Tax Alert. China Issues New Tax Rules on Corporate Restructurings. I. Overview

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1 June 2009 Authors: Clifford Ng Shuang Peng K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit China Issues New Tax Rules on Corporate Restructurings I. Overview China has recently published the much-anticipated rules on the income tax treatment of corporate reorganizations. These rules have a significant impact on M&A transactions and reorganizations involving companies or assets in China, including those directly or indirectly held through offshore companies. The Notice on Certain Questions Regarding the Enterprise Income Tax Treatment of Enterprise Reorganizations (the Reorganization Rules ) was issued jointly by the Ministry of Finance and the State Administration of Taxation on April 30, 2009 and released to the public on May 7, The Reorganization Rules have retroactive effect to January 1, Past transactions which qualify for tax-free treatment under the new Reorganization Rules on which taxes were paid may be eligible for a refund. The Reorganization Rules cover six types of company reorganizations: changes of legal form, debt restructurings, equity acquisitions, asset acquisitions, mergers and de-mergers. Under Article 75 of the Implementation Rules of the Enterprise Income Tax Law of the People s Republic of China, a taxpayer is required to recognize gain or loss from reorganizations unless otherwise exempt by the Ministry of Finance and the State Administration of Taxation. The Reorganization Rules classify all transactions into two types: ordinary reorganizations and special reorganizations. Every transaction is initially classified as an ordinary reorganization by default. Consequently, taxpayers should recognize gains based on the normal default tax rates. For example, if the taxpayer is a resident, the default Enterprise Income Tax (EIT) is 25% of the gain. Alternatively, if the taxpayer is a Non-PRC tax resident, the default withholding tax is 10% of the gain. To fully or partially defer these taxes, special reorganization status must be applied for and obtained. Under the Reorganization Rules, special reorganization status can only be obtained by formal application if certain conditions are met. For a domestic transaction (between a resident company and another resident company) to qualify for special reorganization status, the transaction must meet the five baseline requirements set out below. For a cross-border transaction (where one party is a Non- resident 1 company, which includes enterprises in Hong Kong, Macau and Taiwan) to qualify for special reorganization status, the transaction must meet the five baseline requirements and at least one of the additional requirements set out below. 1 As defined in Article 2 of the Enterprise Income Tax Law of the People s Republic of China, a PRC tax resident company refers both to (i) an enterprise established in accordance with the law within the territory of the PRC, and (ii) an enterprise established in a foreign country (and regions such as Hong Kong, Macau and Taiwan) but whose actual administration institution is located within the territory of the PRC. In essence, offshore companies which are controlled in the PRC can be considered resident companies for purposes of determining which requirements apply.

2 II. Baseline Requirements All domestic and cross-border transactions must meet the following five requirements to qualify for special reorganization status. 1. The corporate restructuring must have a reasonable commercial purpose. That purpose cannot be centered on tax reduction, exemption or deferral 2 ; 2. The equity or assets being acquired, merged or spun-off must reach a certain prescribed ratio to reflect the significance of the corporate restructuring. In an equity acquisition deal, the equity acquired should not be less than 75% of the total equity of the target. In an asset acquisition deal, the assets acquired should not be less than 75% of the total assets of the transferor 3 ; 3. The key business activities of the target must remain unchanged within 12 months after the reorganization (known as the compulsory operating period ); 4. The deal consideration should comprise largely of equity (or shares) such that the portion of equitypayment has to exceed 85% of the total consideration. In other words, the non-share equity (cash, bank deposits, receivables, tradable securities, inventories, fixed assets, other assets and undertaking of liabilities, etc.) cannot exceed 15% of the total consideration 4 ; and 5. The transferor receiving equity as consideration under the reorganization cannot transfer the equity interests within 12 months after the reorganization (known as the compulsory holding period ). III. Additional Requirements for Cross-Border Transactions. Cross-border transactions must meet the five baseline requirements above and at least one of the additional requirements set out below to qualify for special reorganization status. 1. Non- resident to Non- resident: A transfer of equity of a resident from a Non- resident to its 100% directly owned Non- resident subsidiary if: a. The PRC capital gains withholding tax rate for Non- post-transaction is the same as the rate for Non- pre-transaction 5 ; and b. Non- cannot transfer shares in Non- within 3 years post transaction. 2 Local tax bureaus may require a bona fide business purpose. This may be used to prevent the abusive use of incentive tax policies. 3 The Reorganization Rules do not explicitly state which type of method is to be used for valuation of financial assets. 4 Again, the method of valuation of the various assets has not been determined. 5 This may be an anti-treaty shopping provision. The release of Guoshuihan [2009] No. 81 (Circular 81) on February 20, 2009 imposed requirements to apply for tax treaty benefits to obtain a reduced dividend withholding tax (e.g., 5% under the China-Hong Kong Double Tax Agreement). While these requirements are limited to dividends at this time, such procedures could apply to capital gains in the future. The State Administration of Taxation has recently become very focused on treaty shopping and beneficial issues. Interested parties should monitor the situation for new developments. June

3 Non- Non- 2. Non- resident to resident: A transfer of equity of a resident from a Non- resident to its 100% directly owned resident subsidiary. or PRC Assets Non- resident Co or PRC Assets 3. resident to Non- resident: A transfer of assets / equity owned by a resident to its 100% directly owned Non- resident subsidiary in exchange for the subsidiary s shares. Here, instead of a complete tax deferral, special reorganization status allows the gain realized by to be recognized over a 10-year period. The Reorganization Rules require the gain to be recognized upon the completion of the deal but provide a concession for the gain to be subject to tax on a prescribed deferral basis. Non- Non- Non- Non- June

4 4. Other situations: Other situations as approved by the Ministry of Finance (MOF) and the State Administration of Taxation (SAT). IV. Multiple-Step Corporate Restructurings The Restructuring Rules also allow for corporate restructurings with multiple-steps undertaken within a 12- month period to be assessed as one single restructuring transaction 6. This is a favorable provision for the taxpayer since certain baseline requirements (such as the minimum prescribed ratio of equity to be acquired i.e. 75% of total equity of the target, and the minimum prescribed ratio of equity to non-share equity as payment i.e. 85% of total consideration) may be difficult to meet at every stage of the acquisition. If the acquisition of a company occurs in multiple stages, so long as the complete transaction unfolds within a 12- month period, valuation is done on the whole. V. Documentation Required for Application To apply for special reorganization status, both the transferor and the transferee are required to submit relevant documents with the annual tax return filing for the year in which the special reorganization is completed. There is currently no preset application form to assist in the application process. A formal application form, listing the various documents required for different types of reorganizations, is expected to be published in the near future. In the interim, the local tax bureau should be consulted for details of the application procedures and documents to substantiate eligibility as a special reorganization. VI. Summary The new Reorganization Rules represent the continued effort by China to impose a more rigorous and robust tax regime. The tax framework has expanded considerably in the past two years and will trap unwary investors. While tax deferral opportunities are available, careful planning and diligent compliance is required to avoid significant taxes in reorganizations and to provide flexibility in restructuring and exits in the future. K&L Gates would be pleased to discuss the impact of these developments on your investments in China. 6 The principle of substance over form also allows tax bureaus to disregard legal entities that are deemed to lack commercial purpose. For example, in a recent case, a local tax bureau denied the benefits of the China-Singapore Double Taxation Treaty by disregarding the existence of a Singapore SPV which was established to hold the shares of a China tax resident enterprise. The tax authorities reclassified the transaction from its form of transferring an overseas company s shares to substantially transferring a China tax resident enterprise s shares. However, in that case, the Singapore SPV held the China target s equity for less than 12 months, and the China target s equity was transferred to a China buyer where China tax clearance and foreign currency remittance is required. The particulars behind the case were the keys to the challenges by the tax authorities and not the simple conclusion that tax treaty benefits or offshore transactions are now disregarded. Nonetheless, based on these recent developments, existing structures should be reviewed and properly managed to ensure the intended tax benefits may be relied upon. June

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