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STANDFIRST: Tax is a key consideration when divesting a foreign investment, with a number of implications for a company’s bottom line. This article highlights the main impacts when exiting a Chinese investment.
- There are a number of means by which a foreign investor can divest itself of a Chinese investment; each has different tax implications
- No matter the means chosen, tax aspects should be a particular consideration for foreign investors
- Key issues to take into account include ensuring fair market value prices are set, setting out a reasonable commercial purpose, and taking into account the cross-border position
- In the longer-term, an eye should be kept on compliance reviews by the authorities
There can come a time when, due to commercial arrangements, foreign investors may consider disposing of their investments or regrouping their investment resources in China. This could be by selling off properties, transferring shares/equities of Chinese enterprises directly or indirectly, divestment, or liquidating and deregistering the operational entities. Tax is one of the key factors to be assessed when making commercial decisions, and different tax considerations should be taken into account depending on the method of divestment.
I. Direct Equity Transfer by the Foreign Investor
Where the foreign investor directly holds a Chinese enterprise, the foreign investor may sell off its equity in the target company, which is a straightforward exit from a commercial perspective.
Generally, the equity transfer will be subject to income tax in China on the transferor’s income (if any) derived from the transfer. Where the transferor is a foreign enterprise, it will be liable for Chinese enterprise income tax (“EIT”) at 10%, and where the transferor is a foreign individual, he/she will be liable for Chinese individual income tax (“IIT”) at 20%, unless the applicable tax treaty provides preferential treatment. In addition, both the transferor and transferee will be respectively liable for stamp duty at 0.05% for the equity transfer. The key points to consider from the PRC tax perspective are as follows:
1. Sales price
For the purpose of tax assessment, the relevant PRC tax laws require the equity sales price to be in line with the fair market value (“FMV”). If the equity is sold at a price obviously lower than the FMV without reasonable commercial justification, the Chinese tax authorities are empowered to make tax adjustment and deem the taxable income based on the FMV of the sold equity.
As to the determination of the FMV, in general, the Chinese tax authorities may make reference to (i) the latest or recent net book value; (ii) a fair and appropriate appraisal report; (iii) the valuation as of the latest round of financing (if any); and (vi) the equity transfer price conducted in a recent period (if any), of the target company.
2. Deductible investment cost
The investment cost that is able to be deducted when computing the taxable income for the equity transfer is the capital injected by the foreign investor in the target company or the consideration paid by the foreign investor to the former shareholder under an equity acquisition. The Chinese tax authorities will usually request a payment certificate or written notes from the bank for review and assessment of the deductible investment cost.
If there has been intra-group restructuring of the transferred equity and special tax treatment (i.e. tax deferral regime) was applied, the deductible investment cost should refer to the original investment cost before such restructuring.
3. Tax filing procedure
The transferee of the equity transfer is the statutory withholding agent of the EIT or IIT payable by the transferor. If the transferee fails to withhold tax in due course, it may find itself subject to an administrative fine, in the range of 50% to 300% of taxes overdue.
In practice, where the transferee is a Chinese domestic party, the income tax payable should be withheld at the time of making the outbound payment or the due date of consideration payment. Where the transferee is also a foreign party, the transferor may usually make a voluntary tax filing to the Chinese tax authorities of its own volition. With respect to the voluntary tax filing, if the transferor is an individual, he/she should file an IIT return within the first 15 days of the month following the month in which the equity is transferred, or the equity transfer agreement takes effective, or consideration is paid; and if the transferor is an enterprise, a voluntary tax filing is encouraged such that there will no late payment interest due (because the relevant tax rules deem a voluntary tax filing as a timely filing of the EIT).
4. Application for tax treaty
If there is an effective tax treaty between China and the country where the foreign investor is a tax resident, preferential treatment pursuant to the treaty could be applied to the equity transfer, provided that relevant conditions are met. For example, under the China-Germany tax treaty, a German investor could be exempted from Chinese income tax for equity transfer in China provided that the total equity percentage of the foreign investor in the target company is less than 25% over the past 12 months and the target company is not a real property-rich entity.
The foreign investor is allowed to determine the applicability of the treaty treatment by self-assessment when making their tax filing. Related materials are required to be well kept (such as the financial materials of the target company, transaction documents, tax resident status certificate of the transferor, etc.). However, the Chinese tax authorities may conduct a follow-up administration review to determine whether the transferor is entitled to the treaty treatment.
Separately, if Chinese tax should be imposed on the equity transfer, the foreign investor may be able to apply for tax credit in its resident country by fulfilling the tax obligation and obtaining tax payment certificates in China.
5. Cross-border payment
If the transferee of the equity is a Chinese domestic enterprise or individual and the consideration needs to be paid abroad, there will be foreign exchange procedures to be followed. Pursuant to relevant rules, if a single installment of an outbound payment equals USD 50,000 or more, the payer should first file a record of cross-border payment with the Chinese tax authority, and then submit the record filing form and relevant documentation to the bank to apply for cross-border remittance.
II. Equity Transfer through an Onshore Holding Company
In practice, the foreign investor may have set up a Chinese holding company to make their investment in China. If the foreign investor would like to divest part of their portfolio while still retaining another part, or to leave room for future reinvestment in China, it may consider selling off the Chinese entity through the holding company but maintain ownership of the holding company. Such transaction structure involves China domestic equity transfer and cross-border dividend distribution.
1. First layer: equity transfer by the Chinese holding company
The equity transfer in this case is a pure domestic equity transfer, and the Chinese holding company is liable for EIT (usually at 25%) on its income derived therefrom, while both the transferor and the transferee are liable for stamp duty at 0.05%.
Attention should also be paid to the key tax issues such as the equity sales price and deductible investment cost, etc., in the same way as for a direct equity transfer by the foreign investor (described above). As to the tax filing procedure, the Chinese holding company should file the EIT return on a quarterly basis and make the annual EIT filing.
2. Second layer: dividend distribution from the Chinese holding company to the foreign investor
Upon settlement of the taxes with respect to the profit and subject to Chinese company laws, the onshore holding company is able to make dividend distribution to its offshore shareholder. Withholding income tax (“WHT”) should be withheld at the time of making dividend payment. The standard WHT rate is 10% if the dividend recipient is a foreign enterprise, and 20% if the dividend recipient is a foreign individual. If there is an applicable tax treaty between China and the country where the shareholder is a tax resident, a preferential tax rate may apply provided that the relevant conditions are met, of which the determination of tax resident status and beneficial owner status are the most critical. The relevant points of the application for tax treaty and cross-border payment are the same as those set out in the previous section.
In addition, a circular from 1994 provides tax exemption for dividend distribution from a foreign-invested enterprise to a foreign individual (Caishuizi [1994] No. 20). However, given it has been almost 20 years since the circular was issued, its actual implementation may vary from place to place and is subject to confirmation with the local tax authorities.
III. Indirect Equity Transfer through Offshore SPV
In terms of global structure, foreign investors with global investment commercial arrangements may hold their equities of Chinese subsidiaries through relevant offshore intermediate holding companies (“SPV”), among which Hong Kong[1], the British Virgin Islands (BVI), and the Cayman Islands are the most common, in terms of the feasibility of organizational management, capital flow, foreign exchange, and tax treatment.
Under such structure, the foreign investor may sell off the offshore SPV to indirectly dispose of its Chinese subsidiary. This type of transaction offers advantages in closing and foreign exchange between the parties, as well as convenience for the buyer’s restructuring or listing in the future.
1. Bulletin 7 tax filing obligation for indirect transfer
Pursuant to the PRC EIT Law and the State Taxation Administration (“STA”) Bulletin [2015] No. 7 (“Bulletin 7”) (关于非居民企业间接转让财产企业所得税若干问题的公告), where a non-resident enterprise indirectly transfers the Chinese taxable assets (e.g. the equities of a Chinese resident enterprise) through the implementation of an arrangement without reasonable commercial purpose which avoids the Chinese income tax liability, the Chinese tax authorities shall re-characterize such indirect transfer as a direct transfer of Chinese taxable assets for Chinese tax assessment purpose. Accordingly, any capital gain derived by the offshore entity seller from such re-characterized indirect transfer would be regarded as China-sourced income and be subject to income tax in China, with the general applicable tax rate at 10%.
As to the determination of whether the indirect transfer is of reasonable commercial purposes, Bulletin 7 provides a prescribed list of factors and certain safe harbor rules and rules related to blacklisted arrangements that should be evaluated when assessing whether an indirect transfer has a reasonable commercial purpose.
According to Bulletin 7, the parties to the indirect transfer of equities in a Chinese entity must make self-assessment as to whether the deal would be subject to tax under Bulletin 7. The transferee is obligated to withhold the income tax when paying the consideration to the transferor if it is determined that the deal would be subject to tax under Bulletin 7. Technically, if the transferee fails to withhold tax, the tax authority may impose an administrative fine, in the range of 50% to 300% of the tax overdue, on the transferee and may also recover the unpaid tax from the transferor since the transferor is the statutory taxpayer of the underlying tax liability.
It is worth noting that Bulletin 7 provides a voluntary reporting mechanism. That is, if the transaction parties are uncertain as to whether the deal would be subject to tax in China, they may voluntarily report the deal to the relevant Chinese tax authorities and provide the relevant documentation, including (i) the equity purchase agreement; (ii) the shareholding structure prior to and after the equity transfer; (iii) financial statements of latest two years with respect to the offshore target company being directly transferred as well as the Chinese subsidiaries being indirectly transferred; and (iv) a statement letter setting forth the grounds to demonstrate why the deal is not subject to tax under Bulletin 7 (if applicable).
With respect to the computation of Chinese taxable income under an indirect equity transfer, there are no prescribed rules, and in general practice there will be adjustment of the equity sales price offshore and assessment of deductible investment cost, to reflect income attributable to the Chinese equities. A detailed analysis and assessment should be made on a case-by-case basis and will be subject to communication with the Chinese tax authorities.
2. General anti-avoidance rule concerning foreign individuals’ indirect transfer
Although Bulletin 7 is applicable to a non-resident enterprise transferor, a non-resident individual transferor is also subject to an anti-avoidance assessment. The amended PRC IIT Law (中华人民共和国个人所得税法) provides clauses relating to general anti-tax avoidance in the IIT field, which means indirect equity transfer by foreign individuals should be subject to review from an anti-avoidance perspective. In practice, the Chinese tax authorities may make reference to principles set out in Bulletin 7 when assessing whether an individual’s indirect equity transfer has a reasonable commercial purpose.
3. Tax regulations in the offshore jurisdictions
Another factor to be considered when proceeding with an indirect transfer deal is the latest position under tax regulations and supervision requirements in the jurisdiction of the offshore SPVs. This may include, for example, Hong Kong’s foreign source income exemption (FSIE) regime which is effective from 1 January 2023, or the economic substance requirements in the BVI and Cayman Islands.
IV. Capital Reduction or Liquidation of the Chinese Enterprise
1. Capital reduction
Apart from selling off its equities in a Chinese subsidiary directly or indirectly, a foreign investor may also consider reducing or recouping the capital it contributed to the Chinese subsidiary.
In the event the investor is an enterprise, according to the PRC tax laws, the assets (including cash) obtained by the investor through the capital reduction or capital recoupment from the Chinese enterprise should be divided into three parts, among which: (i) the part which equates to the original capital contribution should be recognized as investment recovery, which is non-taxable; (ii) the part which equates to the cumulative undistributed profits and cumulative surplus reserve of the invested enterprise computed in accordance with the percentage of reduced paid-up capital shall be recognized as dividend income, which is subject to WHT at 10% (or preferential tax rate under an applicable tax treaty); and (iii) the remaining part, if any, will be recognized as income derived from equity transfer, which is subject to income tax at 10% (or preferential tax rate under an applicable tax treaty).
Where the investor is an individual, if the assets (including cash) he/she obtained from capital reduction or capital recoupment is higher than his/her original investment amount, he/she must pay IIT at 20% (or preferential tax rate under an applicable tax treaty) on the income it obtains; if the assets (including cash) obtained is lower than or equal to his/her original investment amount, he/she shall not be liable to pay IIT.
In practice, the Chinese tax authorities are likely to pay close attention to the reasonableness of capital reduction by a foreign investor in order to establish whether there is an intention to reduce or avoid a tax obligation in China.
2. Liquidation and deregistration
Under certain circumstances, the foreign investor may consider closing its subsidiary in China, and duly following liquidation and deregistration procedures.
For income tax purposes, the liquidation enterprise should be deemed as selling off all assets, paying off all debts, fulfilling the filing and payment of EIT for its liquidation income (if any), and finally distributing the remaining assets (if any) to the investor. The investor will be subject to income tax for income received from the liquidation enterprise.
Practically, when the invested enterprise applies for liquidation and deregistration, the tax authority in charge of the transaction will conduct a compliance review of all tax-related matters, usually covering a period of the past five years or from the establishment of the company. The invested enterprise should check in advance its compliance status in relation to taxes and invoices arising from its daily business activities, the IIT withholding and social security contributions for its staff, and inter-company transactions (particularly cross-border royalty payments, import or export of goods, etc.). The invested enterprise should also review its accounting books, financial statements, tax returns and bank statements, etc., to prepare for the tax deregistration review.
V. Observations
In view of cost-saving and tax risk mitigation, tax aspects should be a particular consideration when foreign investors are assessing the disposal structure. Foreign investors are advised to conduct tax due diligence on the Chinese invested enterprises, to work out a tax-optimizing approach within the legitimate scope. They should also pay close attention to the tax matters of the transaction in general.
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For the purposes of Chinese regulations governing foreign investments, companies registered in Hong Kong SAR, Macao SAR and Taiwan region are treated as "foreign".
