May 01, 2010

Circular on Strengthening the Administration of Enterprise Income Tax on Income from Non-Resident Enterprises' Equity Transfers

Issuing Body: State Administration of Taxation
Issuing Date: December 10, 2009
Effective Date: January 1, 2008

Continuing China's broad effort to crack down on tax avoidance by foreign investors, late last year the State Administration of Taxation (SAT) issued a circular designed to collect tax on income derived from the transfer of equity in Chinese resident enterprises by offshore holding companies. Enacted on December 10, 2009, the Circular on Strengthening the Administration of Enterprise Income Tax on Income from Non-Resident Enterprises' Equity Transfers (Equity Transfer Circular) is retroactive for two years, to January 1, 2008. It excludes income from the purchase and sale of stock in Chinese-resident companies listed on a public exchange.

China Law Update has recently summarized other legislative efforts to strengthen tax collection efforts in China, such as the Circular on Interpretation and Determination of "Beneficial Owners" Under Tax Treaties and the Provisional Measures for the Administration of Taxation of Foreign Enterprises' Resident Representative Offices.

Issuance of the Equity Transfer Circular has raised concern among foreign investors in China, as it could greatly affect cross-border equity transfer transactions, especially those that involve indirect equity transfers by offshore holding companies. The long reach of the Equity Transfer Circular back to January 2008 has also caused concern.

Transactions Affected by the Equity Transfer Circular

Many foreign investors in China establish offshore companies to hold their Chinese investments, usually in locales such as Hong Kong or the Cayman Islands that have favorable tax structures. Before passage of the Equity Transfer Circular, when the foreign investor sold its stake or otherwise transferred its equity in that offshore holding company, the income derived from that transfer did not trigger taxes under PRC law because the transaction technically took place entirely outside China.

The Equity Transfer Circular is designed to tax the income of such holding companies, which typically have no substantial business operations and are known as special investment vehicles (SPVs).

Reporting Obligations of the Ultimate Seller

In accordance with the Equity Transfer Circular, when an indirect transfer transaction occurs, the ultimate seller (i.e., the owner of the SPV/holding company) is under certain circumstances obligated to report the transfer to the local tax bureau with jurisdiction over the Chinese target company within 30 days after execution of the equity transfer agreement. This obligation applies if the tax jurisdiction where the SPV is located does not levy taxes on the foreign income of its tax residents, or its tax rate on such foreign income is lower than 12.5 percent.

This reporting obligation is intended to help Chinese tax authorities detect "suspicious" indirect transfers that may involve tax avoidance. The ultimate seller must submit extensive documentation to the Chinese tax agency, including:

  • The equity transfer contract or agreement
  • Description of the relationship between the ultimate seller and the SPV in respect of financing, operation, sales, purchase, and other aspects
  • Statement of the operation, personnel, finance and properties of the SPV that was transferred
  • Summary of the relationship between the transferred SPV and the Chinese target company in respect of financing, operation, sales, purchases, and other aspects
  • Statement describing the reasonable commercial purpose of the establishment of the SPV by the ultimate seller
  • Other documents as required by the local tax bureau

Review of the Indirect Transfer

Based on the facts disclosed in the ultimate seller's report to the Chinese tax bureau, officials will review the nature of the transfer. If the seller is found to have transferred equity in the Chinese company via an abusive arrangement (such as establishing the SPV only to avoid paying Chinese enterprise income tax, without a reasonable commercial purpose), the Chinese tax bureau could, upon reporting the indirect transfer to State Administration of Taxation, redefine the nature of the transaction based on its "economic substance" and deny the existence of the SPV. In that circumstance, the ultimate seller will be considered to have directly transferred the equity of the Chinese target company to the buyer, and therefore the transaction will be subject to China's enterprise income tax on gains from the transfer.

Calculation of Equity Transfer Gains

In addition to the reporting obligation and review of the indirect transfer, the Equity Transfer Circular also provides general principles for determining gains from an equity transfer. The gains from the equity transfer that are taxable under Chinese tax law shall be calculated based on the balance of the equity transfer price minus its cost:

Taxable equity transfer gain = equity transfer price - cost of equity.

For tax purposes, the equity transfer price should include the sales consideration received by the transferor in the form of cash, non-monetary assets, equity, and other valuable interests or considerations. Retained earnings (including undistributed profits and other after-tax reserve funds) of the Chinese target company, if transferred along with equity to the purchaser, should not be deducted from the transfer price. Cost of the equity refers to the capital amount paid by the transferor upon setting up the Chinese target company or the consideration actually paid by the transferor to the original shareholder when acquiring the Chinese target company.

Adjustment of the Transfer Price

In the event of an equity transfer between affiliated parties, if the transfer price of the equity being transferred is not consistent with that which would be paid by an unaffiliated party in an arm's-length transaction (the arm's length price), the Equity Transfer Circular empowers Chinese tax authorities to adjust the transfer price for purposes of calculating taxes, based on "reasonable" methods.

In the event of a transaction in which the transferor transfers the equity of more than one Chinese or offshore company simultaneously, the Chinese target company should submit both the master equity transfer agreement and relevant sub-agreements to the competent tax authority. If no sub-agreements can be provided, the Chinese target company is required to submit detailed information on all transferred companies involved, then to apportion the transfer price and specify the equity transfer gains in relation to the Chinese company. Otherwise tax authorities are empowered to determine a transfer price, again based on "reasonable" methods.


The Equity Transfer Circular no doubt imposes burdensome obligations on non-Chinese-resident companies that are involved in equity transfer transactions. The legal basis for Chinese tax authorities to challenge transactions that take place in another jurisdiction is questionable, and interpretation of the circular by local tax bureaus may differ greatly, but it is advisable for foreign investors at the very least to reassess existing SPVs, including, for example, their "reasonable commercial purposes" and the tax burden of the jurisdiction in which the SPV is registered for compliance with the Equity Transfer Circular.

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