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| May 2007, Issue 11 |
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Implications of China's new Corporate Income Tax Law on foreign investors' merger and acquisition activities in China
Welcome to our recent series of News Flash focused on the newly promulgated Corporate Income Tax Law ("CIT Law") to be effective from 1 January 2008. The background, key features and our observations have been covered in the previous issues of News Flash:  Expand / Collapse
In this issue, we would like to share our insights on the implications of the new CIT Law on foreign investors' merger and acquisition ("M&A") activities in China.
Impact on choice of tax-efficient investment holding structures
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It is not uncommon to see foreign investors using offshore special purpose vehicles ("SPV") established in tax treaty countries for holding investments in China for various reasons. The major tax advantages may include:
- Favourable treaty withholding tax ("WHT") rates would be applicable to different forms of passive income, namely capital gain on direct disposal of investment in China, royalty, rental and interest up-streamed from a Chinese company. Some tax treaties offer exemption on capital gain that is restricted to non-real estate rich investee in China or without any restriction at all; and
- Subsequent disposal of the offshore SPV could be considered as an offshore transaction that would not be subject to China tax as capital gain, i.e. tax-efficient exit route.
Under the existing Foreign Enterprise Income Tax ("FEIT") law, WHT on dividends from foreign investment enterprises ("FIEs") to their foreign investors is exempted while WHT rate for other passive income is provisionally reduced from 20% to 10%. The new CIT Law states that the standard WHT rate will be 20%. However, it is silent on whether or not the existing dividend WHT exemption and rate reduction would be kept intact. It is merely stated that the State Council may make a call to exempt or reduce WHT for particular types of passive income.
Such uncertainty could significantly impact the after-tax return and cash up-streaming for foreign investors. Although it is envisaged that the Detailed Implementation Rules of CIT Law ("DIRs") (to be issued later in 2007) would shed light on this matter, it is still advisable for foreign investors to cope with future changes in tax law by using offshore SPVs established in favourable tax treaty countries for holding investments in China. Meanwhile, foreign investors should also take into consideration the tax resident enterprise ("TRE") concept and the general anti-avoidance provision that are newly introduced to the CIT regime.
Firstly, an offshore SPV with its "effective management institute" based in China shall be considered as an TRE and be subject to CIT in respect of its worldwide income. The term "effective management institute" will be defined in the DIRs. However, it is generally believed that, among other things, if the executive directors or senior management personnel are habitually residing inside China to exercise their general authority to manage and supervise the daily business affairs of an offshore SPV, it is possible that the offshore SPV be considered as an TRE for CIT purposes.
Secondly, the general anti-avoidance provision introduced in the new CIT Law will empower the Chinese tax authorities to impose adjustments to taxable revenue or taxable income for business transactions which are conducted without reasonable commercial purpose. It is possible that they may, by virtue of the general anti-avoidance provision, challenge the interposition of offshore SPVs by a taxpayer in the absence of a reasonable commercial purpose, but solely for the purpose of gaining treaty benefits.
In light of this new provision, offshore SPVs for investments in China should be established with reasonable commercial purposes. Hong Kong, being a well established international financial and business centre with her proximity to China, may be more defendable and favourable than other tax treaty locations for foreign investors to set up offshore SPVs for investments in China. Furthermore, foreign investors need to ensure that the "effective management institute" of these offshore SPVs be based outside China in order to avoid the aforementioned potential TRE exposures.
Contrary to an offshore investment holding structure, foreign venture capitalists may consider setting up a venture capital enterprise inside China to enjoy a particular tax incentive under the new CIT Law. A venture capital enterprise in China may claim a certain percentage of its investments in the industry sectors that are specially supported and encouraged by the State as credit against its own taxable income under the new CIT Law. Further details will be provided in the upcoming DIRs or follow-up tax circulars and notices.
Impact on deal structuring
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- Immediate impact on financial projections
The implications of the new CIT Law, including new tax rates, changes in tax incentives and grandfathering of existing tax preferential treatments may cause impact on after-tax earnings and cash-flow projections for potential target companies in China.
In addition, the annual tax filing period will be extended from 4 months to 5 months for FIEs under the new CIT Law. Dividend repatriation from China requires the provision of tax clearance documents from local tax authorities to the remittance banks in China, i.e. settlement of tax for annual tax filing. So, the dividend repatriation process would be deferred accordingly and may impact the cash-flow projections of potential target companies in China.
Furthermore, foreign investors may consider revisiting the after-tax earn-out arrangements of existing China investments to assess the impact of the new CIT Law on the performance indicator used to determine the earn-out payment unless EBIT is adopted.
- More equity deals or hybrid equity-asset deals to come as a result of acquisition of "Old FIEs"
For market entry to China, foreign investors often face the choices between acquiring an existing FIE and setting up of a new FIE.
Under the current FEIT Law, one of the merits for setting up a new manufacturing and export oriented FIE is to refresh the tax holiday entitlement. However, this merit would no longer be valid under the new CIT Law as the tax holidays for general manufacturing and export oriented FIEs will not be available. Rather, "Old FIEs" which are referred to those established prior to the promulgation of the CIT Law (i.e., 16 March 2007) may still be entitled to unused tax holidays.
In addition, the CIT rate will be set at 25% without differentiation in ownership and geographical location. Lower tax rates attributable to geographical location, e.g. Special Economic Zones and Pudong New Area, would no longer be available under the new CIT Law for new FIEs (after a transitional period). Rather, for "Old FIEs" which are currently subject to a lower FEIT rate, namely 15% or 24%, their CIT rates will be gradually increased to 25% over a 5-year transitional period.
Therefore, under the above grandfathering provisions for Old FIEs, a foreign investor may be able to inherit the existing tax preferential treatments by acquiring an "Old FIE" under an equity deal or a hybrid equity-asset deal. The latter refers to a share acquisition of an "Old FIE" followed by an asset or business injection to the "Old FIE". As this tax benefit would not be available otherwise to an asset deal, it is expected that more M&A transactions would be conducted as equity deal or hybrid equity-asset deal.
Despite the potential tax benefits arising from acquisition of an "Old FIE", it is possible that the upcoming DIRs or other tax rules may impose restrictions on the entitlement of grandfathering provisions for "Old FIEs" undergoing a change of ownership or control subsequent to the promulgation of the new CIT Law.
- Thin-capitalization rule imposing additional constraints for debt pushdown
The new CIT Law introduces a thin-capitalisation rule whereby interest for related party loans exceeding a certain threshold would be disallowed for tax deduction. However, this threshold is not defined under the new CIT Law. The terminologies, such as loan investments, equity investments, etc. are very broadly stated in the thin-capitalization rule which are subject to further clarification in the upcoming DIRs.
In any event, the thin-capitalisation rule, together with the existing restriction on foreign debt-to-equity ratio (issued by the State of Administration of Industry and Commerce), will impose additional constraints on the quantum of debt pushdown for leveraged deal structures.
- Uncertainty in tax free reorganisation
In certain cases, it may be necessary to undergo pre-deal corporate restructuring in order to carve out certain businesses from the deal under negotiation. The transfer price may equal to the cost of investment so that there would be no capital gain (or loss) on such transfer that may otherwise be subject to tax. According to a tax circular, Guoshuihan [1997] No. 207 ("Circular No.207"), a foreign investor may transfer its equity interest in an FIE at cost (i.e. no capital gain) to another investor, provided that certain conditions are met to ensure it is a bone fide group restructuring.
As the new CIT Law is silent on tax free reorganisation, it remains unclear whether it would be kept, or removed completely at all. However, since tax free reorganisation is a common international practice, it is more probable that it would be kept intact under the new CIT regime.
Impact on due diligence process and post-deal integration
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While historical tax exposures could largely be shielded under an asset deal structure, such exposures under an equity deal structure could only be mitigated by appropriate terms of tax indemnities and warranties in place under the sales and purchase agreement. As mentioned above, the new CIT Law may result in more equity deals and hybrid equity-asset deals in order to capture the potential tax benefits arising from acquisitions of "Old FIEs". Therefore, identification of key historical tax exposures during the due diligence process would be increasingly important for the purpose of obtaining tax indemnities and warranties.
Moreover, the new CIT Law may cause the following paradigm shift in the focus of China tax due diligence review:
- Robustness of tax incentives
The "Old FIEs" should have written approval documents issued by the in-charge tax authorities in place to confirm their entitlement of tax holiday and/or reduced tax rates so as to facilitate the administration of the grandfathering provisions. The robustness of tax incentives would become a main focus for tax due diligence review so as to confirm whether certain tax incentives would prevail under the grandfathering provision. It also poses a challenge to the buyer in the post-deal integration process that the acquired FIE be operated in a manner that could sustain the tax benefits throughout the grandfathering period.
The new CIT Law will introduce tax incentives in a variety of forms to FIEs and domestic enterprises ("DEs") engaged in particular industries or encouraged activities. The criteria that need to be satisfied in order to qualify for the tax incentives could be quite different from the existing ones. It is envisaged that an important part of the tax due diligence review will be the assessment of the tax incentive entitlement under the new rules. It should also add to the attention of the post-deal integration that the acquired entities or business ventures be capable of obtaining and enjoying these industry-focused and activity-oriented tax incentives.
- Anti-tax avoidance risk
One out of the four key themes of the new CIT Law is "Stringent Administration". Taxpayers are expected to observe a much higher standard in terms of tax compliance. Various anti-avoidance measures have been introduced to close loopholes in tax administration. Interest levy, comprising both components of time value of money as well as penalty, will be newly imposed to discourage aggressive tax avoidance schemes. Potential buyers should therefore factor tax non-compliance risks and interest levy in their deal consideration.
As mentioned above, a foreign enterprise with its "effective management institute" in China would be considered as an TRE that would be subject to CIT on worldwide income. Therefore, in any tax due diligence review, it is necessary to review the target's offshore structure to factor in the possible exposure of the offshore companies to TRE risk, if any.
Besides, in light of the general anti-avoidance provision, the onus of proof as to the reasonableness of a commercial transaction may rest with the target. It deserves the tax due diligence team's particular attention.
The imposition of new interest levy on transfer pricing adjustments (as well as on anti-avoidance adjustments) also signifies the determination of the Chinese tax authorities to counter such acts. It demands for a more sustainable transfer pricing policy to be applied consistently to the acquired entities.
Conclusion
There are many more tax issues and concerns for M&A activities than those stated in the above brief analysis. Some of these issues and concerns have been clarified under the current FEIT regime, but some still left unresolved.
While the new CIT Law has been refined to align with international practices, it merely serves as a legal framework for further elaborations. Hopefully the DIRs to be issued later in 2007 should help clarify some of the uncertainties. Based on the previous experience in China tax legislation developments, the upcoming DIRs may not provide a comprehensive set of solutions to all tax issues and concerns for M&A activities. However, it is expected to see more and more tax circulars and notices. Some of them may simply confirm the continuation of the previous tax treatments, and the others may provide new thoughts and clarifications on unresolved or new issues.
Obviously, M&A activities are not restricted to foreign investments. There are also a great deal of M&A activities among DEs and involving DEs. The CIT regime is aimed to unify the tax treatments for FIEs and DEs. So it is inevitable that the tax treatments for M&A activities need to take both into consideration. This would likely prolong the process of promulgation of tax treatments and involve more complex consultation.
Over the past 15 years or so, China has been the recipient of the largest foreign direct investments among developing nations. The Chinese Government has been emphasising the strategic importance of M&A in developing the country's economy and preferred industries. Hence, it is reasonable to anticipate that the CIT regime would be developed with an aim to smoothen M&A activities as far as CIT is concerned.
However, it is impractical for foreign investors in such vibrant M&A markets in China to wait for further clarifications to the new CIT Law until completely question-free. They have to make investment decisions based on the current status quo. In view of such a dynamic tax environment, foreign investors should closely monitor the latest developments in the CIT Law and the tax implications should be carefully assessed throughout various stages of the M&A process. |
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