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LEGAL: Investment Restructuring Considerations
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Tax Legislation Trends of Indirect Equity Transfers

altIn line with global trends, Chinese tax authorities have recently begun to put more focus on tax anti-avoidance compliance to protect the loss of tax revenues, especially scrutinising enterprises that, through certain tax arrangements, might be seen as shifting profits out of China, to their holding enterprises incorporated overseas, that are actually earning profits in China. Among these regulations, the most attractive one was released by the Chinese State Administration of Taxation (SAT) in 2009, namely Guoshuihan [2009] No. 698 (Circular 698), which has empowered the Chinese tax administration, to tax indirect equity transfers performed by non-tax resident enterprises in China (NR Enterprises).

For the past few decades, it has been common practice that overseas enterprises or individuals have chosen special purpose vehicles (SPVs) as their invest platform in China. Such SPVs will be generally located in a tax haven (Cayman Islands) or a third jurisdiction which has a tax treaty with China to enjoy a preferential tax treatment (Hong Kong). Apart from convenient corporate incorporation and registration formalities, tax savings and efficiency have also been an important factor for foreign investors when arranging their Chinese investment structures through said SPVs. Moreover, when they dispose of the Chinese investment, they could also save tax costs given that, in most cases, the capital gain will not be taxed in the tax haven or overseas jurisdiction and the Chinese tax might also be reduced. In order to stop such tax schemes, Circular 698 was introduced, announcing that the “substance-over-form” approach would also extend to capital gains derived from the indirect transfer for such NR Enterprises. Precisely based on said “substance-over-form” principle, the tax authority is enabled to disregard the conduit SPVs and levy the capital gain tax under the general anti-avoidance rules (GAAR) if said SPVs or holdings were established only for tax avoidance purposes and lack of reasonable business purposes.

Since Circular 698 has taken effect in 2009, there have been many uncertainties in relation to the reporting of indirect equity transfers. Therefore, on 29 March 2011, the SAT released the Announcement on Several Issues Concerning the Administration of Income Tax on Non-tax-resident Enterprises (Announcement 24) to provide clarifications for certain unclear issues in Circular 698, in particular, the reporting of indirect equity transfers by NR Enterprises.

What’s in Circular 698?

Chart 1 below shows the typical indirect share transfer model which, under certain conditions, could be subject to the tax reporting obligation established in Circular 698. The indirect share transfer in the chart refers to indirectly transferring shares of C (a Chinese tax resident enterprise or “R Enterprise”), through the transfer of the shares in B, a NR Enterprise holding the equity in the Chinese C, to D. B is owned by another NR Enterprise, A.

Chart 1
According to Circular 698,

1) During the transaction, if the jurisdiction where B is located either taxed the capital gains of the said transfer at a tax rate of less than 12.5% or levied no actual tax burden on such capital gains, A should report the share transfer to the in-charge tax authority of C in China and submit relevant documents within 30 days after the execution of the transfer agreement; and

2) If the sale of B to D is conducted by A through abuse of company legal structures and for an unreasonable commercial purpose, such as for the avoidance of Chinese taxes, the Chinese tax authority will be entitled to disregard the existence of B in such transfer and levy enterprise income tax directly on A for its capital gains derived from the indirect transfer of C. As a consequence, the capital gain derived from the transfer of the shares in B will be subject to 10% Enterprise Income Tax (EIT) in China, as if C had been transferred directly.

With regards to the aforementioned regulation, Announcement 24 has regulated uncertain aspects contained in Circular 698 that caused confusion when NR Enterprises intended to define their tax reporting obligation.

What’s in Announcement 24?

Effective controller

Before issuance of the Announcement 24, some NR Enterprises used to argue in favour of a non-performance of the tax reporting obligation on the basis that they only held a minority of shares in the share capital of the PRC entities to be transferred (i.e. in our example, A argued that it only held a minor shareholding percentage in C through B). However, Announcement 24 has clearly closed the door for said argument that will no longer be adopted.

altIn Announcement 24, the effective controller, i.e. referring to the overseas holding company indirectly owning the shares in the Chinese company, has been further clearly defined as “all investors that indirectly transfer equity in the Chinese R Enterprise shall be subject to the reporting obligation, if all other requirements of Circular 698 were met; e.g. even if A owned 1% of C through B, it might still be deemed as the effective controller of C, and, therefore, should be subject to the tax reporting obligation and could eventually be taxed for its capital gains derived from the indirect equity transfer.

Actual tax burden

Announcement 24 has now also clarified that the following two indicators should be taken into consideration when defining whether there is a tax reporting obligation of the indirect equity transfer. These indicators refer to the tax features of the overseas holding jurisdiction :

1) Effective tax rate of less than 12.5% on equity transfer income; or

2) No taxation on foreign equity transfer income in the foreign jurisdiction deriving from the transfer of R Enterprises.

This means that the Chinese tax authority will potentially be entitled to levy income tax on the indirect equity transfer provided either the residence country of B, as mentioned in the above example, does not levy Enterprise Income Tax on the equity transfer income derived from the sale of B or the residence country of B levies Enterprise Income Tax, but the total effective taxation on said equity transfer income amounts to less than 12.5%.

This has clarified that Circular 698 refers to the effective tax burden on the transaction, i.e. on the indirect equity transfer, but not on the general Enterprise Income Tax rate applicable in the holding’s home jurisdiction, as could be interpreted before Announcement 24.

Procedural issues

According to Announcement 24, where two or more NR Enterprises indirectly transferred the equity of an R Enterprise at the same time, either one of the NR Enterprises can report the indirect transfer to the local-level tax authority in charge of company A, if the other conditions under Circular 698 are met.

Chart 2
Meanwhile, if the NR Enterprise (i.e. C) indirectly transfers, through the sale of the intermediary holding B, the shares of two or more Chinese enterprises (i.e. A, F and G in chart 3 below) that are located in different provinces (municipalities) at the same time, then:

1) Company C may choose to report the indirect transfer to the local-level tax authority in charge of either company A, F or G;

2) That in-charge authority should coordinate with the other in-charge tax authorities (in charge of companies F and G) to determine whether to impose Chinese Enterprise Income Tax on the indirect equity transfer and report it to the State Administration of Taxation (“SAT”);

3) If it is confirmed that EIT should be imposed on the indirect equity transfer, company C should file and pay EIT to the respective local-level tax authority in charge of each of the Chinese companies being indirectly transferred.

Chart 3
What has been left apart from Announcement 24?

Although Announcement 24 can be seen as a great effort made by the SAT in clarifying the implementation of Circular 698, there still are unclear issues left in relation to the taxation on capital gains of NR Enterprises derived from indirect equity transfers. From a tax practitioner’s perspective, some of these uncertainties leave certain space for tax planning opportunities, especially in relation to the overseas holding jurisdiction.

Form of SAT’s feedback

Regarding the procedure of reporting and documentation, it is not provided by any rules issued how the SAT would formally reply to a tax reporting obligation under Circular 698, neither in terms of detailed timing nor format for the in-charge tax authority to give its feedback (i.e. approval, record filing , etc.)


A significant number of precedents have shown that the Chinese tax authorities do have many channels to trace indirect share transfers, such as PRC entities certificate alterations and annual inspections, amongst others. Keeping this in mind, documentation should be well prepared and a pre-advanced discussion with the Chinese tax authorities before implementing an indirect equity transfer is suggested in order to obtain a clearer attitude of the local Chinese tax authorities.

NR Enterprises acting as transferors and relevant parties concerned are highly recommended to assess the merits of each indirect equity transfer from both a technical and practical perspective to mitigate their potential Chinese tax exposures.

By Manuel Torres (Partner) & César González Palliser (Senior Lawyer), Garrigues, Shanghai.

Garrigues has over 13 years of experience in advising companies in their investments in China. The team of experienced Western and Chinese professionals at Garrigues Shanghai provides legal advice to foreign companies on a wide range of issues such as incorporation of companies and negotiation of joint ventures, commercial contracting, M&A, tax, real estate, employment, intellectual property, arbitration and infrastructures, as well as to Chinese companies with investments abroad.

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