Keeping Up with Moving Assets

China’s new indirect transfer rules to have major impact on corporate transactions

By Christopher Xing and Conrad Turley

Companies working on cross-border mergers and acquisitions, take note. A new set of Chinese tax rules for offshore indirect disposals of Chinese taxable properties went into effect Feb. 3. Issued by the State Administration of Taxation, Announcement 7 replaces Circular 698 – a source of much tax controversy over the past five years – and broadens the reporting scope and tax collection requirements pertaining to the offshore indirect transfer of Chinese companies and assets.

Announcement 7 is expected to have a major impact on cross-border M&A transactions as well as corporate restructurings in China. Compared to Circular 698, Announcement 7 expands the scope of reportable transactions to include not just transfers of offshore holding companies that ultimately own China assets such as shares, but also those holding real estate and other taxable assets. The parties exposed to the tax implications of such transactions have also been extended beyond just sellers to include buyers and even the Chinese company which is indirectly transferred.

Announcement 7 imposes more stringent tax settlement and collection mechanisms by levying a withholding tax. This requires the buyer to withhold tax at 10 percent on the realized gain derived from a taxable transaction. The timeline for transaction reporting is 30 days, and seven days for the payment of withholding tax to tax authorities. Consequently, this would likely present the parties to an M&A transaction with a multitude of issues for resolution and alignment within a short period of the transaction negotiations. The impact of “getting it wrong” under Announcement 7 could result in onerous penalties.

The touchstone criterion by which an offshore indirect transfer is considered to be taxable is the application of the “reasonable business purpose test” stemming from the general anti-avoidance provisions of China’s tax laws. In ascertaining the existence of the “reasonable business purpose” of a transaction, Announcement 7 refers to a seven factors test, which calls for a holistic consideration of the following:

  • Whether the offshore company’s principal value or source of income is derived from China
  • The functionality, duration of existence and “substitutability” of the offshore holding company
  • The overseas taxation position of the offshore transfer, including the application of double tax treaties 

Furthermore, there are also instances under Announcement 7 where transactions would be “automatically” deemed to be without reasonable business purpose if, amongst others, more than 75 percent of the value and 90 percent of the income of the offshore holding company are derived from China.

Practically, considering the strong penalties that could be imposed under Announcement 7 on both sellers (as the ultimate taxpayers) and purchasers (as withholding agents) in an M&A transaction, the transaction parties would likely need to carefully evaluate the risk of the transaction being considered taxable by Chinese tax authorities. The parties would also need to consider the potential for mitigation of penalties through a combination of voluntary reporting or the timely payment of withholding taxes, which, in theory, are refundable by the tax authorities if the transaction is eventually declared non-taxable. Nevertheless, given the limited precedents under Announcement 7, it would be difficult for buyers and sellers to know when a transaction would be considered to lack “reasonable business purposes,” and there is a greater potential for disputes between transacting parties over whether transactions should be reported, and whether tax needs to be paid or withheld.

While Announcement 7 has only recently been released, it is yet to be seen how the local tax authorities will interpret and apply the rules. Investors who at the moment indirectly hold Chinese taxable property and intend to undertake an offshore indirect transfer or corporate restructuring in the future would be well advised to carefully assess the potential impact of Announcement 7. Tax payers should also take note as the new rules will likely apply to old Circular 698 filings that are pending tax authorities’decision.