Issues Affecting Cross-Border Mergers and Acquisitions in China

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By Eunice Ku, Cory Lam and Shirley Zhang

M&A-Regulations-in-ChinaApr. 8 – Along with the rapid development of China’s economy in recent years, there has also been an increase in inbound and outbound investments by both domestic and foreign investors, as well as corporate restructuring transactions to improve the operational efficiencies of these investments. Prior to 2008, a special purpose vehicle (SPV) was the most common structure used by foreign companies to hold direct investments in China. An SPV is a holding company set up by a foreign investor outside of China – usually in Hong Kong or other locations that boast notable tax advantages and favorable tax treaties with China – for the special purpose of holding equity interest in an onshore foreign-invested enterprise (FIE).

One of the advantages of using an SPV is that it may benefit from preferential withholding tax rates on dividends and other passive income under the tax treaties between China and the jurisdiction in which the SPV is located. For example, Hong Kong’s double tax agreement (DTA) with China reduces the withholding tax rate on dividends from 10 percent to 5 percent. In addition, the jurisdiction in which the SPV is located usually imposes low, or even zero, capital gains taxes on income from equity transfers. When the foreign investor disposes of the investment in China by transferring equity in the SPV (i.e., an offshore indirect equity transfer), the transfer is also technically exempt from capital gains taxes in China since both the seller and subject matter are located offshore.

However, in recent years, offshore equity transactions have been subject to heightened scrutiny by the Chinese tax authorities as the country strives to protect its tax revenues. The State Administration of Taxation (SAT) has specifically stated that one of its main tasks in 2013 is to enforce the collection of taxes derived from income from equity transfers.

A general anti-avoidance rule (GAAR) was first introduced in China under the CIT Law which came into effect in 2008. The GAAR empowers Chinese tax authorities to make reasonable adjustments where an enterprise implements an arrangement without reasonable business purposes in order to reduce its taxable income or profit. The CIT Law’s Implementing Rules provide that “an arrangement without reasonable business purpose” refers to an arrangement which has the main purpose of obtaining tax benefits such as the reduction, elimination, or deferral of tax payments.

The GAAR can thus be used as the basis for disregarding the existence of offshore holding companies that are perceived to be tax avoidance arrangements. In the following two tax cases reported at the end of 2008, the SAT indicated its intent to scrutinize the use of SPVs and to deny the tax benefits they obtain in China under certain circumstances.

The Chongqing Case
At the end of 2008, the Chongqing state tax bureau announced its decision to impose a withholding tax on the capital gains from the equity transfer of a Singaporean SPV to a Chinese buyer. In this case, a Singaporean parent company sold its wholly-owned Singaporean subsidiary – an SPV that held a 31.6 percent equity stake in a Chinese company – to a PRC buyer in May 2008. Based on the form of the transaction, it should not be subject to Chinese tax since it involves the transfer of a Singaporean subsidiary by a Singaporean holding company. However, upon finding that the Singaporean subsidiary had a very small amount of capital and did not carry on any business activity other than owning the shares of the Chinese subsidiary, the Chongqing tax bureau disregarded the SPV on the basis of lack of economic substance. As a result, the transaction was deemed a direct sale of the Chinese company by the Singaporean parent company, and the capital gains from the sale were subject to a 10 percent tax rate. The SAT reviewed and approved the case.

The Xinjiang Case
Also at the end of 2008, the SAT announced a case in Xinjiang pertaining to the prevention of tax treaty abuse. In this case, two Xinjiang companies jointly established a JV in 2003. In 2006, a Barbados company was set up by an American investment group. Soon after, the Barbados company and the two Xinjiang companies entered into an agreement to transfer shares in the JV company to the Barbados company. Less than a year later, the Barbados company re-transferred its shares in the JV company to one of the Xinjiang companies. The Barbados company derived US$12 million in capital gains from the transaction. To remit the income from the equity transfer, the payment entity requested the in-charge tax authority in China to issue a tax exemption certificate based on Article 13 of the China-Barbados DTA, which basically provides that this income is only taxable in Barbados.

However, the Xinjiang tax bureau held that the Barbados company is not entitled to capital gains tax exemption under the DTA. As the basis for this decision, the tax bureau said that a consularized document from the Chinese embassy in Barbados showing that the Barbados company was registered in Barbados was insufficient proof of tax residency. Through initiating exchange of information procedures under the DTA, information was obtained from the Barbados authorities showing that the Barbados company has no actual business and no tax obligations in Barbados. This led to the conclusion that it was not resident in Barbados for tax purposes. The tax bureau also referred to a lack of legitimate business purpose for the transaction. Capital gains tax was ultimately imposed on the proceeds from the share transfer.

Circular 2
Shortly after the announcement of these cases, on the basis of the GAAR provisions in the CIT Law and Implementing Rules, the SAT issued the “Implementation Measures for Special Tax Adjustments (for Trial Implementation) (‘Circular 2’)” on January 9, 2009 to, among other purposes, provide a stronger regulatory basis for disregarding a SPV that lacks economic substance. The areas specified for anti-avoidance investigation include:

  • Abusing tax treaties;
  • Avoiding tax through tax havens;
  • Abusing corporate organizational form; and
  • Other arrangements without reasonable business purposes.

Circular 2 empowers tax authorities to disregard the existence of an enterprise that has no economic substance and to annul the tax benefits obtained by such an enterprise – specifically enterprises established in tax havens that cause their related parties or non-related parties to avoid taxes.

Offshore Equity Transfer Reporting Requirements
At the end of 2009, China tax authorities further cemented their intention to scrutinize offshore indirect transfers of Chinese equity interests by non-resident enterprises by promulgating Circular 698. According to Circular 698, where an offshore equity transfer involves abuse of corporate organizational forms, and the arrangement has no reasonable business purpose except for the main purpose of evading the obligation to pay CIT, the tax authorities can deny the existence of the offshore holding company and impose a 10 percent withholding tax on the transfer.

Specifically, Circular 698 requires that, where an offshore controlling shareholder indirectly transfers equity in a Chinese resident enterprise, the Chinese authorities be notified within 30 days after the signing of the relevant equity transfer agreement if:

  • The actual tax burden in the jurisdiction of the offshore holding company is lower than 12.5 percent; or
  • The jurisdiction exempts taxes on foreign-sourced income.

Rather than simply relying on self-initiated disclosures by non-resident enterprises, tax authorities are now becoming increasingly adept at proactively collecting information from public sources for changes in company ownership, such as by reviewing press releases abroad and annual reports released by listed companies. To strengthen administration in this respect, the SAT and the State Administration for Industry and Commerce also established a platform for sharing information on equity transfers in 2012. Similar information exchange mechanisms have also been set up in certain regions such as Anhui Province.

When investors use holding companies in a tax treaty jurisdiction to affect their investments in China, they should ensure there is sufficient commercial substance, and they should develop relevant supporting documentation. Readers can download the April 2013 issue of China Briefing Magazine, titled “M&A Regulations in China,” for more information.

Transfer Pricing
Circular 698 also cross-references transfer pricing rules that will be applied by the tax authorities in dealing with the offshore indirect transfer of resident enterprises. According to Circular 698, where a non-resident enterprise transfers its equity in a Chinese resident enterprise to its related parties, the tax authorities are empowered to adjust the transaction price based on reasonable methods if it does not comply with the “arm’s length principle” and results in reduced taxable income. According to the CIT Implementing Rules, the arm’s length principle refers to conducting business according to fair value, as if between unrelated parties. Where transactions between an enterprise and its related parties do not abide by the arm’s length principle, the tax authorities are empowered to make tax adjustments within 10 years from the transaction year and claw back any underpaid taxes.

Corporate Restructuring Exemption
Circular 698 provides that, if a non-resident enterprise deriving capital gains from an equity transfer satisfies the conditions for corporate restructuring exemption under Caishui [2009] No. 59 (Circular 59) and chooses to adopt the treatment, it must submit written materials to the local Chinese tax authority to prove that the transaction meets the requisite conditions.

Special tax treatment applies to a reorganization satisfying all of the below conditions:

  • The reorganization has a bona fide commercial purpose and is not carried out to reduce, exempt, or defer any tax;
  • The assets or equity transferred in the acquisition is above 75 percent;
  • The original business of the enterprise remains unchanged for 12 months following the reorganization;
  • The equity consideration is at least 85 percent of the total consideration (for mergers, the alternative is where no consideration is paid and the companies in question are under the same control); and
  • The equity consideration received will not be transferred within 12 months after the reorganization.

Tax exemption is achieved through the carry-over of tax bases in the acquired shares or assets to the transferee, but only to the extent of the portion of the purchase consideration comprising shares. Gains or losses with respect to non-share considerations (e.g. cash, deposits, and inventories) would still have to be recognized at the time of the transaction.

Cross-border reorganizations would need to meet additional conditions in order for the exemption to apply, including a 100 percent shareholding relationship between the non-resident transferor and non-resident transferee when transferring a Chinese resident enterprise.

Note that when applying for corporate restructuring exemptions, a valuation report is required, which may trigger a challenge from the tax authorities on the valuation of a share transfer – particularly ones between related parties – and can therefore lead to unwanted investigations from the local tax bureau into the transfer pricing history of the group.

“Many of our clients in a global corporate restructure, and involved in an indirect share transfer, are usually not aware of the compliance requirements specified by Circular 698,” comments Richard Cant, Regional Director of Dezan Shira & Associates’ Shanghai Office. “For example, many assume that since the direct ownership of the WFOE has not changed, no reporting is required at all in China. It is important to be aware that tax authorities are now aggressively scrutinizing these transactions and there is a legal obligation to report them, or heavy penalties may be imposed.”

“In addition, the authorities could request that a full transfer pricing audit be done to ascertain the true value of the Chinese subsidiary, and can look back as far as the last 10 years of transaction history,” Cant adds. “What might have initially been considered as a minor sale of a subsidiary as part of a group reorganization transaction could evolve into a full China transfer pricing audit for the group. Although the tax bureau is only focusing on the bigger companies at the moment, it is very likely that the tax bureau will also impose this on smaller SMEs in the near future.”

In China, the valuation system for evaluating shares is still fairly premature when compared to the already established systems in the West. The major approaches used include the income approach, market approach and cost approach (or assets-based approach). In the past, net asset positions were used without question.

Nowadays, however, many tax officers will demand that the profits in the past, as well as potential future profits, be considered within the valuation. Existing Chinese tax laws do not regulate how valuations should be conducted for tax purposes, and the practice is thus highly inconsistent. In an effort to strengthen the area, many tax officers now tend to automatically demand that formal valuations be done by a qualified Chinese CPV firm to evaluate the fair market value of the subsidiary to be sold. This can result in additional costs for the company since CPV firms in China can be costly and, apart from the Big 4 firms, the majority of the smaller (and cheaper) Chinese CPV firms are still not equipped to handle complex valuation approaches. In addition, many tax officers in China will impose their own values when giving a decision on a deal. As such, this poses a significant impact on the tax risks for companies considering M&A transactions or corporate restructuring for their company.

“Many M&As are done through the purchase of the offshore holding company’s shares. As a result, filing under Circular 698 and the withholding of capital gain taxes are common discussion points with clients,” comments Chet Scheltema, Legal Affairs Consultant at Dezan Shira & Associates’ Beijing Office. “The Circular 698 filing may be made within 30 days after the sale and the subsequent tax assessment received after that, but the seller will have already received its money and ‘disappeared.’ To manage the risk of the Chinese tax authorities imposing tax on the unprepared purchaser, one should negotiate with the seller a mechanism to ensure potential tax liabilities are provided for.”

Portions of this article came from the April 2013 issue of China Briefing Magazine titled, “M&A Regulations in China.” This issue of China Briefing Magazine focuses on the regulatory issues affecting cross-border M&As, and the key tax points foreign investors should be aware of when conducting M&As involving domestic Chinese companies. We also address the key aspects of transfer pricing, corporate restructuring exemption, and valuation as they relate to M&As.

Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email, visit, or download the company brochure.

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