Tax Issues for Indirect Transfer of Property by Non-resident Enterprises

Introduction

On February 6, 2015, the State Administration of Taxation promulgated the Announcement on Several Issues of Income Tax of Enterprises with Indirect Transfer of Property by Non-resident Enterprises (Announcement No. 7 of the State Administration of Taxation, 2015, hereinafter referred to as "An-nouncement 7") and related interpretations. This is the third time since the State Administration of Taxation promulgated the Notice on Strengthening the Income Tax Administration of Non-resident Enterprises Income from Equity Transfer in 2009 (State Tax Letter [2009] 698, hereinafter referred to as "Article 698") and the Announcement on Several Issues of Income Tax Administration of Non-resident Enterprises in 2011 (State Administration of Taxation Announcement 24, hereinafter referred to as "Announcement 24"). 

According to Article 698, if a non-resident enterprise transfers an overseas intermediate shareholding enterprise that directly or indirectly holds the equity of a Chinese resident enterprise, which is deemed by the Chinese tax authorities to have unreasonable commercial purposes, the transaction will be reclassified as a direct transfer of the equity of a Chinese resident enterprise, thus creating an enter-prise income tax obligation in China. Announcement 24 gives a more detailed explanation of some clauses in Article 698.

Announcement 7 abolished part of the provisions of Article 698 and Announcement 24, and made more detailed provisions on some income tax matters concerning indirect transfer of property such as equity of Chinese resident enterprises by non-resident enterprises. This article will discuss several key points of Announcement No. 7.
 
Scope of application

Article 1 of the Announcement 7 clearly states: "If a non-resident enterprise evades the tax obligation of enterprise income tax by indirectly transferring property such as equity of Chinese resident enter-prises through arrangements without reasonable commercial purposes, it shall redefine the indirect transfer transaction in accordance with the provisions of Article 47 of the Enterprise Income Tax Law, and confirm it as direct transfer of property such as equity of Chinese resident enterprises".

Property which is directly owned by non-resident enterprises and from which the income is subject to enterprise income tax in China can be divided in the following three categories according to the provi-sions of the Chinese Tax Law, collectively referred to as "China's taxable property":

• Property of institutions and places in China; 
• Real estate in China; 
• The equity investment assets of Chinese resident enterprises.

Article 698 does not use the expression of "China's taxable property", but only refers to the indirect transfer of equity in Chinese resident enterprises. Therefore, the scope of indirect transfer of property covered by Announcement 7 is broader than that in Article 698.

Announcement 7 defines the concept of "indirect transfer of taxable property in China” as: non-resident enterprises making transactions with the same or similar substantive results as transferring Chinese taxable property directly, including change of shareholder(s) of overseas enterprises caused by restructuring non-resident enterprises, directly or indirectly transferring the equity and other similar rights and interests of overseas intermediate shareholding enterprises (excluding overseas registered Chinese resident enterprises, hereinafter referred to as "overseas enterprises"). Therefore, it is neces-sary to analyze relevant transactions from a substantive point of view in order to determine whether a transaction constitutes an indirect transfer of Chinese taxable property as stipulated in Announcement 7.

According to Article 5 of Announcement 7, the following two types of transactions do not apply (i.e., constituting essentially the "Safe Harbor Rules"):

• Non-resident enterprises purchase and sell shares of the same listed overseas enter-prises in the open market and obtain income from indirect transfer of Chinese taxable property. 
• When a non-resident enterprise directly holds and transfers Chinese taxable property, the income from the transfer of such property may be exempted from enterprise income tax in China in accordance with applicable tax agreements or arrangements.

 
Transaction Report 
Announcement 7 has made the following major changes to the reporting requirements for indirect transfer transactions in article 698: 

1. Change mandatory report to voluntary report; Article 698 requires that qualified indirect transfer transactions must be reported. Announcement 7 cancels the compulsory reporting obligation for all types of indirect transfer transactions, and the subject of the transaction report voluntarily chooses whether to report the relevant indirect transfer transactions to the competent tax authorities.
2. Expanding the Subject of Transaction Reporting; Article 698 stipulates that the reporting subject of the indirect transfer transaction is the overseas in-vestor (the actual controlling party) who makes the indirect transfer, i.e. the non-resident enterprise as the transferor. Announcement 7 stipulates that both parties to the transaction and Chinese resident enterprises whose shares are indirectly transferred may report indirect transfer transactions to the competent tax authorities. Moreover, the 7th Announcement clearly stipulates that the Chinese tax authorities may request the parties involved in the indirect transfer of Chinese taxable property, the Chinese resident enterprises whose shares are indirectly transferred, and the planners of the transac-tion to provide information related to the indirect transfer transaction. This change is significant for tax planners.

 
Judgment of Reasonable Business Purpose            
Compared with article 698, Announcement 7 gives more detailed guidance on how to judge "reasona-ble commercial purposes". Announcement 7 lists the relevant factors to be taken into account in judg-ing "reasonable commercial purpose". For some specific cases, it is directly recognized as "unreasonable commercial purpose", and introduces the Safe Harbor Rules applicable to intra-group reorganization.

Judgement factors：           

• Article 3 of Announcement 7 states that all arrangements relating to the indirect transfer of taxa-ble property in China should be taken into account in judging reasonable commercial purposes, and the following relevant factors should be comprehensively analyzed in light of the actual situation:
• Whether the main value of equity of overseas enterprises comes directly or indirectly from taxable property of China;
• Whether the assets of overseas enterprises are mainly made up of direct or indirect in-vestment in China, or whether the income they earn mainly comes from China directly or indirectly;
• Whether the functions and risks actually performed by overseas enterprises and their subordinate enterprises directly or indirectly holding Chinese taxable property can prove the economic essence of the enterprise structure;
• The duration of shareholders, business models and related organizational structures of overseas enterprises;
• Indirect transfer of taxable property in China pays income tax abroad;
• The substitutability of indirect investment, indirect transfer of China's taxable property transactions and direct investment, and direct transfer of China's taxable property trans-actions by equity transferors;
• The applicable tax agreements or arrangements for indirect transfer of income from tax-able property in China, etc.            

Transactions directly identified as not having reasonable commercial purposes

In addition to the two types of circumstances that do not apply to Announcement 7 (see the "Scope of Application" section above) and the application of the Safe Harbor Rules (see point 4 below), if the overall arrangement relating to indirect transfer transactions meets the following four conditions simul-taneously, the arrangement will be directly recognized as having "unreasonable commercial purposes":

• Over 75% (including 75%) of overseas enterprises' equity value comes directly or indi-rectly from Chinese taxable property.            
• At any point in the year before the indirect transfer of Chinese taxable property occurs, more than 90% of the total assets of overseas enterprises (excluding cash) are directly or indirectly made up of investments in China, or more than 90% of the income of over-seas enterprises (including 90%) comes directly or indirectly from China within one year before the indirect transfer of Chinese taxable property occurs.            
• Although overseas enterprises and subsidiary enterprises directly or indirectly holding Chinese taxable property are registered in their respective countries (regions) to meet the organizational forms required by law, their actual functions and risks are limited, which is insufficient to prove their economic essence.           
• The tax burden of indirect transfer of taxable property in China is lower than that of direct transfer of taxable property in China.            

The interpretation of Announcement 7 explains the "tax payable abroad" in the fourth condition men-tioned above. The tax burden includes not only the tax payable by the transferor in the country where the transaction is located, but also the tax payable by the transferor in the country where the trans-ferred overseas enterprise is located.

Reorganization of Safe Harbor Rules within the Group           
For eligible intra-group reorganization, Article 6 of Announcement 7 introduces a Safe Harbor rule. If the indirect transfer transaction meets the following three conditions at the same time, it shall be deemed to have reasonable commercial purposes without having to pay enterprise income tax in Chi-na:            

1) The equity relationship between the two parties involved in the transaction has one of the following circumstances:            

• The transferor directly or indirectly owns more than 80% of the transferee's equity (in-cluding 80%).            
• The transferee directly or indirectly owns more than 80% of the equity of the transferor (including 80%).            
• The transferor and transferee of shares are directly or indirectly owned by the same par-ty by more than 80% of the shares (including 80%).            

If more than 50% of the value of foreign enterprises' equity (excluding 50%) comes directly or indirectly from real estate in China, the above-mentioned share-holding ratio will increase to 100%.            

2) Compared with the same or similar indirect transfer transaction without the indirect transfer transac-tion, the income tax burden of China will not be reduced.            

3) The transferee of shares shall pay the equity transaction consideration in full with the equity of the enterprise or the enterprise with a controlling relationship (excluding the equity of the listed enter-prise).            

Although the aforementioned Safe Harbor Rule has facilitated the reorganization of the group, the provisions on equity consideration in Item 3 still set a certain threshold for the treatment. In addition, the announcement does not have a clear definition of "the enterprise with controlling relationship with it". Literally, this concept may be understood as either the parent company of the transferee or the subsidiary company of the transferee.
 
Consequences of failure to withhold or pay corresponding taxes 
Announcement 7 clarifies two controversies related to article 698: whether the transaction party con-cerned has tax withholding obligations and how to calculate interest related to indirect transfer of tax.            

In most cases, the transferee of equity is the payer of the transaction, so it will be liable for tax with-holding. This provision derives from Article 8 of Announcement 7: "Where income from indirect trans-fer of real estate or equity is subject to enterprise income tax in accordance with the provisions of this Announcement, the entity or individual directly obligated to pay the relevant amount to the transferor of equity shall be the withholding agent in accordance with relevant laws or contractual agreements."      

Article 8 also stipulates that if the withholding agent fails to withhold the tax payable and the transferor of equity fails to pay the tax payable, the competent tax authorities may pursue the responsibility of the withholding agent in accordance with the relevant provisions of the Tax Administration Law and its implementing rules. If the withholding agent should withhold the tax withheld, the tax authorities may impose a fine of not less than 50% but not more than three times of the tax withheld on the withholding agent. However, in indirect transfer transactions, where the withholding agent has submitted the transaction data within 30 days from the date of signing the equity transfer contract or agreement, Article 8 allows the withholding agent to be mitigated or exempted from liability.            

If the transferor fails to declare and pay the taxable income from indirect transfer of Chinese taxable property on time or in full, and the withholding agent fails to withhold the tax, Announcement 7 clearly says interest should be imposed on the transferor. Interest shall be calculated at the benchmark inter-est rate if the transferor provides transaction information or declares and pays taxes in accordance with regulations within 30 days from the date of signing the equity transfer contract or agreement for overseas enterprises; if the transferor fails to provide information or declare and pay taxes in accord-ance with regulations, interest shall be calculated at the benchmark interest rate plus 5 percentage points. 

Because of the risk of fines imposed by withholding agents, transferees of equity in indirect transfer transactions would prefer to report relevant transactions to tax authorities, or at least negotiate with transferors of equity in order to protect their own interests. Similarly, in order to avoid the possibility of applying higher interest rates to calculate interest rates, the willingness of the transferor to report transactions will also increase.
 
Coordination with general anti-tax avoidance management measures  
Article 11 of Announcement 7 stipulates that if the tax authorities need to investigate and adjust the indirect transfer of taxable property in China, they should implement the relevant provisions of the general anti-tax avoidance. This regulation is expected to improve the tax collection and management of indirect transfer transactions by tax authorities, and to improve the certainty and protection of the tax law applicable to relevant enterprises. For example, according to the regulations, the competent tax authorities must obtain the approval of the State Administration of Taxation for major decisions in the examination and treatment of general anti-tax avoidance cases, and the enterprises concerned may express their objections to the adjustment decisions before the closure of the cases according to the methods.            
 

_{Do you want to receive news and updates directly in your mailbox? Subscribe to our newsletter. Or follow us on LinkedIn or on WeChat.}