China - Tax impact on warranty clauses | KPMG | GLOBAL

China - Tax impact of warranty clauses

China - Tax impact of warranty clauses

Tax impacts of warranty clauses in China.

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Does the seller grant warranties or indemnities to the purchaser when acquiring a company?

Yes, the seller grants warranties or indemnities to the purchaser when acquiring a company.    

Does the tax treatment of the warranty depend on its legal classification (e.g. indemnity vs. reduction in the purchase price vs. others)?

There are NO specific Chinese tax regulations setting out specific tax treatments for such items. The actual tax treatment may be subject to the specific contract clauses, relevant accounting treatments and the negotiation with the in-charge tax authority rather than merely the classification of the warranty from a legal standpoint.    

To elaborate, generally speaking, the legal form of compensation arrangement in the SPA, i.e., an indemnity or a price adjustment, has different accounting treatments, which may have impacts on the tax implications. Specifically, as for an indemnity, from the Acquirer’s perspective, it would normally be recognized as non-operating income and, hence, should be included in the taxable income for Corporate Income Tax (“CIT”) purposes. Whereas, for a price adjustment, from the Acquirer’s perspective, if the auditors are willing to accept that the price adjustment goes straight to the Acquirer’s balance sheet (i.e. Dr Cash, Cr Assets), there would be no CIT impact at the current stage. However, the capital gain for future disposal will be increased.

Nevertheless, as mentioned above, since there are NO specific Chinese tax regulations to govern the tax treatment in respect of M&A transaction price adjustments or indemnities, the local tax authority’s interpretation also plays an important role in determining the actual tax treatment. Take the case mentioned above for example, if the Acquirer recognizes the indemnity as non-operating income or reduces the cost base of the asset in the case of a price adjustment, it would be questionable as to whether the Vendor will be able to deduct the indemnity before CIT or adjust the capital gain recognized previously. As such, the level of discretion the tax authorities have could potentially lead to inconsistencies and asymmetries. The potential for asymmetries is even greater when the Acquirer and Vendor are in different tax districts in China. Furthermore, the tax treatment would become more uncertain if a transaction involves PRC individuals given the individual taxpayers are unlikely to prepare audited financial statements which could influence the tax treatment.

Is classification of the contractual warranties as a price reduction clause or an indemnity clause relevant in your jurisdiction?

Yes, it is relevant. Since, as mentioned in the above, each classification may have different tax implications depending on various factors, the Vendors/Acquirers may, from a tax perspective, spend a lot of time negotiating the terms of an indemnity or a price adjustment in the SPA.   

Are mixed clauses included in the SPA (for instance, a warranty drafted partially as a price-reduction clause for the portion corresponding to the purchase price and as an indemnity clause for the amount exceeding the purchase price)?

Based on our experience, normally, only one type of warranty, i.e., either price adjustment or indemnity clause, is included in a SPA.  

Is the classification usually mentioned in the SPA?

The legal classification is usually mentioned in the SPA, which would then help differentiate the classification of the warranties from a tax perspective.    

Are there criteria to distinguish between a price reduction clause and an indemnity clause? Could you briefly describe these criteria?

There are NO specific Chinese tax regulations to govern the tax treatment in this respect. As such, there are no clear criteria specified in the Chinese tax regulations to differentiate between a price reduction clause and indemnity clause. Relevant legal terms in the SPA would help differentiate the classification of the warranties. In addition, generally, in the case where the potential payout exceeds the purchase price, the exceeded amounts may consequently be treated as an indemnity.   

What is the most common type of warranty in your jurisdiction?

The type of warranty would normally be determined based on the commercial negotiation between the vendor and seller. As for the most common type of warranty, the level of customization seen in practice is such that it is not possible to identify a ‘most common’ form of arrangement.  

Is a tax warranty usually provided by way of a separate warranty agreement (different from the SPA)?

Based on our experience, the tax warranty is normally included in the SPA.  

Is it usual / a market practice to negotiate after-tax settlements, i.e. to reduce the price adjustment to a net payment (i.e. indemnity minus the tax effect of the deduction for the acquirer or target) or to guarantee full indemnification (i.e. gross-up payment to guarantee a net indemnity)?

Based on our experience, we have not seen a specific tax clause in an SPA to govern the tax consequences arising from the indemnity/price adjustment. However, the tax treatment of the indemnity/price adjustment may be subject to the general tax clauses of the SPA.   

Acquirer

  Corporate Income Tax Personal Income Tax
Price reduction clause In general, it may be treated as a decrease in the investment value of the shares if the relevant contract clauses and accounting treatment (please see above for details) can also support this. Again, negotiation with the tax authority may also be necessary to determine the tax treatment.
Consequently, future capital gains will be increased.
In general, it may be treated as a decrease in the investment value of the shares if the relevant contract clauses can also support this. Again, negotiation with the tax authority may also be necessary to determine the tax treatment.
Consequently, future capital gains will be increased.
Indemnification clause In general, the indemnity payment is treated as taxable income No specific regulations on that. The indemnity payment may be treated as taxable income. Again, negotiation with the tax authority may also be necessary to determine the tax treatment.

Vendor

  Corporate Income Tax Personal Income Tax
Price reduction clause In principle, the price adjustment may be used to adjust the taxable income for the year in which the transaction is incurred and claim the tax refunds, if any, provided that the relevant contract clauses and accounting treatment can also support this. Again, negotiation with the tax authority may also be necessary to determine the tax treatment. There may be a risk that the tax authority treats the price adjustment as a non-deductible capital loss, i.e., the asymmetries mentioned above may arise. In principle, the price adjustment may be used to adjust the taxable income for the year in which the transaction occurred and claim the tax refunds, if any, provided that the relevant contract clauses can also support this. Again, negotiation with the tax authority may also be necessary to determine the tax treatment. There may be a risk that the tax authority treats the price adjustment as a non-deductible capital loss, i.e., the asymmetries mentioned above may arise.
Indemnification clause In principle, the indemnity may be tax deductible in the year in which the indemnity is made if the relevant contract clauses and accounting treatment can also support this. Again, negotiation with the tax authority may also be necessary to determine the tax treatment. There may be a risk that the tax authority denies the deduction of the indemnity payment for CIT purposes, i.e., the asymmetries mentioned above may arise No specific regulations on that. The capital gain, if any, may be reduced by the indemnity for the year in which the transaction occurred and the vendor may be able to claim tax refunds from the tax authority. However, negotiation with the tax authority may also be necessary to determine the tax treatment. There may be a risk that the tax authority treats the indemnity as a non-deductible capital loss, i.e., the asymmetries mentioned above may arise

Target

Price reduction clause N/A**
Indemnification clause N/A

*The comments above are provided based on the assumption that the term ‘warranty’ used here is in a general sense only (i.e., focused solely on indemnities and price adjustments) and, hence, our comments will only deal with indemnities and price adjustments and not with warranties which may have a broader implication than the above. Before providing our comments, we would also like to highlight that there are NO specific Chinese tax regulations to govern the tax treatment in respect of M&A transaction price adjustments or indemnities. The comments are provided based on the general principles of PRC tax laws and regulations. However, please note that, given that there are no specific Chinese tax regulations in this area, local tax authorities have relatively wide discretion in applying the tax rules. As such, the actual tax treatment may be impacted by the local authority’s reaction to/interpretation of specific contract clauses and relevant accounting treatments and ultimately final outcomes may turn on negotiations with the tax authority in charge. In addition, the comments are provided based on the assumption that both Acquirer and Vendor are Chinese domestic companies/individuals and that the price adjustment / indemnity will be made in one way, i.e., the Vendor makes a payment to the Acquirer. Furthermore, we assume that the underlying target involved in transactions is an unlisted company.

** Non-available

Contacts

John Gu

KPMG China

Partner, Head of Deal Advisory, M&A Tax

Tel : + 86 (10) 8508 7095

john.gu@kpmg.com

Christopher Xing

KPMG China

Partner, M&A, Head of International Tax

Tel : + 86 (10) 8508 7072

christopher.xing@kpmg.com


Josephine Jiang

KPMG China

Partner, M&A, R&D Tax Services

Tel : + 86 (10) 8508 7511

josephine.jiang@kpmg.com
 

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