IIT treatment for natural person partners of venture capital funds was finally released

Transcription

1 IIT treatment for natural person partners of venture capital funds was finally released News Flash China Tax and Business Advisory January 2019 Issue 5 In brief On 12 December 2018, the State Council Executive Meeting decided to allow natural person partners of a qualifying venture capital (VC) fund in the form of a partnership to select to be taxed according to the 20% IIT rate applicable to the income category of income derived from equity transfer and income derived from dividends and profits distribution. However, this treatment involved several technical issues which need to be further clarified and triggered different interpretations over the past few months 1. On 10 January 2019, the Ministry of Finance (MOF), the State Administration of Taxation (SAT), the National Development and Reform Commission (NDCR) and the China Securities Regulation Commission (CSRC) finally jointly released Caishui [2019] No.8 (hereinafter referred to as Circular 8 ), clarifying that VC funds can select from the following two calculation methods: individual investment fund method or annual taxable income of the VC partnership as a whole method, for the IIT treatment of their natural person partners. This puts an end to the uncertainty over the last half year. In this issue of China Tax and Business News Flash, we will analyze the difference between the two calculation methods, as well as share our observations. In detail Policy background On 30 August 2018, the SAT clarified at the video conference on policy interpretation that natural person partners shall be subject to IIT according to the income category of income derived from production and business operations at the progressive rate of 5% - 35% on equity transfer income allocated from domestic partnerships. In that respect, the previous lenient local tax treatment can no longer continue which triggered heated discussion within the domestic private equity industries. Fortunately, on 6 September and 12 December 2019, the State Council Executive Meeting decided to maintain the stability of the local tax policies supporting VC funds that have been implemented in various regions and requested the relevant governmental departments to further optimize the tax policy to support the development of VC funds based on the principle of not retrospectively applying the rules and ensuring the general tax burden of natural person partners of VC funds does not increase. The fundamental framework of Circular 8 was put forward at the meeting as well. Policy contents To be consistent with the current tax preferential policies for Venture Capital Enterprises (VCEs) 2 (Caishui [2018] No.55), VC funds in Circular 8 also refer to VC funds in the form of a partnership enterprise that conform with the provisions relating to VC enterprises (funds) stated in the Provisional Measures on the Administration of Venture Capital Enterprises (NDRC Order [2005] No.39, supervised by NDCR), or the Provisional Measures on the Supervision and Administration of Private Investment Funds (CSRC Order [2014] No.105, supervised by CSRC and the Asset Management Association of China), and have performed record filing accordingly.

2 According to Circular 8, effective from 1 January 2019 to 31 December 2023, qualifying VC funds can select IIT calculation method for their natural person partners from the following two methods: (1) individual investment fund method or (2) annual taxable income of the VC partnership as a whole method. There are significant differences between the two calculation methods in several aspects, such as the income category, deductible items, applicable tax rate, carry-forward period of losses and collection and administration methods, etc., which is summarized as follows: Income category Tax Base Applicable tax rate Key points Tax Collection and Administration Calculation based on individual investment fund method Income derived from equity transfer Income from equity transfer - original cost of the equity - reasonable expenses incurred during the transfer 20% Other expenses such as general and administration expenses and performance remuneration of the fund managers are not deductible. Gains and losses from the equity transfer of different investments projects within a taxable year can be netted against each other, but such losses cannot be carried forward to other years. Qualified natural person partners can simultaneously enjoy the tax preferential policies for VCEs which allow them to offset their taxable income by a certain percentage of the investment amount. However, any unutilized amount in the year cannot be carried forward to the following years. Only applicable to the IIT calculation for natural person partners. IIT of the natural person partners shall be withheld by the VC fund before March 31 of the following year. Income derived from dividends and profits distribution Dividend income, profits distribution + income from other fixed income securities 20% Gains and losses derived from Income derived from dividends and profits distribution and from Income derived from equity transfer cannot be offset against each other. IIT of the natural person partners shall be withheld by the VC fund on a transaction basis. 2 PwC

3 Income category Tax Base Applicable tax rate Key points Tax Collection and Administration Calculation based on the annual taxable income of the VC partnership as a whole Business operation income Annual income of the VC fund - costs, expenses, and losses Natural person partners without "comprehensive income" may also deduct the standard basic deduction, specific deductions, specific additional deductions and other deductions according to the new IIT Law. 5%-35% progressiv e tax rate The loss incurred in a tax year by a VC fund is allowed to be carried forward to the following years and set off against the profits of the following years, but the carry-forward period shall not exceed a maximum of 5 years. Qualified natural person partners can simultaneously enjoy the tax preferential policies for VCEs which allow them to offset their taxable income by a certain percentage of the investment amount. Any unutilized amount can be carried forward and deducted in the following years. Natural person partners shall report and prepay taxes on a monthly or quarterly basis; Natural person partners shall conduct annual IIT reconciliation filing before March 31 of the following year. The takeaway Since the deductible items, carry-forward period of losses as well as applicable tax rates are different under the two calculation methods, it may result in different effective IIT rates. It is suggested that VC funds should perform a comprehensive evaluation of the investment scale, current investment stage, expected return and expenditure structure of the fund, in order to choose a more favorable IIT calculation method for their natural person partners. It is worth noting that once the calculation method is selected, it cannot be changed for 3 years. The annual taxable income of the VC partnership as a whole calculation method basically follows the prevailing IIT policy for natural person partners. However, Circular 8 has not mentioned whether there is an exception for interests, dividends and profits distribution, i.e. whether the policy in Guoshuihan [2001] No.84 allowing interest, dividends and profits distribution derived from investments by partnerships to be regarded as interest, dividends and profits distribution of the individual investors in calculating IIT (i.e., look-through principle) is still applicable once this method is selected. The individual investment fund calculation method in Circular 8 is a brand new method in response to the decision of the State Council Executive Meeting. There are several points that deserve attention. This method is only applicable to the IIT calculation for natural person partners. That is to say, CIT calculation for corporate partners of the VC fund shall still follow the principle in Caishui [2008] No.159. In this case, it is a big challenge to the management of the VC funds on how to apply two sets of calculation methods and track the carryforward period of losses. The method only applies to "income derived from equity transfer, dividends, profits distribution and other fixed income securities" of natural person partners. For other types of income, natural person partners shall still self-report and file IIT according to the income category of "business operation income". In practice, difficulties may exist on how to adjust the profit distribution according to the partnership agreement to the income category of income derived from equity transfer or income derived from dividends and profit distribution. In addition, Circular 8 specifically disallowed the deduction of general and administration expenses and performance remuneration of the fund managers, which is also a challenge for VC funds in making corresponding adjustments. We understand that the term losses of equity transfer cannot be carried forward to other years only refers to the losses that are actually incurred and does not include unrealized losses caused by fair value changes. Similarly, for those who are simultaneously enjoying the tax preferential policies for VCEs which allow them to offset their taxable income by a certain percentage of the investment amount, it is stipulated that any unutilized amount in the year cannot be carried forward to the following years. The term in the year refers to the year the 2-year holding requirement of investing in a qualified start-up technological enterprise according to the provisions of Caishui [2018] No.55 is met. 3 PwC

4 In addition, it remains to be clarified whether the IIT treatment of natural person partners of fund of funds investing in the VC funds would be impacted. After the implementation of Circular 8, when the individual investment fund calculation method is selected, the nature of the income derived from equity transfer and/or from dividends and profits distribution would be retained at the partners level. If one of its investors is a fund of fund partnership, can the above income nature be retained in the fund of fund partnership level and whether there would be any additional record filing requirement? If the fund of fund partnership is also a VC fund under Circular 8, can it still select between the IIT two calculation methods or it is bound by the IIT calculation method selected by the investee fund. Furthermore, since some of the general partners of a VC fund are also partnerships, they may also be facing similar issues as fund of funds. Lastly, circular 8 stated that, for VC funds that have completed regulatory filing before 1 January 2019, if they choose the individual investment fund calculation method, they shall conduct the record filing of calculation method with the in-charge tax authorities no later than 1 March Other newly established VC funds shall perform the record filing of calculation method within 30 days after the completion of regulatory filing, which means that there is limited time left for the first batch of VC funds to make a decision. Endnote 1. For more discussions on tax policies of VC partnerships, please refer to China Tax and Business News Flash [2018] Issue 27, Issue 28 and Issue If the conditions specified under the <Notice Jointly Issued by the MOF and SAT Regarding the Tax Policies of VCE and Angel Investors> (Caishui [2018] No.55) can be satisfied, 70% of the equity investment in qualified start-up technological enterprises can be used to offset the taxable income of the individual partners of VC partnerships. 4 PwC

5 Let s talk For a deeper discussion of how this issue might affect your business, please contact PwC s China Asset & Wealth Management Service Team: Beijing Qing Ni (Assurance) +86 (10) qing.ni@cn.pwc.com Oliver Kang (Tax) +86 (10) oliver.j.kang@cn.pwc.com Scott Qian (Tax) +86 (10) Shanghai Jane Xue (Assurance)* +86 (21) jane.xue@cn.pwc.com Matthew Wong (Tax) +86 (21) matthew.mf.wong@cn.pwc.com Daphne Su (Tax) +86 (21) daphne.su@cn.pwc.com Kevin Xu (Assurance) +86 (21) kevin.xu@cn.pwc.com Kenny.Lam (Tax) +86 (21) kenny.lam@cn.pwc.com Frank Shan (Assurance) +86 (21) frank.shan@cn.pwc.com Stella.Fu (Tax) +86 (21) stella.fu@cn.pwc.com Shenzhen Tracy Cao (Assurance) +86 (755) tracy.c.cao@cn.pwc.com Guangzhou Janet Xu (Tax) +86 (20) janet.xu@cn.pwc.com Kevin Huang (Tax) +86 (755) kevin.j.huang@cn.pwc.com Cindy Li (Tax) +86 (755) cindy.j.li@cn.pwc.com Hong Kong Florence Yip (Tax)** florence.kf.yip@hk.pwc.com Puay Khoon Lee (Tax) puay.khoon.lee@hk.pwc.com Jeremy Ngai (Tax) jeremy.cm.ngai@hk.pwc.com David Kan (Tax) david.kh.kan@hk.pwc.com * China Asset and Wealth Management Leader ** China/ Hong Kong Tax Leader, Financial Services, Asset and Wealth Management 5 PwC

6 In the context of this News Flash, China, Mainland China or the PRC refers to the People s Republic of China but excludes Hong Kong Special Administrative Region, Macao Special Administrative Region and Taiwan Region. The information contained in this publication is for general guidance on matters of interest only and is not meant to be comprehensive. The application and impact of laws can vary widely based on the specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual PwC s client service team or your other tax advisers. The materials contained in this publication were assembled on 31 January 2019 and were based on the law enforceable and information available at that time. This China Tax and Business News Flash is issued by the PwC s National Tax Policy Services in China and Hong Kong, which comprises of a team of experienced professionals dedicated to monitoring, studying and analysing the existing and evolving policies in taxation and other business regulations in China, Hong Kong, Singapore and Taiwan. They support the PwC s partners and staff in their provision of quality professional services to businesses and maintain thought-leadership by sharing knowledge with the relevant tax and other regulatory authorities, academies, business communities, professionals and other interested parties. For more information, please contact: Matthew Mui +86 (10) matthew.mui@cn.pwc.com Please visit PwC s websites at (China Home) or (Hong Kong Home) for practical insights and professional solutions to current and emerging business issues PricewaterhouseCoopers Consultants (Shenzhen) Ltd. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers Consultants (Shenzhen) Ltd. which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.