One Way Around an Onerous China Tax Law? Ignore it

Chinese tax authorities surprised Western companies last December with a new tax law aimed squarely at a standard legal mechanism to do business in China, the offshore holding company.

Now, nearly one year later, companies have found a surprisingly successful—yet potentially risky—strategy to comply with the law: pretend it’s not there.

Bureaucratically known as Circular 698, the rule calls for corporations to register the sale of offshore intermediaries if those business units hold China assets. In effect, the rule means that for some companies, even transactions occurring entirely outside China’s borders must now be reported to Beijing.

“There is a very strong focus on the taxation of non-residents,” explains Chris Finnerty, a partner at Ernst & Young. “And this is quite serious, in part because of the way U.S. groups have historically structured [their ventures] in China.” Most international corporations use an offshore intermediary to hold assets in China.

Experts say western companies use this structure for several reasons, not all of them related to taxes. For example, limited legal liability is still largely untested in China, so it helps to have a firewall between the parent corporation and the Chinese operations. Also, selling assets in China requires lots of regulatory compliance. By comparison, selling a special purpose vehicle (which is what an offshore intermediary is, after all) could usually be done quickly and easily if both parties were non-Chinese.

But under Circular 698, deals that were once simple and tax-free must now be logged with Chinese authorities—and any gains could be taxed at a 10 percent rate. That means that Chinese holdings may be worth less than originally thought. Worse, Circular 698 is retroactive, so some companies may already owe significant taxes, including penalties and interest.

“There are a lot of people in the market who look at the circular and say: ‘it’s over-reaching, it’s out of China’s jurisdiction, and you know what? I am not going to comply with it.’”

—Larry Sussman,

Managing Partner,

O’Melveny & Myers

“They could look back to January 1, 2008, and potentially uncover massive exposure to Chinese taxation. That is a real concern,” Finnerty says.

Tsoi

Alan Tsoi, managing director of the China tax practice at Deloitte, says companies, especially those that report under U.S. accounting principles, may need to set aside provisions to cover the potential liability.

Getting Around Circular 698

Yet a number of companies—the vast majority, by some estimates—are simply refusing to register. And while such a bold strategy has its risks, there are lawyers who say that doing so makes a certain amount of sense.

Sussman

“There are a lot of people in the market who look at the circular and say: ‘it’s over-reaching, it’s out of China’s jurisdiction, and you know what? I am not going to comply with it,’” says Larry Sussman, managing partner at the Beijing office of law firm O’Melveny & Myers.

Why the bold stance? Many believe that China has neither the right nor the ability to do what it has legislated. The transactions in question take place wholly outside of the country. The buyer, seller, and the company sold are all beyond China’s jurisdiction.

EQUITY TRANSFER PROCEEDS RULES

Notice of the State Administration of Taxation

on Strengthening the Management of Enterprise Income Tax Collection of

Proceeds from Equity Transfers by Non-resident Enterprises:

I. Proceeds from an equity transfer as referred to in this circular represents proceeds from

the alienation of the equity interests in Chinese resident enterprises (excluding the

purchase and sale of the stock of Chinese resident enterprises on public securities markets)

by non-resident enterprises;

II. Where the withholding agent fails or is unable to fulfill its withholding obligations, non-

resident enterprises shall file and pay the enterprise income tax to the competent tax

authority supervising the Chinese resident enterprises whose equity interests are

transferred (i.e., the tax authority in charge of collecting enterprise income tax of such

resident enterprise) within seven days after the equity transfer date as agreed in the

contracts or agreements (or after the date when the proceeds are actually obtained, if the

transferors receive the proceeds of equity transfers in advance). If non-resident

enterprises fail to file timely and accurately, the relevant provisions in the Tax Collection

and Management Law of the People’s Republic of China shall apply.

III. Proceeds from equity transfer refers to the difference between the consideration of the

equity transfer minus the cost of the equity interest;

Consideration of the equity transfer represents the total amount received by the transferor

in the form of cash, non-monetary assets or interests with respect to the equity transfer; if

the investee enterprises have retained earnings or after-tax reserves and such retained

earnings and after-tax reserves are transferred to the transferee along with the equity

interests being alienated, such amount of retained earnings and after-tax reserves shall not

be deducted from the consideration of the equity transfer;

Cost of the equity interest represents the capital contribution actually paid to the Chinese

resident enterprises when the transferor made such investment, or the consideration

actually paid to the prior transferor when the equity interests were purchased;

IV. In calculating the proceeds from equity transfers, the currency used by non-resident

enterprises to make investments into Chinese resident enterprises whose equity interests

are transferred, or the currency used to purchase such equity interests from the former

investors shall be used to calculate the consideration of the equity transfer and cost of the

equity interest. If a non-resident enterprise made investments for more than one time, the

currency it used for the first investment shall be used to calculate the consideration of the

equity transfer and cost of the equity interest, and a weighted average method shall be

adopted to calculate the cost of the equity interest. Where different currencies were used

in making the investments, the then-prevailing exchange rate on the date when the capital

was injected shall be used to convert the currency into the one used for the first

investment;

V. When the offshore investor (actual controlling party) indirectly transfers the equity

interests in a Chinese resident enterprise, if the actual tax burden in the jurisdiction of the

offshore holding company being transferred is less than 12.5 percent, or if such jurisdiction

exempts income tax on foreign-sourced income for its tax residents, the following

documents should be provided to the tax authority supervising the Chinese resident

enterprise whose equity interests are transferred, within 30 days after signing the equity

transfer agreement:

Equity transfer agreement/contract;

The relationship between the offshore investor and the offshore holding company

being transferred in terms of capital, operation, sales and purchase etc.;

Introduction of operation, employees, bookkeeping, and assets of the offshore

holding company being transferred by the offshore investor;

The relationship between the offshore holding company being transferred by the

offshore investor and the Chinese resident enterprise, in terms of capital,

operation, sales and purchases;

Explanation of the reasonable business purpose with respect to the offshore

holding enterprise being transferred by the offshore investor; and

Other materials requested by the tax authority.

VI. If the offshore investor (actual controlling party) indirectly transfers the equity interests

in a Chinese resident enterprise via abuse of organization forms and certain enterprise

income tax obligations are avoided without a reasonable business purpose, after being

reported to higher authorities and reviewed by the State Administration of Taxation, the

supervising tax authority can decide the nature of the transaction of such equity transfer

according to its business substance and deny the existence of the offshore holding

company which is used for tax planning purposes.

VII. The tax authority can adjust the taxable income using reasonable methods, provided that

the income is reduced as a result of an equity transfer of Chinese resident enterprise by a

non-resident enterprise to its related parties not applying the arm’s length principle.

VIII. If the offshore investor (actual controlling party) transfers its equity interests in several

onshore and offshore holding companies simultaneously, the Chinese resident enterprises

being transferred should provide the supervising tax authority with the agreements

regarding the whole transaction and the agreement with respect to itself. If there is no

separate agreement for the Chinese resident enterprise, it should provide to the

supervising tax authority detailed information with respect to each of the holding

companies being transferred, for the purpose of allocation of transfer amounts with

respect to the domestic entity. The tax authority has the discretion to adjust the transfer amount if it cannot be allocated precisely.

IX. If the capital gain derived from an equity transfer by a non-resident enterprise is qualified

for special tax treatment provided by Caishui [2009] No. 59 and such non-resident

enterprise chooses the special restructuring method, written documentations should be

submitted to the supervising tax authority to prove such qualification, subject to approval

from the provincial tax authority.

X. This Notice is effective from January 1, 2008. Issues in implementation of the Notice

should be reported to the International Taxation Department of the State Administration

of Taxation in a timely manner.

Source

O’Melveny & Myers on Form 698 on Equity Transfers (2009).

Sussman explains that this approach is not as absurd as it sounds; the law has so many issues, he says, that non-compliance is a reasonable position. The jurisdictional doubts are foremost. Professionals who have examined the law say that its long-arm provisions are unprecedented. Sussman also says that the way the law was put together and published raises doubts about its enforceability. He believes that a number of fundamental statutes, such as those on the collection of taxes, would have to be amended to make Circular 698 effective and credible.

“The legal scholars are pretty adamant. They are waiting for this to be challenged. They see 698 as a huge mistake,” Sussman says. “Once you get a certain set of facts, some party is going to file an administrative appeal.”

Still, several recent enforcement actions have tempered enthusiasm for that strategy. Earlier this year, the Carlyle Group paid $25 million under Circular 698 on gains it made in the acquisition and sale of a stake in Yangzhou Chengde Steel Tube via a Hong Kong intermediary. Carlyle did not respond to a request for comment. Other companies have reportedly been snagged by Circular 698, including Goldman Sachs, but the rulings have not been published.

For companies that don’t want to take such a bold approach, there are other ways around the law. For example, if the intermediary has both “substance” and “reasonable business purpose,” according to Circular 698, it is not considered a special-purpose vehicle and not subject to the tax law. That is, if the business is more than a simple paper corporation and a bank account, Chinese authorities are less likely to view it as a shell company created to dodge taxes.

Private equity firms and investments banks might not be able to upgrade their SPVs to an acceptable level, but manufacturers and businesses engaged in long-term operating activities in China might be able to put enough meat on the SPV’s bones to pass muster. For example, they could transfer employees and give a financial management role to the holding company, or they can better capitalize it.

Circular 698 does not define what “substance” or “business purposes” specifically are, and the State Administration of Taxation provides no guidance on the question. But accountants who have approached Chinese officials on behalf of clients say they have had fair hearings and have been able to get structures accepted. They say that Chinese tax officials consider many factors, such as the timing of the restructuring, the nature of the assets moved to the subsidiary, and the company’s history.

Finnerty

“The cure is to put the China operations under a company with a requisite amount of substance, but the requisite amount of substance is not provided in any sort of brightline guidance,” Finnerty says. “It is a fact-and-circumstances situation. But you need enough substance for the Chinese authorities not to look through an intermediary and treat what would otherwise be an indirect sale generating foreign-source income as a sale generating Chinese-source income.”

“If there is no physical substance, you are going to have an issue. Even if you have a business purpose for the holding company, you need some amount of physical substance,” he adds.

Following reports of enforcement, companies that had been tempted to ignore the Circular are now more inclined to comply.

Buyers are also forcing the compliance question. While their liability under the law is unclear, many fear they are exposed if the seller doesn’t pay the taxes owed—so they are seeking confirmation from the seller that Circular 698 has been obeyed, or are demanding guarantees of restitution if they end up stuck with a tax bill.

“The buyer may be concerned that there will be potential liability if the seller doesn’t pay,” says Richard Lawrence, a partner at Holland & Knight in Beijing. “The buyer is at risk of being the one that the Chinese come after.”