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11.1.2. Additional Considerations / Reorganization Relief

China law includes provisions for enterprise reorganization relief in some cases. The following outlines when relief can be applied (special tax treatment), and when it cannot (standard tax treatment).

Taxable Reorganizations (Standard Tax Treatment)

If a transaction does not qualify for special tax treatment, a resident enterprise which is disposing of its assets or liabilities will be subject to CIT of 25% on any gains realized. If the selling enterprise is a non-resident, it will be subject to withholding tax of 10%.

The following outlines the tax implications for various forms of reorganization.

Change in Legal Form

See Sec. 11.2.

Debt Restructuring

If non-monetary assets are used in repayment of debt, they will be treated as a sale of the assets at fair market prices, followed by a repayment of debt. Debt to equity transaction will be treated as repayment of debt followed by equity investment.

In either case, any gain or loss will be recognized to the extent of the difference between the repayment amount and the debt basis.

Share and Asset Acquisitions

Any gain or loss from the sale of shares or assets will be recognized by the seller. The buyer’s tax basis in the acquired shares or assets shall be determined based on their fair market value.

The tax attributes of the target, such as tax losses and tax holidays, shall generally remain the same in the case of a share acquisition.

Mergers

The basis of the assets and liabilities of the acquirer after a merger is determined based on their fair market value. The merger shall be treated as a taxable liquidation for the target enterprise and its shareholders. In a taxable merger, the losses of the target cannot be carried forward to the acquirer.

Non-Taxable Reorganizations (Special Tax Treatment)

If all of the following five tests are met, enterprises are allowed to elect for special tax treatment:

  • Business purpose test - the reorganization must have reasonable business purposes and the main purpose is not to reduce, avoid or defer tax;
  • Substantially all test - the shares or assets acquired are not less than 50% (changed from 75% effective 1 January 2015) of the total shares or assets of the target;
  • Equity consideration test - no less than 85% of the total consideration must be in equity form;
  • Continuity of business test - the substantial operations of the target must not change within 12 consecutive months after the reorganization; and
  • Continuity of proprietary interest test - the main shareholders receiving equity as consideration must not transfer such equity within 12 consecutive months after the reorganization.

If the special tax treatment applies, then to the extent the reorganization is paid in equity, no gain or loss shall be recognized and all the assets and liabilities shall have a carry-over basis. A gain or loss shall be recognized for the portion of the reorganization paid in cash or other property, based on the following formula:

Gains or losses = (Fair market value of the transferred assets – Tax basis in such assets) × (Cash or other property ÷ Fair market value of the transferred assets)

Specific special tax treatment for each form of reorganization that qualifies is as follows.

Debt Restructuring

If the debt restructuring income accounts for more than 50% of the total taxable income of an enterprise in a tax year, the income can be spread over a 5-year period.

Share and Asset Acquisitions

For the shareholders of the target, the basis in the equity received will be determined on the original basis in the equity or assets sold (exchange basis).

The basis of the acquirer in the target shall also be determined based on the target’s shareholders’ original basis in such equity or assets.

The basis of other assets and liabilities of the target and the acquirer as well as all the tax attributes shall remain the same.

Mergers

The acquirer’s basis in the acquired assets and liabilities shall be determined based on the target’s original basis in those assets and liabilities (carryover basis). All the tax attributes of the target shall be carried over to the acquirer, except that the carryover of losses is subject to the following limitation:

Limitation = Fair market value of the net assets of the target × Interest rate of the longest term government bond issued by the State as of the end of the year of the merger

The basis of the shareholders of the target in the equity received shall be determined based on their original basis (exchange basis).

Approval for Special Tax Treatment

Prior to tax year 2015, special tax filing was required for approval for special tax treatment. However, under Public Notice 48/2015, the special tax filing is no longer required. Instead, to apply special tax treatment, the parties to a reorganization are required to submit designated forms, schedules, and supporting documents when filing their annual tax returns for the tax year in which the reorganization is completed. The dominant party to the transaction must submit a report explaining the business purpose of the reorganization, including:

  • The method of reorganization and the result;
  • The change in each party’s tax and financial position as a result of the reorganization; and
  • Whether non-resident enterprises were involved in the reorganization

If a party to a merger or corporate division results in corporate liquidation, the documentation must be submitted before the tax liquidation process. The definition of parties to a reorganization, dominant party, and reorganization date are provided in Notice 48 as follows.

Parties to a reorganization:

  • The debtor and creditor in a debt restructuring;
  • The transferor, transferee, and acquired entity in an equity acquisition;
  • The seller and buyer in an asset acquisition;
  • The seller and buyer of the assets and liabilities and the shareholders of the seller in a merger; and
  • The seller and buyer of the assets and the shareholders of the seller in a corporate division

Individual persons may also be a party to a reorganization, but the special tax treatment is not available and the standard rules for individual income taxation apply.

Dominant party in a reorganization:

  • The debtor in a debt restructuring;
  • The transferor in an equity acquisition (if there is more than one, the dominant party is the transferor who sells the highest percentage of equity in the transaction);
  • The seller in an asset acquisition;
  • The seller of the assets and liabilities in a merger (if there is more than one, the dominant party is the seller with the greatest equity value); and
  • The seller of the assets in a corporate division

Reorganization completion date:

  • In a debt restructuring, the date on which the reorganization agreement or court decision takes effect;
  • In an equity acquisition, the date on which the equity acquisition agreement takes effect and the change of ownership of the equity is completed;
  • In an asset acquisition, the date on which the asset acquisition agreement takes effect and the parties to the asset acquisition have made the necessary adjustment to accounting records;
  • In a merger, the date on which the merger agreement takes effect, the parties to the merger have made the necessary adjustment to accounting records, and the procedural registration or change for the merger has been completed; and
  • In a corporate division, the date on which the corporate division agreement takes effect, the parties to the merger have made the necessary adjustment to accounting records, and the procedural registration or change for the separation has been completed

Cross-Border Reorganizations

The special tax treatment rules discussed above apply to reorganizations taking place within mainland China. In order to receive special tax treatment in cross-border reorganizations, the reorganization must meet additional conditions stipulated by China tax authorities in addition to the five tests discussed above. Specific additional conditions are outlined below.

Foreign to Foreign Transfers of Equity in a Chinese Enterprise

When a foreign enterprise transfers its equity in a Chinese enterprise to a related foreign enterprise, the special tax treatment is available only when the following three additional conditions are met:

  • The transferor must have a 100% direct ownership in the transferee
  • The transfer must not result in a reduction in the Chinese withholding tax on capital gains from future exit
  • The transferor undertakes in writing that it will not sell the equity in the transferee within three years after the transfer

Foreign to Domestic Transfers of Equity in a Chinese Enterprise

Where a foreign enterprise transfers its equity in a Chinese enterprise to a related enterprise in China, special tax treatment is available only if the transferor has a 100% direct ownership in the transferee.

Outbound Investments

When a Chinese enterprise makes outbound investments using the assets or equity it has, the special tax treatment is available only if the Chinese enterprise has a 100% direct ownership in the investee enterprise. If a gain is recognized from the investment, it can be spread evenly over a 10-year period.

For all other circumstances involving cross-border reorganizations, the special tax treatment is available only upon special approval of the MOF or the SAT.

Documentation Requirements

If an enterprise wishes to elect for special tax treatment, it must file its annual tax return together with relevant supporting documents to the relevant tax authorities once the reorganization is completed. The documents should substantiate the enterprise’s qualifications for tax-free treatment and failure to file such documents will result in the denial of the special tax treatment.

Special Rules on Tax Incentive Carryover

In cases where an existing enterprise merges into another existing enterprise with the former being dissolved, then provided that the latter’s business operations and conditions for enjoying the tax incentive remain unchanged, the surviving enterprise can continue to enjoy its incentives regardless of the tax treatment of the merger.

However, such incentives are subject to a cap equal to the amount of the taxable income of the surviving enterprise in the year prior to the merger. If the enterprise incurs a loss in the year prior to the merger, the cap is deemed to be zero.

Step Transaction Notion

Under the substance over form principle, a series of formally separate steps taking place within a 12-month period before or after a reorganization shall be collapsed and treated as if they constituted a single integrated transaction. In such cases, the parties to the reorganization are allowed to temporarily apply special tax treatment in the year of the first step if it is expected that the entire reorganization will meet the conditions for special tax treatment.

The parties must submit the required documentation with their annual tax return for that first year and report whether there were other related transfers of assets or equity in the past 12 months. If there were, the party must explain whether the current reorganization and the past transactions are considered a single transaction. The parties must also report in the second year when the reorganization steps are complete, and determine if the reorganization meets the requirement for special tax treatment. If the requirements are not met, the tax return of the previous year is adjusted.

China’s Rules on Indirect Equity Interest Transfers

Non-residents need to be careful when transferring holdings with an indirect ownership in Chinese companies as the Chinese tax authorities are more actively seeking to tax such transactions.

From 2008, China’s Enterprise Income Tax Law allows tax authorities to impose a 10% tax on capital gains earned by a non-resident from the disposal of an equity interest in a Chinese company. In order to circumvent the tax, non-resident companies began using holding companies established in low or no tax jurisdictions to indirectly hold Chinese companies. As a result, China’s State Administration of Taxation issued Circular 698 in 2009, which includes provisions for the taxation of indirect transfers, and issued SAT Bulletin 24 in 2011 for further clarification.

Circular 698 states that when an intermediate entity with a Chinese company ownership interest is in a jurisdiction that does not tax overseas income or has a tax rate lower than 12.5%, transactions involving the transfer of shares of such entity must be disclosed to the local tax administration authority of the Chinese company. When there is no commercial justification for the entity or the transaction aside from tax avoidance, the transaction will be taxed. If a tax treaty is in place, the provisions concerning capital gains may apply.

Rules for Indirect Transfers Revised and Expanded

On 6 February 2015, the State Administration of Taxation issued Public Notice 7 (2015), which expands upon and generally replaces the rules provided in Circular 698 and SAT Bulletin 24.

Recharacterization and Scope of Assets

An indirect transfer of assets will be recharacterized as a direct transfer for tax purposes if the arrangement does not have a reasonable commercial purpose and avoids CIT. Assets are defined as:

  • Assets attributed to an establishment in China (movable property);
  • Immovable property situated in China; and
  • Shares in a China resident company.

An indirect transfer is defined as a transfer of shares or equity-like interests in a non-resident intermediary enterprise that directly or indirectly holds Chinese taxable assets.

Reasonable Commercial Purpose

Notice 7 includes seven factors to be considered in determining if an indirect transfer transaction has a reasonable commercial purpose:

  • Whether the equity value of the nonresident intermediary enterprise is derived directly or indirectly mainly from Chinese taxable assets;
  • Whether the nonresident intermediary enterprise’s assets consist directly or indirectly mainly of investment in China, or whether its income is directly or indirectly mainly from a Chinese source;
  • Whether the functions and risks undertaken by the nonresident intermediary enterprise and its subsidiaries directly or indirectly holding the Chinese taxable assets can justify the economic substance of the organizational structure;
  • The length of time the shareholders, the business model, and the relevant organizational structure of the nonresident intermediary enterprise have existed;
  • Whether foreign income tax applies to the income from the indirect transfer;
  • Whether the indirect investment/transfer could have been made through a direct investment/transfer; and
  • Whether an income tax treaty or other arrangement applies to the indirect transfer.

In addition to the seven factors to be considered, Notice 7 introduces four conditions that, if all are met, will result in an indirect transfer being deemed to not have a reasonable commercial purpose unless the safe harbor rules apply (below):

  • 75% or more of the equity value of the nonresident intermediary enterprise is directly or indirectly derived from Chinese taxable assets;
  • 90% or more of the nonresident intermediary enterprise’s total assets (excluding cash) directly or indirectly consist of investments in China at any time in the 12 months prior to the indirect transfer, or 90% or more of its income is directly or indirectly derived from China within the 12 months prior to the indirect transfer;
  • The nonresident intermediary enterprise and its subsidiaries directly or indirectly holding the Chinese taxable assets do not perform sufficient functions or assume sufficient risk to prove their economic substance; and
  • The foreign tax payable on the gain resulting from the indirect transfer of assets is less than what the Chinese tax payable would be if transferred directly.

Safe Harbor

Notice 7 introduces two situations where the indirect transfer rules will not apply, including:

  • When a non-resident derives income from the indirect transfer of Chinese taxable assets through the acquisition and sale of shares of a foreign enterprise listed on a public exchange; and
  • When the provisions of an applicable tax treaty or other arrangements would have resulted in an exemption if the transaction was a direct transfer.

Also introduced in Notice 7 is a safe harbor for group reorganizations. A qualifying internal reorganization involving an indirect transfer of Chinese assets will be deemed to have reasonable commercial purpose if the following three conditions are met:

  • The transferor and transferee are qualified related parties, meaning one party directly or indirectly owns 80% or more of the shares of the other, or a third party directly or indirectly owns 80% or more of the shares of both - however, the ownership requirement is 100% if 50% or more of the equity interest value of the of transferred non-resident intermediary enterprise is derived directly or indirectly from immovable assets in China;
  • The Chinese tax payable on a possible subsequent indirect transfer of the same Chinese taxable assets must not be lower than what the tax payable would have been on the first transfer in the same or similar circumstances; and
  • Consideration paid by the transferee must consist entirely of its own shares, or shares of the company controlling the transferee (excluding shares of companies listed on a public exchange).

Reporting Obligations and Penalties

The mandatory reporting obligations that were included in Circular 698 are made voluntary by Notice 7. However, the tax authorities may now request information on a transaction from either party to a transaction, as well as the China resident enterprise and any person involved in planning the transaction. Under Circular 698, only the transferor was required to submit information.

Although now voluntary, if an indirect transfer results in a China tax obligation and is not reported, higher late payment interest penalties will apply and withholding agents will also be subject to penalties. Required documents include:

  • Share transfer agreement;
  • Organization charts prior to the transfer and after;
  • Financial statements for the two previous fiscal years of the nonresident intermediary enterprise and its subsidiaries directly or indirectly holding the Chinese taxable assets; and
  • A statement detailing why the indirect transfer should not be recharacterized as a direct transfer.

If required documents are not submitted within 30 days of signing the transaction agreement, the late payment interest penalty (if tax obligation applies) will be the basic loan rate published by the People’s Bank of China plus 5%. If submitted within 30 days, the basic loan rate applies.

If the withholding agent fails to withhold tax, a penalty of 50% to 300% of the tax not withheld may be imposed.

Method and Timing of Taxation

When an indirect transfer is recharacterized as a direct transfer, the taxation of the capital gain will depend on whether attributed to an establishment or not. If effectively connected to the transferor’s establishment or place of business in China, the gain will be included in taxable income of the establishment or place of business. If not effectively connected with an establishment or place of business, the gain will be subject to withholding tax. In either case, the tax liability arises in the year the share transfer agreement has become effective and the change of ownership completed.

As with previous rules, final assessments must be approved by the SAT.

Public Notice 7 is dated 3 February 2015, and applies from that date. The rules also apply for pending cases of indirect transfers prior to that date if not yet settled by the Chinese tax authorities.