Tag:tax-tax compliance and tax planning
(This article was originally published by ALM China Law & Practice on 25 November 2024)
Standfirst: Part I of this series introduced the implications of the amended PRC Company Law for Formal Capital Reductions. Part II will focus on the accounting and tax treatments of Substantive Capital Reductions, and analyze the tax risks of shareholders with regard to capital reductions not made at fair market value.
Summary
- Different from Formal Capital Reductions, Substantive Capital Reductions will lead to a net asset outflow from the company.
- As such, the tax treatment of shareholders under the Substantive Capital Reduction route will be more complicated.
I. The Accounting and Tax Treatments of Substantive Capital Reductions
In the case of Substantive Capital Reductions, shareholders may receive income from the company through the capital reduction, which is subject to corresponding tax implications. This leads to various tax and accounting implications for different types of entities, which differ from those encountered where a Formal Capital Reduction is used.
1. The accounting and tax treatments of the company
According to the relevant rules and regulations, when an enterprise repurchases its own stock on an open market for the purpose of a capital reduction, from an accounting perspective is only treated as a change in the Owner’s Equity. This means that the difference between the repurchase price and the original capital contribution does not have to be recorded in the profit and loss statement. From a tax perspective, the tax treatment of the difference between the repurchase price and the original capital contribution is consistent with the accounting treatment and no tax adjustment is required. As such, regardless of whether the capital reduction is made at book value, at discounted value or at premium value, there will be no tax implications for the company.
However, it should be noted that if the consideration for a capital reduction paid by the company consists of non-monetary assets, the company must treat them as deemed sales, which may give rise to value-added tax, land value-added tax, and enterprise income tax (“EIT”), etc., depending on the nature of the non-monetary assets.
2. The tax treatment of the shareholders
In the case of Substantive Capital Reductions, the tax treatment varies depending on the types of shareholders.
(1) Companies as Shareholders
The State Taxation Administration, Announcement on Several Issues Concerning the Enterprise Income Tax (Announcement of the State Taxation Administration [2011] No.34, “Announcement [2011] No.34”) provides that, “when an investing enterprise withdraws or reduces its investment from an invested enterprise, the portion of assets acquired by the investing enterprise equivalent to its initial capital contribution shall be recognized as a recovery of its investment cost; the portion equivalent to the accumulated undistributed profits and accumulated surplus reserves of the invested enterprise calculated by the proportion of the reduced paid-in capital shall be recognized as dividend income; the remaining portion of the assets acquired shall be recognized as income derived from transfer of investment assets.”
According to the above provision, for shareholders in the form of a company (i.e. a corporation or similar entity under the Enterprise Income Tax Act), the income obtained from a capital reduction is divided into three portions: a) the first portion is the recovery of the investment cost; b) the second portion is dividend income corresponding to the retained earnings; and c) the third portion is the property transfer income that remains after deducting the investment cost and dividend income.
For domestic shareholders:
Dividend income obtained by a resident enterprise from another resident enterprise is exempt from EIT. Therefore, dividend income that constitutes the second portion of income derived from the capital reduction is exempt from EIT.
On that basis, for domestic shareholders, only the property transfer income needs to be included in the taxable income for EIT purpose.
For non-resident shareholders:
However, the tax implications for shareholders of non-resident enterprises are not the same as for domestic enterprises. Non-resident enterprises are generally subject to withholding EIT at 10% for the dividend income they receive and are not eligible for the EIT exemption. Therefore, for the shareholders of non-resident enterprises, both the second portion of dividend income and the third portion of transfer income are taxable to withholding EIT at the rate of 10%, unless tax treaty benefits are applicable.
Nevertheless, it is also necessary to differentiate the nature of these two types of income. The reason is that, if the tax treaty benefit could be applicable, the applicable conditions of dividend income and property transfer income are different, as the dividend income is governed by the Dividends Article while the property transfer income is governed by the Capital Gains Article of the treaty.
Specifically, with regard to dividends, generally if the non-resident shareholder is the beneficial owner of the dividends and a company which directly holds at least 25% of the capital of the invested company paying the dividends, a preferential tax rate (e.g. 5%) could be applicable. (It should be noted that the conditions and the applicable benefits may vary in different tax treaties, and that the circumstances described here are only an example.)
With regard to the property transfer income governed by the Capital Gains Article, under certain tax treaties, if the non-resident shareholder, as recipient of the capital gain,at any time during a certain period (e.g. month) preceding the transfer, directly and indirectly held less than a certain ratio (e.g. 25%) of the invested company and the main value of the invested company does not come from the immovable assets, the property transfer income may be exempt from the withholding tax in China. (Again, these circumstances are provided by way of example only.)
(2) Individuals as Shareholders
The State Taxation Administration, Announcement on Issues Concerning the Collection of Individual Income Tax on Recoveries by Individuals from Terminations of Investments (Announcement of the State Taxation Administration [2011] No.41, “Announcement [2011] No.41”) provides that, “where an individual terminates the investment, joint venture, operational cooperation and other activities for various reasons, the funds received from the enterprise, cooperative project, other investors of the same enterprise or the other operational cooperators in the form of equity transfer income, liquidated damages, compensations, indemnities, and other items, are subject to individual income tax and shall be calculated as ‘property transfer income’. The formula for calculating the taxable income is: Taxable income = Total amount of recovered funds received as equity transfer income, liquidated damages, compensations, indemnities, and other items – Amount of the original actual contribution (investment amount) and related taxes and fees.”
For resident individual shareholders:
According to the above provision, for shareholders in the form of resident individuals, the income obtained from a capital reduction is divided into only two portions: a) the first portion is still the recovery of the investment cost; b) the second portion is the portion exceeding the investment cost, which shall be recognized as “property transfer income” and is subject to 20% individual income tax (“IIT”). Unlike EIT, in general, the applicable IIT rate for both dividends and property transfer incomes received by domestic individuals is 20%, so that there is no difference in tax burden if dividends and equity transfer incomes are not distinguished.
For non-resident individual shareholders:
Considering that Announcement [2011] No.41 defines the income received by individuals from capital reductions as “property transfer income”, the applicable article of tax treaty is the Capital Gains Article. If tax treaty benefit provided by Capital Gains Article under certain tax treaty could be applied, the non-resident individual shareholder may be exempted from IIT in China when the relevant conditions are satisfied.
If the tax treaty benefit cannot be applied, then the non-resident individual is subject to 20% IIT for the property transfer income. However, since the foreign individual shareholder is exempted from IIT on the dividends income derived from the invested enterprise, it might be an optimal choice if the invested enterprise makes profit distribution to the foreign individual shareholders first before making capital reduction if commercially feasible. Under this circumstance, the non-resident individual shareholder should be eligible to an exempted IIT treatment on the portion of dividend income, which should reduce the overall tax burden during the capital reduction.
(3) Partnerships as Shareholders
Compared to situations where the shareholder is a company or an individual, there is a lack of clear legal provisions for the tax treatment of capital reduction for partnerships as shareholders. In addition, the special nature of the partnership as a “flow-through entity” under tax law makes it even more difficult to determine the applicability of tax policies.
For domestic partnership shareholders:
Simply speaking, for the capital reduction income obtained by a partnership, after deducting the amount of investment costs, it is controversial in practice whether there is a requirement to distinguish the remaining amount between “dividend income” and “property transfer income” (which would be qualified as “business income”) in order to apply the corresponding tax policies at the partner level. The tax treatments of “dividend income” and “business income” are different for partnerships: the individual partner is subject to a 20% tax rate with regard to “dividend income” passing through the partnership, while the tax rate of “business income” is progressive from 5%-35%.
Therefore, if the portion of “dividend income” can be separated from the capital reduction income, the individual partner can apply the 20% tax rate accordingly. If not, then all income will be subject to the 5%-35% tax rate applicable to “business income”.
For non-resident partnership shareholders:
If the shareholder is a foreign partnership, the application of tax treaties is a more complicated issue.
Firstly, the qualification of the income derived from the capital reduction gains is a prerequisite for applicability of the tax treaty, as this decides which article is to be applied. Pursuant to relevant regulations, foreign partnership shareholders should be treated as non-resident enterprise under PRC enterprise income tax rules and apply with relevant tax policies. As such, Announcement [2011] No.34 should be applied to non-resident partnership shareholders and the capital reduction income will be distinguished into three portions of investment cost recovery, dividend income, and property transfer income.
Secondly, after qualifying the capital reduction gains, the next step is to determine under the Dividends Article and the Capital Gains Article whether the treaty benefit is applicable.
In light of relevant regulations, only when the partnership could be regarded as a resident of the other Contracting State can it enjoy the preferential tax treatment. The exceptions are a few tax treaties that use the flow-through rule, under which the partners of the partnership enjoy the treaty benefit (such as the tax treaties between China and France, Spain, Argentina, etc.).
In addition, with regard to the application of treaty benefits for dividends, it should be noted that the Dividends Article may explicitly state that the beneficial owner eligible for the preferential tax rate should be a company rather than a partnership, under which the partnership could not meet the requirement of the treaty.
II. Tax Risks of Not Reducing Capital at Fair Value for Shareholders
It is a controversial topic in practice whether there will be tax risks for shareholders when the capital reduction is not at fair value, since currently there are no clear legal regulations. The implications may vary depending on whether the shareholder is an individual or a company.
1. Individuals as Shareholders
Pursuant to the provisions of Notice [2014] No.67 (which governs the IIT treatment of capital reductions for individuals as it has replaced Notice [2009] No.285, which is specifically referred to in Announcement [2011] No.41), where the income from an equity transfer is significantly low without justified reasons, the tax authority has the right to assess the equity transfer income on a deemed basis. Generally, if the company does not hold any assets such as land use right, real estate, or intellectual property, etc., the tax authority may consider the income to be significantly low if the equity transfer price is lower than the corresponding proportion of the net asset value.
Capital reductions can be understood as the company repurchasing shares, and the repurchasing price is the shareholder’s income obtained from the capital reduction. If the capital reduction income obtained by the individual does not meet the fair value of the shares (e.g. the corresponding net asset amount), it may be assessed by the tax authority at a deemed basis based on the fair value, and levy IIT in accordance with Announcement [2011] No.41.
2. Companies as Shareholders
As for EIT, there is no clear guidance on the questions of whether an equity transfer income is at fair value or whether a low price is justified. With regard to capital reductions involving companies as shareholders, different local tax authorities may have different implementation attitudes as to whether it is necessary to assess whether the consideration for the capital reduction is at fair value.
In practice, some tax authorities take the view that in the case of proportional capital reductions, since the proportion of equity among shareholders will not change, the reduction will not constitute a transfer of benefits between shareholders. Therefore, the capital reduction income generally will not be adjusted and not taxed based on the fair value of the equity.
Nevertheless, under non-proportional capital reductions, since the proportion of equity among shareholders will change, if the capital reduction is not carried out at fair value, it may constitute a benefit transfer. In this case, the tax authorities may require the capital reduction income to be assessed based on the fair value of the shares, and levy EIT according to Announcement [2011] No.34.
It is underst that, regardless of whether the shareholder is an individual or a company, capital reductions should not simply be considered as an equity transfer and assessed based on the fair value of the shares. The transaction may be more complicated in practice, requiring a comprehensive analysis of the purpose of the capital reduction, whether the reduction and its related transactions are made with the intention of achieving a low-cost equity transfer, and whether it constitutes an obviously unreasonable benefit transfer. For transactions that clearly aim to avid tax, it is necessary to make adjustments accordingly. However, for transactions that are not for tax avoidance purposes and have certain reasonable commercial purpose, it is not appropriate to adopt a one-size-fits-all approach to make adjustments, so as to avoid affecting the normal capital movement of an enterprise.
III. Conclusion
In practice, there are diverse scenarios for capital reductions, and adjustments to any part of the transaction may potentially affect the tax implications. Therefore, due attention should be paid to the tax risks involved when planning capital reductions. The two parts of this article Tax Treatment of Capital Reductions: Part I Formal Capital Reductions, and Part II Substantive Capital Reductionshave provided useful references for relevant entities when making capital reductions after implementation of the new Company Law.
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