Strategizing Mainland China Investment Exit through Indirect Equity Transfers www.pwccn.com
In the past few years, China has been enjoying a major boom in the growth of innovation activities under its rapid economic growth and the strong push through government policies. As a result, the competition in the TMT sector has been more fierce and capital driven, rather than purely based on the invention of new products and business models. The Mainland China has been and continues to be a heaven for start-up companies. After several rounds of severe competitions, we have seen quite a few cases of mega-mergers happened in the past few years, and some of the mergers happened between some unlisted companies. In addition, there have been also an increasing numbers of acquisition of unlisted companies by listed companies. This means that a lot of early investors would have the chance of cashing out through merger and acquisitions instead of IPOs. The Variable Interest Entities ( VIE ) structure has been a widely used structure since the late 90s for founders to build up a set of offshore structure and operates in certain restricted business areas through the parallel ownership of a locally incorporated entity. Under the VIE structure, the most widely used holding company would be a Cayman Islands holding company where most of the above mentioned merger and acquisitions happened with the transfer of the shares of the Cayman Islands holding company. After the corporate income tax ( CIT ) reform in 2008, the Mainland China has introduced the famous Public Notice 7 to govern the transfer of assets in the Mainland China through the transfer of offshore companies shares such as the Cayman Islands ( indirect equity transfers ). The essence of reporting of indirect equity transfers is to collect information and documents that are relevant for the examination of whether a particular indirect equity transfer would be subject to China withholding tax due to the fact that the use of overseas structure has no reasonable commercial purpose (in practice often translated by the Chinese tax authorities as equal to the fact that the offshore structure has no operational substance) and hence can be seen through under an indirect equity transfer situation. After a few rounds of successful cases where investors of a Cayman Islands company agreed to pay China withholding tax under an indirect equity transfer situation in the past few years, the China tax authorities have been more active in searching for similar tax collection opportunities and have gathered more experiences in analysing complicated offshore structures and making decisions on how to impose China tax. On a positive side, this would also give investors of future ventures more clarity in understanding how to strategize and structure Mainland China investments. This article tries to summarize some of our observations of the current practices in the indirect equity transfer area for the tax reporting obligation for the offshore structure entities. 1. First Defence For the first line of defence for indirect equity transfers, one would look at the substance of the offshore holding and intermediate holding companies. If one can build a case where the offshore intermediate holding company has operational substance, then a particular indirect equity transfer may not be subject to China withholding tax. The current practice of a young start-up company would not focus on the building of substance at the 2 PwC
intermediate holding company level. The most famous intermediate holding company for Chinese founders under a VIE structure would be a Hong Kong company. As such, under an investment exit situation before the IPO, we have seen a lot of cases where the founders have no preparation for the build-up of substance for their intermediate holding company. Unless the founders have chances to work on their international expansions, it is often the case where an intermediate holding company would not have enough substance to create a sensible defence. For more mature companies, we have seen cases where Chinese founders are willing to invest and expand in Hong Kong. We have also helped listed companies to take videos of their Hong Kong operations and their executives in Hong Kong to substantiate their Hong Kong substance. 2. Second Defence The second line of defence would be the green zone scenarios. Transactions in the green zone scenarios are predetermined as not taxable in China. The most frequently used green zone scenario is where the double tax treaty between China and the investor s holding company provides protection to the transaction from being taxed in China. If when the offshore structure is seen through for China CIT purposes, an investor may rely on the fact that the investor s holding company is in a country where China has entered into a double tax treaty to get a tax exemption, the indirect equity transfer shall not be taxable in China. The Mainland China has issued specific regulations and required documents for the application under double tax treaties. The key documentation for the application under a double tax treaty would be the presence of a Tax Resident Certificate issued by the corresponding tax authority in the holding company s country. In some countries, this may not be a practical and easy task. Some local Chinese tax authorities with intense experience of handling indirect equity transfers have developed regular procedures in examining whether an indirect equity transfer is qualified under the protection of a double tax treaty. The other green zone scenarios includes the case of a company s internal restructuring with pure share consideration, and the case of purchasing and disposing the shares of a listed company in a stock exchange. 3. Tax Credit in Home Country If an investor is able to make a claim of foreign tax credit for the China withholding tax that is payable under an indirect equity transfer, then the common practice is to obtain a proof of tax paid in China and the corresponding amount of taxable income. This would normally refers to the tax return completed and the tax payment certificate issued by the relevant tax authorities in the Mainland China. It is important to understand the documentation requirements in the investor s Home Country for claiming foreign tax credit. It is worth noting that in certain countries, tax paid for indirect equity transfers may not be recognised for foreign tax credit purpose. For example, a US company paying China tax for indirect equity transfers without being asked by the Chinese tax authority in advance, may be regarded as paying the tax by volunteer and therefore cannot claim foreign tax credit with it. 4. Tax Payable Cases If China withholding tax cannot be avoided under an indirect equity transfer case, then it is important for an investor to understand the various calculation methods that can be adopted by various China tax authorities. Different tax calculation methods sometimes lead to huge differences in tax payable. 4.1 Deduction from Sales Proceeds Although it is not specifically mentioned in the relevant regulations, the tax authorities may accept a deduction of the amount of cash or cash equivalent assets that are kept offshore from the sales proceeds. This is based on the argument that part and partial of the sales proceeds are for the transfer of offshore assets rather than onshore Chinese assets. Our experience has indicated that gathering the evidence for these cash or cash equivalent assets may be the most difficult and time consuming part in practice. If the other subsidiaries of the offshore company being transferred have substantial operations outside China, the value of the overseas operations may also be considered to be deducted from the sales proceeds. In practice, the discussion with the Chinese tax authority may focus on the valuation of the overseas operations. Strategizing Mainland China Investment Exit through Indirect Equity Transfers 3
In case where the selling price also covers other assets, e.g. loans, IP rights, etc. the allocation of the total price between the equities and non-equity assets may be examined with focus by the tax authorities. It is recommended that an allocation is clearly indicated in the transfer contract. However, one should be aware that the tax authority may disagree on the allocation in the contract for tax purpose if they consider the allocation unreasonable. 4.2 Cost Base A commonly adopted cost base for the calculation of taxable gain for China withholding tax purposes is the total amount of paid-up capital of the Wholly Foreign Owned Enterprises ( WFOE ) in the Mainland China, if the seller is an original investor to the company. The WFOEs are the 100% owned Chinese subsidiaries of the intermediate holding companies. If the total investments of a WFOE is funded partly by capital and partly by shareholders loan (e.g. a shareholder loan from a Hong Kong intermediate holding company), then the amount of total registered capital of a WFOE may be less than the amount of total funding invested by the investors at the Cayman Islands holding company level. This may imply that from the ultimate shareholders level, it may be preferred to have all the investment funds injected into the China ventures in the form of registered capital. The other possible cost base is to adopt the amount of actual investment cost of a particular investor (e.g. the investor acquired the shares of a Cayman Islands holding company from an earlier investor). However, in order for the tax authorities to accept this cost base, the relevant investor has to present the evidence of China tax payment/ exemption from the previous investor(s). As such, if an investor would like to acquire some unlisted shares from another investor, the incoming investor needs to ensure that the selling shareholder performs the China tax reporting or exemption application properly to ensure a smooth adoption of the acquisition cost as the cost base for future disposal purposes. There have been many cases in which the buyer and seller in a transaction have disputes in the tax clearance position, especially in cases where the seller pursues aggressive tax saving or non-taxable position. 4.3 Multiple Tax Reporting Locations in China It often happens that under a VIE structure a number of WFOEs are set up to operate in different locations in China. As such, the tax reporting under an indirect equity transfer situation would need to be performed in various locations. Although a taxpayer may choose a particular location for initial tax reporting purpose, it would be a good practice to understand whether the same filing position (either be a tax payable or tax exemption case) can be agreed upon by tax authorities in various locations. This would mean that the more locations involved, the more difficult a consensus can be reached among different tax authorities. The good news is that the tax authorities in secondary cities often agree to the judgement call of the tax authorities in major cities like Beijing, Shanghai, Guangzhou and Shenzhen. 5. Filing Routes and Duration The tax reporting starts with the district level in charge State Tax Bureau(s) for the relevant WFOE(s). The district level authority would be responsible for the collection of the relevant information and documents for their own examination and also the future examination by upper level authorities. After the first satisfactory review by the district level authority, then the case would be considered by the Municipal/ Provincial Level State Tax Bureau where most of the decisions on tax payable/ exemption would be made. If necessary, the Municipal/Provincial Level State Tax Bureau may refer the case to the State Administration for Taxation for consideration. The initial reporting for an indirect equity transfer within 30 days after signing the contract is not mandatory, but highly recommended. It can help reduce the interest if the tax settlement cannot be made by May 31 the next year (the latest regulation of the State Administration of Taxation Public Notice [2017] No.37 implies further waiving of the interest if a tax payer settles the tax payment before the prescribed timeline set by the tax authority. Yet by the date of this article, there are still different understandings to the applicability of this stipulation to the interest imposed on indirect share transfer). It also reminds the in-charge tax authority to start reviewing the case as early as possible to prevent late tax filing considering the long duration of tax assessment as introduced below. The tax payable cases would normally be preferred to complete by May 31 every year for the previous year s cases. Tax filing later than the date may lead to interest in addition to the tax payable, subject to the tax authority s understanding to the relevant stipulation in the State Administration of Taxation Public Notice [2017] No.37. The tax exemption applications would normally be handled after the consideration of the tax payable cases, if in one transaction there are both 4 PwC
investors who pay tax and investors who seek for tax exemption. The normal duration for tax payable or tax exemption cases would therefore be 6 months to 24 months. Since the tax authorities are often reluctant to issue specific tax exemption proofs, a selling shareholder may want to impose some form of agreed procedures with the incoming investor or a prescribed period after which the escrow amount of tax withholding may be released to the selling shareholder. In the case of a group exit by a number of investors, differences in filing positions may happen if each of the selling shareholders is filing their owned tax return or tax exemption applications. We have helped some of our clients in handling group filing so that the speed of completion of the tax filing can be enhanced, and the consistency amount different exit investors can be arranged. The above is a high level outline of the current practices in indirect equity transfer reporting for the Mainland China withholding tax purposes. Please be aware that the above may not be a full consideration of all the relevant factors for a selling shareholder and we strongly advise every selling shareholder to consult their tax advisor before any actions are taken. We will also keep observing the practices in the Mainland China and provide updates where necessary. The following areas may also be relevant for the selling shareholders to consider: entity should be considered when calculating the amount of taxable gain under an indirect equity transfer situation; d. Detail tax calculation and tax filing procedures set out in the State Administration of Taxation Public Notice [2017] No.37. Important Note: This article is prepared only for the purpose of general technical discussions. The comments and observations set out in this article do not constitute any advice to any party. If you wish to have any assistance in practice, please seek for professional advice based on your specific case separately. a. Whether an entity can be seen through at the investors holding company level (e.g. a US partnership); b. Whether offshore non-monetary assets can be deducted from the sales proceeds; c. Whether the equity of a VIE local Strategizing Mainland China Investment Exit through Indirect Equity Transfers 5
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