|Rocky T Lee|
In a circular issued on December 10 2009, the State Administration of Taxation (SAT) made clear its intention to target offshore transactions involving the indirect transfer of PRC enterprises (Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-Resident Enterprises Circular 698).
Circular 698 requires foreign (meaning offshore) companies and funds, which are non-China tax resident enterprises (non-TRE), to pay taxes in the PRC when selling or transferring equity of an intermediate offshore company, where the underlying intermediate offshore company directly or indirectly holds an interest (any assets, subsidiary, business operations) in the PRC.
Circular 698 applies in two scenarios, namely: (i) a direct transfer of a China tax resident enterprise; and an indirect transfer of such an enterprise by a non-TRE. A direct transfer occurs when a non-TRE transfers the shares of a PRC enterprise. An indirect transfer occurs when a non-TRE transfers the shares of an offshore company that holds a subsidiary in the PRC. Given the beneficial tax treatment, it is very common for foreign investors to utilise intermediate offshore holding companies or SPVs to hold PRC subsidiaries.
Circular 698 provides that if a non-TRE seller indirectly transfers a PRC enterprise using a business entity that lacks a reasonable commercial purpose, in an effort to evade paying PRC taxes, the PRC tax authorities can disregard the existence of the intermediate holding company for the purpose of calculating taxes.
If the intermediate holding company is disregarded, the transaction is effectively treated as a direct transfer. The offshore seller's capital gain (if any) from the sale will be treated as PRC-sourced income and will be subject to PRC income tax at a rate of 10%, or at a rate otherwise stipulated in an applicable tax treaty or arrangement.
Circular 698 does not address the consequences of non-compliance. However, the Law of the People's Republic of China of Tax Administration and Collection specifies a significant penalty for the non-payment of tax, namely 0.05% of the amount due per day (or 18.25% per annum), plus a penalty of up to five times the unpaid tax. The law also stipulates a penalty ranging from Rmb2,000 ($300) to Rmb10,000 for failure to comply with tax reporting obligations.
Although PRC tax authorities have various methods through which to identify an unreported indirect equity transfer, given the breadth and scope of Circular 698 the SAT will face challenges with regard to enforcement. This does not however alleviate the need for all companies to assure that their structures or transactions are compliant with Circular 698.
Specifically excluded from the scope of Circular 698 are gains derived from the buying and selling of the shares of PRC enterprises listed on a public stock exchange. However, it is unlikely that this exception would apply to shares listed on a stock exchange following their acquisition.
Having become effective on the implementation date of the Enterprise Income Tax Law, Circular 698 applies retroactively to any transfer after January 1 2008.
Rocky T Lee
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