China Tax/Business News Flash 

Special tax treatments for equity and assets acquisitions
  
Welcome to our News Flash series featuring the newly promulgated tax rules for corporate restructuring ("Restructuring Tax Rules") under the Notice entitled "Several Questions about Corporate Income Tax Treatments for Corporate Restructuring" - Caishui [2009] No. 59, ("Circular 59") promulgated by the Ministry of Finance ("MOF") and State Administration of Taxation ("SAT") on 30 April 2009.
      
The salient points, key features and our observations of the Restructuring Tax Rules in general have been covered in our News Flash Issue 11, May 2009.
    
In this Issue, we will discuss the tax treatments and share our insights specific to two types of corporate restructuring, namely equity acquisition and assets acquisition, under the Restructuring Tax Rules.
     
Prescribed conditions for special tax treatments
   
The general principle of the Restructuring Tax Rules is that gain and loss should be instantly recognized at the time of the corporate restructuring for the various forms of corporate restructuring.  While Circular 59 provides the rules on how to calculate the taxable gain and loss on a restructuring, it also allows special tax treatments which have attracted most of the attention.  Circular 59 stipulates that, if all of the following conditions can be satisfied, special tax treatments could be adopted:

1. Anti-tax avoidance: The equity/asset acquisition has to have reasonable commercial reasons and the main purpose of the corporate restructuring is not for tax reduction, avoidance or postponement of tax payment;
      
2. Significance: In an equity acquisition, the equity acquired should not be less than 75% of the total equity of the enterprise being acquired; whereas in an assets acquisition, the assets acquired should not be less than 75% of the total assets of the enterprise whose assets are being acquired;
      
3. Continuation of business: There should not be any changes in the actual business activities within 12 consecutive months after the restructuring;
     
4. Equity payment: The equity payment portion should not be less than 85% of the total consideration.  In other words, the non-equity payment portion (including cash, bank deposits, receivables, tradable securities, inventories, fixed assets, other assets and undertaking of liabilities, etc.) cannot exceed 15% of the total consideration; and
      
5. Continuation of shareholding: The original shareholder receiving the equity payment from the sale of equity/asset has to commit not to transfer those equity received within 12 consecutive months after the transaction.

As far as equity acquisitions and assets acquisitions are concerned, the special tax treatments are virtually tax deferral treatments by not recognizing the gains or losses at the time of the transactions.  Let us use some numerical examples to illustrate the key features of the special tax treatments in the case of equity acquisitions and assets acquisitions.
    
Equity acquisitions

• Election of special tax treatments
  
  
  The special tax treatments appear to be beneficial to the transferor as they would in general allow the transferor to defer the recognition of the transfer gains for tax (CIT) purposes.  However, it is not always the case.  For instance, in an equity acquisition, where the transferor is a tax resident in a tax jurisdiction which has the taxing right on equity transfer gain, e.g. Ireland, Barbados, Switzerland, etc. under their double tax treaties with China, the recognition of the equity transfer gain at the fair value, instead of original tax basis, upfront at the time of corporate restructuring would not result in China withholding tax.  Meanwhile, the tax basis will be stepped up in the hands of the transferee which may be in another tax jurisdiction which does not have the taxing right on equity transfer gain in its double tax treaty with China.  If special tax treatments are elected, then the intrinsic gain is not recognized by the transferor at the time of corporate restructuring; but inherited by the transferee.  When the transferee subsequently sells the equity at fair value, the intrinsic gain will be recognized and subject to China tax.
     
  Hence, it is important for the transferor, in each case, to consider whether it should elect special tax treatments or not.
    
  

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• Transferor may gain at the expense of transferee
  
  
  Under the special tax treatments for equity and assets acquisitions, the transferor can receive transferee's equity on a tax deferred basis at the expense of the transferee.  This is because the transferee would be saddled with the carryover basis of equity/assets being acquired.  Thus, if the transferee subsequently disposes of the acquired equity/assets (assuming it to take place after the 5 prescribed conditions are met), its gain on disposal will be measured by the excess of the proceeds it receives over the carryover tax basis, rather than the stepped-up tax basis under the general tax treatments.  It may also result in double taxation taking into account the tax on the potential gain to the transferor when it disposes of the equity received.
       
  Hence, the allocation of economic benefits and losses arising from tax deferral of equity/assets could become one of the key issues in price negotiation between buyers and sellers.
    
  

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• Prescribed conditions to be covered in sales and purchase agreements
  
  
  Special tax treatments for equity and asset acquisitions require both the seller (transferor) and buyer (transferee) to commit to certain conditions subsequent to the acquisitions.  For instance, there should be no change of the actual business activities of the equity/assets acquired by the buyer within 12 consecutive months after the restructuring.  On the other hand, the seller (transferor) receiving the equity-payment has to commit not to dispose of the equity received within 12 consecutive months after the restructuring.  Additional requirements are also imposed on cross-border equity acquisitions in order to qualify for special tax treatments.
       
  It is imperative that the sales and purchase agreements for equity and assets acquisitions qualifying special tax treatments should include appropriate tax warranties and indemnities to ensure that the prescribed conditions and additional requirements as mentioned above will be met by both the seller (transferor) and buyer (transferee) even after the restructuring.
    
  

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• No deferral of turnover taxes and transactional taxes for asset acquisitions
  
  
  Firstly, tax deferral benefits under special tax treatments are limited to CIT only.  In assets acquisitions, the seller (transferor) and buyer (transferee) of the assets is still subject to certain turnover taxes and other transactional taxes (e.g., business tax, value-added tax, consumption tax, deed tax, stamp duty, etc.) immediately upon the transfer based on the total consideration (including both equity payment and non-equity payment portion), irrespective of whether or not such an assets acquisition can qualify for special tax treatments for CIT purpose.
    
  

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• Differences between accounting books and tax books
  
  
  In an equity or assets acquisition qualifying for special tax treatments, the equity and assets acquired by the transferor and transferee may be recognized at the original tax basis for tax (CIT) purposes.  In some cases, the accounting books have to reflect the transactions at the transaction values, instead of the original tax basis.  This could result in a difference between the book cost and tax cost of the equity or assets being acquired.  Deferred tax (liabilities) may then have to be accounted for, where appropriate.
       
  In other cases, the accounting books may be allowed to account for the corporate restructuring at the original costs, while the general tax treatments have to be adopted instead of special tax treatments due to the non-compliance of the prescribed conditions.  Then similarly, there could be differences between book cost and tax cost.  Deferred tax (assets) may have to be accounted for, where appropriate.
     
  This implies that special tax treatments, where available and elected, may only provide a cash-flow (deferral) benefit as the accounting books may still have to reflect the deferred tax expenses.
    
  

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Conclusion
     
It is not uncommon for companies to undergo corporate restructuring including equity and asset acquisitions to achieve various business objectives.  For instance, a private company may acquire a public company to achieve "back-door listing" via equity acquisitions.  Successful companies with high price/earning ratios may use their shares as currency to acquire underperforming competitors for horizontal integration or to acquire suppliers / customers for vertical integration.
    
The Restructuring Tax Rules provide relief in the form of tax (CIT) deferral to taxpayers who would like to achieve these commercial objectives via equity and asset acquisitions under special tax treatment.  However, seller (transferor) and buyer (transferee) of equity and assets acquisitions should be mindful that special tax treatments may not always end up as a win-win situation for them.  As we have already mentioned above and also pointed out in the case of a cross-border share acquisition of a TRE from a non-TRE by a TRE (i.e. Type 2 cross-border corporate restructuring as mentioned in our News Flash Issue 11, May 2009) and assets acquisitions under special tax treatments, tax deferral treatment for the transferors could be granted at the expense of higher tax cost to the transferees in the future.
   
As the Restructuring Tax Rules provide the right for the parties involved to elect for special tax treatments, the pros and cons should be carefully assessed on a case-by-case basis before the seller (transferor) and buyer (transferee) mutually agree on whether or not to elect for special tax treatments.  Moreover, the sharing of economic benefits from special tax treatments between them may also become one of the key discussion points for deal pricing.
    
Although there are still certain unclear issues and a lack of guidance on compliance requirements from the Chinese tax authorities, it is just a matter of time for taxpayers involving in corporate restructuring to capitalize on the special tax treatments benefits under the Restructuring Tax Rules.  We will continue to keep an eye on further guidelines from the SAT, implementation rules and practices by local-level tax bureaux, and share with you in due course.
        
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