Chinese Tax Resident Enterprise ("TRE", herein as "Chinese investee company") directly or indirectly by Non-TREs.  However, gains derived from buying and selling of shares of listed Chinese investee companies in public stock exchanges are explicitly excluded from the scope of Circular 698.

Close

The taxable equity transfer gain shall be calculated based on the following formula:
   
Equity transfer gain = equity transfer price - cost of equity investment

• Equity transfer price refers to the sales consideration received by the transferor in the form of cash, non-cash assets, equity, etc.  The retained earnings (including undistributed profits and other after-tax reserve funds), if any, of the Chinese investee company which is being transferred along with the equity to the transferee should not be deducted from the transfer price;
     
• Cost of the equity investment refers to the capital injected by the Non-TRE transferor on setting up the Chinese investee company; or the consideration originally paid by the Non-TRE transferor to acquire the equity of the Chinese investee company.

For the purpose of calculating the equity transfer gain, the equity transfer price and cost of equity investment should be determined based on the currency used by the Non-TRE transferor in making the original equity investment in the Chinese investee company or in paying for the purchase consideration on acquiring the Chinese investee company.

Close

• In a related party equity transfer, the relevant transfer price of the equity being transferred should observe the arm's length principle.  Otherwise, the Chinese tax authorities can adjust the transfer price based on reasonable methods.
     
• In a multi-target equity transfer, where the Non-TRE transferor transfers the equity of more than one Chinese or overseas company at the same time, the Chinese company should obtain and provide the master equity transfer agreement or relevant sub-agreement to its in-charge tax authority.  Also, the equity transfer price of the Chinese company should be specified in order to determine the equity transfer gains in relation to the Chinese company.  If the said transfer price is not specified in the transfer agreements, and the Chinese company cannot accurately apportion the transfer price, then its in-charge tax authority is empowered to determine the transfer price based on reasonable methods.

Close

• Where the withholding agent is failed or unable to withhold China withholding tax ("WHT") on the transfer gains derived by the Non-TRE transferor, the Non-TRE transferor shall self-declare and settle WHT to the tax authority in charge of the Chinese investee company within 7 days after the date of equity transfer as stipulated in the relevant agreement or the date on which the Non-TRE transferor receives the proceeds of equity transfer, whichever is earlier.
     
• If the equity transfer satisfies the prescribed criteria for Special Tax Treatment as stipulated in Caishui [2009] No.59 ("Circular 59") [note 1], Circular 698 now stipulates that the Non-TRE transferor may elect for the Special Tax Treatment upon approval by the tax authority at the provincial levels.

[note 1]: Circular 59 entitled "Notice Regarding Certain Corporate Income Tax Treatments of Enterprise Restructuring" was issued jointly by the SAT and Ministry of Finance on 30 April 2009.

Close

Under the former FEIT regime, where Non-TREs transferred its equity in a Chinese investee company, the retained earnings could be deducted from the transfer price in calculating the gains.  Circular 59 which has addressed CIT treatment for corporate restructuring is silent on this calculation.  Now Circular 698 clarifies that, under the CIT regime, the retained earnings of the Chinese investee company being transferred cannot be deducted from the transfer price.
   
Apparently, this will not be welcome by Non-TRE transferors, because double taxation may arise where the retained earnings are effectively taxed upon equity transfer (as part of the transfer gain) and then may be taxed again later when they are distributed to the new shareholders (as dividends) after the transfer.  Of course, an effective way to resolve this potential double taxation issue is to distribute the retained earnings before the equity transfer, where commercially viable.
   
Circular 698 also clarifies that, for purpose of calculating the equity transfer gains, the currency used by the Non-TRE transferor in making the original equity investment in the Chinese investee company (either upon set-up or acquisition) will be adopted to determine the transfer price and cost of equity investment.  For instance, if a US investor set up a Chinese company by injecting capital in USD, then the USD should be adopted to determine both the cost of equity investment and transfer price, and thus the gain in USD.  The gain in USD would then be converted to RMB for WHT clearance.  At times when RMB keeps appreciating, the gains calculated under this approach would result in more WHT to be paid by the Non-TRE transferor.

Close

The literary reading of Circular 698 suggests that multi-target equity transfer can occur in either a direct transfer or indirect transfer.  Direct transfer refers to the situation where  the Non-TRE transferor is selling a group of companies which include one or more Chinese companies, while indirect transfer refers to the situation where the Non-TRE is selling a foreign holding company which holds Chinese and foreign companies.
   
In indirect transfer cases, the relevant provisions in Circular 698 regarding indirect transfer have to be applied first to determine whether the foreign holding company should be disregarded.  Only when the foreign holding company is disregarded, would the transfer prices of the underlying Chinese investee companies need to be determined in order to assess the accurate amount of WHT to be paid by the Non-TRE transferor in respect of the gains arising from transferring (indirectly) the Chinese investee companies.  Hence it would also be important that the transfer prices of the Chinese investee companies be specified in the master equity transfer agreement or the relevant sub-agreement.  Otherwise, the Chinese tax authorities may assess the transfer prices of the Chinese investee companies using their own methods if they consider that the overall transfer prices cannot be apportioned accurately.  Obviously, whether the foreign holding company should be disregarded or not could be very controversial (please refer to our News Flash [2009] Issue 27 for more detailed analysis on the topic of indirect transfer).

Close

Equity transfer is one of the forms of corporate restructuring addressed in Circular 59 (please refer to our previous News Flash [2009] Issue 11 and Issue 15 for more detailed analysis on Circular 59).  Circular 698 should merely provide some further detailed implementation rules for equity transfer by Non-TRE.  It is worth noting that, for corporate restructurings qualifying for the Special Tax Treatments, Circular 59 only requires the relevant parties to file documents with the in-charge tax authority for records.  However, Circular 698 seems to indicate that for a cross-border equity transfer involving Non-TREs, approval of the provincial-level tax authority should be required in order to qualify for the Special Tax Treatments.  This means that Circular 698 has escalated the administrative requirement for an equity transfer where the transferor is a Non-TRE.  We believe that this is to better protect China's taxing right on the transfer of Chinese equities.

Close

The compliance requirement of Non-TRE transferor set out in Circular 698 is consistent with that under another circular Guoshuifa [2009] No.3 ("Circular 3") [note 2] issued by the SAT in January 2009.  While Circular 3 sets out the general requirements for withholding at source on various types of China-sourced passive income of Non-TREs, Circular 698 is only on equity transfer gains.  In other words, where Circular 698 is silent or unclear, the relevant provisions in Circular 3 should apply.
   
For instance, if the Non-TRE transferor fails to fulfill the self-reporting obligation as per Circular 698, the Chinese tax authorities may, relying on Circular 3, require the Chinese company whose equity is being transferred to assist in collecting the WHT from the Non-TRE transferor.  Meanwhile, if the Non-TRE has other China-sourced income, the Chinese tax authorities may even require the other Chinese payers to withhold the unpaid tax and relevant surcharge from their payments to the Non-TRE transferor.

[note 2]: Circular 3 entitled "Notice Regarding Issuance of <Provisional Administration Measures of Withholding at Source for Non-Tax Resident Enterprises>" is issued by the SAT on 9 January 2009.

Close