July 01, 2011

Announcement on Several Issues Concerning the Administration of Income Tax on Non-Tax-Resident Enterprises

Issuing Body: State Administration of Tax
Issuing Date: February 28, 2011
Effective Date: April 1, 2011

China's State Administration of Taxation (SAT) has issued an announcement to clarify certain provisions of a 2009 circular designed to collect tax on income derived from the transfer of equity in Chinese resident enterprises by offshore holding companies. Enacted on February 28, 2011, and effective April 1, 2011, the Announcement on Several Issues Concerning the Administration of Income Tax on Non-Tax-Resident Enterprises (Equity Transfer Announcement) seeks to resolve questions involving matters such as the tax treatment of installment payments, exclusions, and the meaning of the term "effective tax burden," all of which were raised by SAT's Circular on Strengthening the Administration of Enterprise Income Tax on Income from Non-Resident Enterprises' Equity Transfers ("Equity Transfer Circular". The Equity Transfer Circular, issued on December 10, 2009, and retroactive to January 2008, was itself part of China's broader efforts to crack down on tax avoidance by foreign investors.

The Equity Transfer Announcement looks in particular at the reporting obligations for indirect equity transfers by Non-tax-resident Enterprises ("Non-TREs"). Though effective as of April 1, 2011, the announcement also applies to transactions that occurred prior to that date for which the tax treatment had not been carried out.

Background: Transactions Affected by the Equity Transfer Circular

Many foreign investors in China established offshore companies, sometimes called special investment vehicles, in jurisdictions with favorable tax treatments, such as Hong Kong, the British Virgin Islands, and the Cayman Islands, for the sole purpose of holding their interest in Chinese companies. Before passage of the Equity Transfer Circular, when a foreign investor sold or otherwise transferred its interest in such an offshore holding company, thus indirectly transferring its interest in the Chinese company, the income derived from that transfer did not trigger taxes under PRC law because the transaction technically took place outside China. The Equity Transfer Circular was designed to tax such income in cases where the offshore holding companies lacked a separate "reasonable commercial purpose" and therefore appeared to have been established for the primary purpose of avoiding PRC taxes.

Treatment of Installment Payments

As enacted, the Equity Transfer Circular did not specifically address the tax treatment of transactions in which consideration was to be paid in installments. In accordance with the Equity Transfer Announcement, if a Non-TRE directly transfers equity in a Chinese tax-resident enterprise, and pursuant to the equity transfer contract or agreement, payment is to be made in installments, for tax purposes realization of revenue shall be recognized (and thus taxed, if indeed tax is owed) at the time the contract or agreement enters into effect or procedures for the change in equity are completed, whichever comes later.

Exclusions to the Equity Transfer Circular

Previously, the Equity Transfer Circular did not apply to "gains derived from purchasing and selling shares of Chinese tax residents effected through public stock exchanges."

The Equity Transfer Announcement clarifies the scope of such excludable transactions by defining "gains derived from purchasing and selling shares of Chinese tax residents effected through public stock exchanges" as those gains in which the seller, purchaser, quantity of shares sold, and price are not determined in advance by the purchaser and seller but rather are determined based on normal trading rules of a public securities market.

With the above clarification, it appears that when a Non-TRE purchases or sells listed shares in Chinese resident enterprises in an over-the-counter transaction or private placement it is no longer excluded from the Equity Transfer Circular.

Reporting Obligations of "a Foreign Investor (Party with Effective Control)"

The Equity Transfer Circular imposed certain reporting obligations on "a foreign investor (party with effective control)" that indirectly divested shares in a Chinese resident enterprise by disposing of shares in a holding company. Since passage of the circular, there has been considerable controversy about what constitutes "a foreign investor (party with effective control)." In practice, many foreign investors claimed they did not have "effective control" wherever they did not hold a controlling interest in the holding company. The Equity Transfer Announcement now provides that ALL foreign investors who have indirectly transferred equity in a Chinese resident enterprise (even those holding or transferring only one percent of shares in a holding company) are subject to reporting obligations under the Equity Transfer Circular.

Effective Tax Burden

The Equity Transfer Circular imposed an obligation to report any indirect equity transfer transaction where the intermediate holding company is located in a jurisdiction with an "effective tax burden" of less than 12.5 percent. The Equity Transfer Announcement makes it clear that the term "effective tax burden" refers to the tax levied on gains from an equity transaction rather than taxes levied on general income. It therefore appears that if the jurisdiction where the holding company is located levies an effective tax rate of over 12.5 percent on gains from the equity transfer, the equity transfer transaction will not be subject to the reporting requirements of the Equity Transfer Circular. This clarification, however, may raise new questions, such as whether it applies to jurisdictions that tax trading gains rather than capital gains and jurisdictions that allow for participation exemptions.


The Equity Transfer Announcement represents SAT's effort to streamline and unify implementation of the Equity Transfer Circular. However, there are still many issues related to the taxation of indirect equity transfers that are left unaddressed, such as how to determine what a "reasonable commercial purpose" is under the circular. Foreign investors are advised to assess the merits of every indirect equity transfer transaction both technically and practically to mitigate potential Chinese tax burdens.

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