August 01, 2010

Case Report: First Tax Case Relating to Indirect Equity Transfer Deals

Issuing Body: Jiangdu Tax Bureau
Issuing Date: June 8, 2010

Some six months after China's State Administration of Taxation (SAT) cracked down on attempts to evade taxes via the indirect transfer of equity in holding companies, a real-life case involving taxation of an indirect equity transfer has been reported on the website of a local tax bureau in Jiangdu, Jiangsu Province (the Jiangdu Case). The Jiangdu Case appears to be the first published example of a successful effort by Chinese tax authorities to capture revenue from an indirect transfer since SAT released the Circular on Strengthening the Administration of Enterprise Income Tax on Income from Non-Resident Enterprises' Equity Transfers (Equity Transfer Circular) in December 2009.

 The Equity Transfer Circular—also commonly known as Circular 698—was designed to tax income generated by the indirect transfer of equity in holding companies (a commonly used investment tool), which are usually based in locales, such as Hong Kong or the Cayman Islands, that have favorable tax structures. Such holding companies, which typically have no substantial business operations, are known as special investment vehicles (SPVs). The Equity Transfer Circular imposed a reporting obligation on the ultimate seller (i.e., the owner of the SPV/holding company) under certain circumstances after an indirect transfer transaction occurs. 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 if its tax rate on such foreign income is below 12.5 percent.

In accordance with the Equity Transfer Circular, based on the facts disclosed in the ultimate seller's report, officials in the Chinese tax bureau will review the transfer, looking primarily at the nature of the SPV. If the tax bureau determines that the SPV in the transaction was established only to avoid China's enterprise income taxes and has no reasonable commercial purpose, the Chinese tax bureau could, upon reporting the indirect transfer to SAT, redefine the nature of the transaction, effectively denying the existence of the SPV. In such a circumstance, the transaction will be subject to China's enterprise income tax of 10 percent on gains from the transfer.

Facts of the Jiangdu Case

In the Jiangdu Case, it has been reported that the ultimate seller, a well-known U.S. fund, co-owned a joint venture company in Jiangdu municipality through its wholly owned Hong Kong intermediate holding company (SPV/special investment vehicle). The U.S. fund held 49 percent of shares in the company. In early 2009, during the course of normal tax administration procedures looking at the joint venture company in question, the Jiangdu Tax Bureau became aware that the ultimate seller might dispose of its equity interest in the joint venture through an indirect transfer, and it reported the case to its supervising tax bureaus and SAT. The ultimate seller transferred shares of the Hong Kong SPV to another U.S. purchaser in January 2010, soon after SAT issued the Equity Transfer Circular.

The Jiangdu Bureau investigated the transfer, mainly by reviewing the Equity Transfer Agreement and other supporting documents, but also by reading news reports on the seller's and buyer's websites. The tax authorities concluded that the Hong Kong-based SPV was without "substance" and thus should be disregarded, as it had no employees, assets, or liabilities; no other investments; and no other business other than the investment in the joint venture company. The Jiangsu Tax Bureau and SAT confirmed the Jiangdu bureau's determination and ruled that the transaction should be subject to income taxes in China on capital gains deriving from the indirect transfer. After several rounds of negotiation, the ultimate seller agreed to file a tax return and paid taxes amounting to RMB173 million (roughly US$25 million).

Analysis of the Jiangdu Case

The Jiangdu Case illustrates that, while the Equity Transfer Circular imposed a reporting obligation on ultimate sellers, such reports are not the only way for local tax bureaus to detect indirect transfer cases. In the Jiangdu Case, the indirect transfer came to the attention of Chinese tax authorities when the Jiangdu Tax Bureau carried out normal administrative procedures involving the joint venture company—even before the indirect transfer took place. After completion of the indirect transfer, the Jiangdu Tax Bureau managed to collect information from various public sources, including websites published by the relevant parties.

This case shows that at least some Chinese authorities are taking a proactive approach in seeking to detect indirect transfers, rather than merely relying on investors' obligation to report such transactions under the Equity Transfer Circular.

Both the Equity Transfer Circular and the Jiangdu Case remain silent, however, on the liabilities that are incurred when the ultimate seller fails to fulfill its reporting obligation. In the Jiangdu Case, there was no indication that the seller made such a report to the Jiangdu Tax Bureau at the time of the indirect equity transfer, yet public reports do not indicate that the ultimate seller was penalized with fines, penalties, or interest on taxes. Still, if an ultimate seller fails to report an offshore transfer and Chinese tax authorities subsequently become aware of the transaction, triggering an investigation that subsequently determines income taxes are owed, chances are that Chinese tax authorities could impose strict legal liabilities, and may even disclose the case to the public, which could cause serious damage to the ultimate seller's reputation.

It is also worth noting that the RMB173 million collected in the Jiangdu Case is claimed to be the largest single sum of income tax ever collected by Chinese tax authorities in a case of this nature. That may be seen as a powerful signal by SAT that Chinese tax authorities are serious about implementation of the Equity Transfer Circular, with the goal being to halt—or at least capture revenue from—overseas transactions designed to avoid Chinese taxes. It is therefore advisable for foreign investors, especially those involved in large indirect transfer deals, to reevaluate existing SPVs, making sure they have a "reasonable commercial purpose," or to revise the valuation and allocation of tax burdens in case any tax in China is owed in accordance with Equity Transfer Circular.

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