Over the past year, new People’s Republic of China1 tax rules affecting merger and acquisition (M&A) activities in China were issued by the State Administration of Taxation (SAT) and other government departments. While these new tax rules mostly enhance and update existing rules, they have brought significant changes for investors undertaking M&A activities in China.
Over the past year, new People’s Republic of China1 tax rules affecting merger and acquisition (M&A) activities in China were issued by the State Administration of Taxation (SAT) and other
government departments. While these new tax rules mostly enhance and update existing rules, they have brought significant changes for investors undertaking M&A activities in China.
China also remains at the forefront of implementing the Organisation for Economic Co-operation
and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) projects and has issued the
Chinese language version of the BEPS deliverables. In February 2018, the SAT updated its rules for determining beneficial ownership (BO) status in
order to claim treaty benefits. In September 2015, the SAT issued a public discussion draft on special tax adjustments regarding general anti-avoidance rules (GAAR) and transfer pricing; to date, these rules are not finalized.
The SAT also issued Announcement  No.42 (Announcement 42), which set out guidelines
for reporting related-party transactions and contemporaneous documentation. Further, the SAT issued Announcement  No.6 (Announcement 6), which provides for tax risk management, tax investigations and adjustments, and negotiation procedures on special tax adjustments imputed by the Chinese tax authorities.
This report highlights recent M&A-related tax developments in China and then addresses the three fundamental decisions that a prospective buyer typically faces when undertaking M&A transactions in China:
Determining beneficial owner status for claiming treaty benefits
On 6 February 2018, the SAT issued the SAT Announcement  No.9 (Announcement 9), which will replace Guoshuifa  No.601 (Circular 601) and SAT Announcement  No.30 (Announcement 30) as of 1 April 2018, both of which were key circulars setting out the rules for foreign investors claiming treaty benefits on their Chinese-sourced dividend, interest and royalty income (‘Chinese-sourced passive income’).
In the context of M&A, the key changes to the BO assessment requirements in Announcement 9 are set out below.
Extended the BO safe harbor rules (Announcement 30) Announcement 30 introduced a BO safe harbor rule that allowed a foreign recipient that is a listed company or directly
or indirectly held by a listed company to qualify as a BO for the
purpose of claiming treaty benefits on their Chinese-sourced passive income. However, Announcement 30 requires the recipient of the Chinese-sourced passive income to have
a 100 percent equity relationship with the listed company, which must be a tax-resident enterprise (TRE) in the same jurisdiction as the recipient.
Announcement 9 extends the BO safe harbor rules to broadly include government bodies and individuals who are either the direct recipients of the Chinese-sourced passive income, or indirect recipients where the intermediary companies (if any) are TREs in the same jurisdiction as the government bodies and individuals.
Same jurisdiction rule for treaty benefits
Announcement 9 further allows the immediate recipient that meets the following two conditions to qualify as a BO for the purpose of claiming treaty benefits on their Chinese-sourced passive income:
Negative factors under Circular 601
Announcement 9 amended and removed some of the ‘seven negative factors’ under Circular 601.
The first negative factor considers whether the foreign recipient (as the BO applicant) is obligated to pay or distribute some (e.g. 60 percent or more) or all of its income to its shareholder(s) or other parties within a certain timeframe. This factor has been amended to consider whether the same BO applicant is obligated to pay or distribute 50 percent of its income to its shareholder(s) or other parties or more within 12 months after receiving the Chinese-sourced passive income. Announcement 9 defines ‘obligated’ to include both agreed obligations and situations where there are no agreed obligations but the income has actually been paid by the BO applicant to its shareholder(s) or other parties.
For the second negative factor considers whether the BO applicant has little or no other business activities except for the properties or rights from which the Chinese-sourced passive income is derived. This factor has been amended to consider the substance of the BO applicant’s business activities (including manufacturing, retail and management
activities) as well as the function and risk assumed by the BO applicant in carrying out these activities. Additionally, for the investment holding and management activities undertaken by the BO applicant, Announcement 9 clarifies that the substance requirements for carrying on such activities should generally include preliminary study, assessment and analysis, investment decisions, implementation and post-investment management activities. Where the BO applicant’s investment holding, management and other business activities are considered insignificant, the BO applicant would be regarded as not carrying on substantial business activities.
A BO applicant that exhibits a number of the negative factors under Announcement 9 would be at risk of losing treaty benefits on its Chinese-sourced passive income.
The issuance of Announcement 9 has further demonstrated the SAT’s commitment to implement the BEPS Action Plan recommendations to further improve the overall Chinese tax system. For M&A transactions, the safe harbor rules under Announcement 9 allow for a more efficient and effective structure where the commercial substance of other group companies can now be shared under the same jurisdiction/same treaty benefit rule (provided the relevant conditions are met).
New guidance on withholding tax (WHT) administration
On 17 October 2017, the SAT issued the SAT Announcement  No.37 (Announcement 37) and new official interpretative guidance on withholding tax (WHT) administration. Announcement 37 is effective from 1 December 2017, but certain provisions may apply to unsettled cases occurring before the effective date. Announcement 37 replaces a number of tax circulars, including Circular  No.3 (Circular 3) on WHT administration, the remaining provisions in Circular  No.698 (Circular 698) on the calculation of capital gain, and certain other tax circulars.
In a M&A context, the key changes to the existing WHT administration rules introduced under Announcement 37 broadly as follows:
While Announcement 37 reduces the WHT compliance burdens of the withholding agents and non-Chinese resident payees/investors, it has raised a number of ambiguities that need to be addressed. For example, it remains uncertain whether penalty interest should be imposed on a seller under an indirect transfer transaction, if taxable under SAT Announcement  No.7 (Announcement 7). Therefore,
it is important to consider the new WHT administration timing requirements when undertaking M&A transactions in China, in particular, in sale and purchase agreement (SPA) negotiations involving the indirect transfer of Chinese taxable assets.
Deferral of WHT on dividends reinvested into ‘encouraged projects’
On 28 December 2017, the Ministry of Finance (MOF), Ministry of Commerce (MOFCOM), National Development and Reform Commission (NDRC) and SAT jointly issued Caishui  No.88 (Circular 88). The SAT subsequently issued the SAT Announcement  No.3 on 2 January 2018. Collectively, these circulars set out the rules and guidance providing foreign investors with preferential WHT deferral treatment on dividend reinvestments in China.
The above rules and guidance broadly cover the following:
Conditions for attaining the dividend WHT deferral
Circular 88 outlines the following four principal conditions that foreign investors must all satisfy to attain the WHT deferral benefit:
As with many tax circulars in China, Circular 88 provides new guidance on the WHT treatment on reinvestment projects but also raises uncertainties (e.g. whether the dividend WHT rates under tax treaty can claimed by the foreign investors if they divest their equity interest in the reinvested Chinese resident enterprises). KPMG in China expects the SAT to address these uncertainties through supplementary guidance in the future. When planning for future reinvestment of dividends in China for M&A transactions, it would be important to consider whether such reinvestment would fall within the scope of Circular 88, and especially whether the conditions for accessing the dividend WHT deferral benefits would be met.
Offshore indirect disposals
China’s existing offshore indirect disposal reporting and taxation rules were completely revamped, with Announcement 7 (replacing Circular 698, which was abolished by Announcement 37).
The offshore indirect disposal rules seek to ensure that Chinese tax cannot be avoided through the interposition of an offshore intermediary holding entity that holds the Chinese assets. Under these rules, if an offshore indirect disposal
of Chinese taxable property (discussed further below) by a non-Chinese TRE is regarded as being undertaken without reasonable business purposes with the aim to avoid Chinese corporate income taxes (CIT), the transaction would be re- characterized as a direct transfer of Chinese taxable property and subject to Chinese WHT at the rate of 10 percent under the Chinese GAAR.
However, the tax basis for calculating taxable gains for indirect transfers has been unclear, and the practice varies between different locations and tax authorities.
Compared with Circular 698, Announcement 7 expands the scope of the transactions covered, enhances the enforcement mechanism and sets out a more specific framework
for dealing with so-called ‘tax arrangements’ with the introduction of a safe harbor and a black list. The major aspects of the rules under Announcement 7 are as follows:
A parallel ‘automatic deeming’ test was introduced, which treats an indirect transfer transaction as lacking reasonable business purpose if, among other black-list factors, more than 75 percent of the value and more than 90 percent of the income or assets of the offshore holding company are derived from or attributable to China. New safe harbor rules to deem a transaction as having ‘reasonable business purposes’ or otherwise not taxable cover the following situations:
In practice, Announcement 7 creates many challenges in its application to indirect transfer transactions due to the difficulties of aligning buyer and seller positions on the reporting and taxability of an indirect transfer M&A transaction. The seller and buyer sometimes find it difficult to agree on whether the Chinese tax authorities would consider an indirect transfer transaction as lacking reasonable business purposes, particularly where there is certain substance offshore. Given the potential stiff penalties that could apply, particularly for buyers as the withholding agents, and given the potential mitigation of penalties through timely voluntary reporting of the indirect transfer cases to the Chinese tax authorities, disputes can arise between transacting parties over whether transactions should be reported at all and whether, and how much, tax needs to be paid or withheld. Historically, escrow and indemnity arrangements have been used in practice. Now, buyers increasingly tend to require sellers to timely report the transaction to the Chinese tax authorities as a condition for closing the deal.
Announcement 7 was supplemented by Shuizonghan  No. 68 (Circular 68), which provides further implementation guidance and an improved reporting mechanism. The circular clarifies Announcement 7’s measures regarding formal receipts for taxpayer reporting (giving assurance in relation to the penalty mitigation measures), single reporting for transferred Chinese taxable assets in multiple locations in China, and GAAR procedures (including SAT review and appeal procedures). However, there is still a need for a clarified refund process, confirmation on the applicability of
safe harbors, and timeframes for the conclusion of the GAAR investigations.
Also, there have been cases in the past where the gains on the sale of offshore companies were regarded as Chinese- sourced on the basis that the offshore company’s tax residency is deemed to be in the Chinese under Chinese domestic tax laws (broadly based on the place of effective management). The approach was first applied in a Circular 698 reporting case in the Heilongjiang province of China in 2012 that was made public. Hence, the tax resident status of foreign incorporated enterprises (particularly those controlled by Chinese residents) should be considered when assessing whether gains from the disposal of Chinese equities offshore by foreign investors in the M&A space could be taxable in the Chinese resident company simply under Chinese domestic tax laws.
This additional exposure needs to be monitored and factored into M&A transactions where foreign investors make offshore indirect acquisitions and disposals of Chinese investments.
Negotiations may be further complicated where investors seek to obtain warranties and indemnities that the deal target is not effectively managed from the Chinese.
Value-added tax and land appreciation tax on onshore indirect disposals of properties situated in China
Under Chinese land appreciation tax (LAT) regulations, a transfer of an equity interest in Chinese TRE technically should not give rise to LAT as any underlying properties are not directly transferred. However, the tax authorities may seek to impose LAT on the transfer of an equity interest in a Chinese company that directly holds real estate if the transfer consideration is equivalent to the value of the real estate and/ or the primary purpose of the equity transfer is to transfer the land use right and property (rather than the company). There have been some enforcement cases where transfers of equity interests in Chinese property holding companies were re-characterized as direct transfers of Chinese properties for LAT purposes and thus LAT was imposed on the sale of equity interests in the Chinese holding company as if the underlying property had been disposed of.
Further, a local tax circular issued by the Hunan tax authority (i.e. Xiang Di Shui Cai Xing Bian Han  No.3) clarifies that the ‘transfer of properties in the name of transfer of equity’ should be subject to LAT, because the transfer of Chinese company shares, which in substance represents a transfer of the underlying Chinese properties, should be subject to LAT.
Currently, only transactions that are deemed as ‘disguised’ property transfers would be subject to LAT, which would be assessed case-by-case. In making the assessments, the Chinese tax authorities would look at certain criteria to decide whether the nature of the transaction is, in substance, a property transfer transaction. These criteria include:
The look-through of an equity transfer to impose LAT is not explicitly supported by existing LAT law (which, unlike the CIT Law, does not have an anti-avoidance provision). Hence, these look-through cases are still rare in practice, but investors should closely monitor future developments as this approach could significantly affect investment returns.
The position under China’s new value added tax (VAT) rules, in effect since 1 May 2016, is similar.That is, the transfer of unlisted equity interests is not subject to VAT. However, the transfer
of real estate assets is generally subject to 11 percent VAT (or a reduced rate of 5 percent, where certain grandfathering arrangements apply).The new VAT rules contain an anti- avoidance provision and the tax authorities could take a look-
through approach similar to the above on LAT and impose VAT on disguised transfers of properties via equity transfers.
Treaty relief claims
In 2009, the Chinese tax authorities adopted measures to monitor and resist granting tax treaty relief in cases of perceived treaty shopping through the use of tax treaties to gain tax advantages. Guoshuifa  No. 124 (Circular 124, issued in 2009, which is superseded by another tax circular; see below) introduced procedural requirements under which tax authority pre-approval may be required before treaty relief can be applied. This has made it easier for the tax authorities to identify cases where the taxpayer is relying on treaty protection.
Circular 601 and Announcement 30 (both of which will be superseded by Announcement 9 from 1 April 2018) and
Shuizonghan  No. 165 (Circular 165, issued in April 2013) set out the factors that the Chinese tax authorities should take into account in deciding whether a treaty’s BO requirements are satisfied. These circulars also provide guidance on the interpretation of the negative factors.
In 2015, the SAT issued SAT Announcement  No. 60 (Announcement 60), which replaced Circular 124 and revamped the tax treaty relief system. The new system, which took effect as of 1 November 2015, abolishes the tax treaty relief pre-approval system under Circular 124. Instead, the taxpayer self-determines whether tax treaty relief applies and informs the withholding agent (or the tax authority directly where no withholding agent is involved) that it will be claiming the treaty relief.
To encourage the withholding agent to process the relief without taking on excessive risk and uncertainty, the detailed tax treaty relief forms, completed by the taxpayer, include
a section requiring information that the withholding agent will check before applying the treaty rate and a separate, more detailed section that the tax authorities may refer to during their follow-up procedures. The withholding agent’s section includes, along with basic details on how the taxpayer satisfies the terms of the treaty, a BO test defined under Circular 601 (to be replaced by Announcement 9 from 1 April 2018), which is a control test along the lines of that applied in other countries.
Following the release of Announcement 60, on 29 October 2015, the SAT further issued Shuizongfa  No. 128 (Circular 128) to clarify the follow-up procedures as emphasized in Announcement 60. Circular 128 stipulates that the Chinese tax authorities would audit at least 30 percent
of the tax treaty relief claim cases on dividends, interest, royalties and capital gain within 3 months after the end of each quarter and perform special audits to assess the risks of treaty abuse in various aspects. If the tax authorities discover on examination that treaty relief should not have applied and tax was underpaid, the tax authorities would instruct the taxpayer to pay the underpaid tax within a set time period.
If the payment is not made on time, then the tax authorities can pursue other Chinese sourced income of the non-resident or take stronger enforcement action under the ChineseTax Collection and Administration Law.The tax authorities may also launch anti-avoidance proceedings, either under the relevant anti-abuse articles of tax treaties or the domestic GAAR.
In view of Circular 128, there have been cases where the Chinese tax authorities have sought to recover underpaid taxes from treaty relief claimants due to their improper treaty claims. In a recent case in Quanzhou City, Fujian Province published in 2017, a Hong Kong (SAR) company was regarded by the Chinese tax authorities as a conduit company that was established predominantly for the purpose of attaining the reduced WHT rate of 5 percent instead of 10 percent under the Hong Kong-China tax treaty. Consequently, the Chinese tax authorities have recovered the underpaid dividend WHT of 10.46 million Chinese Yuan Renminbi (CNT) and imposed a late payment surcharge of CNY423,600.
On 6 February 2018, the SAT issued Announcement 9, which will replace Circular 601 and Announcement 30 as of 1 April 2018 (see ‘Recent developments’).
In summary, the treaty relief system under Announcement 60 remains as an open and efficient channel to access treaty relief and aid the conduct of M&A and restructuring transactions. However, taxpayers have a greater burden
to ensure that self-assessment is grounded in prudence and satisfies the relevant conditions, including those under Circular 601 and Announcement 30 (before 1 April 2018) and
Announcement 9 (on and after 1 April 2018).
While Announcement 9 has set out the relevant rules and addressed certain issues pertaining to treaty benefit claims for foreign investors, there are still uncertainties regarding how the assessment of BO of dividends distributed from Chinese resident enterprises to their foreign shareholders would align with international practice and norms. For example, it is uncertain whether unincorporated entities such as partnerships and trusts that are paying foreign CIT in their own capacities would be eligible to apply for treaty benefits in their own right, rather than being treated by the Chinese tax authorities as a pass-through.
In 2014 and 2015, a number of key improvements to the Chinese tax restructuring reliefs were made to the STT that results in tax deferral treatment for corporate restructurings. The changes lower the eligibility threshold and introduced new ways to access STT.
Circular 59, the principal tax regulation on restructuring relief issued in 2009, sets out the circumstances in which companies undergoing restructuring can elect for STT. Absent the application of STT, the general tax treatment (GTT) requires recognition of gains/losses arising from the restructuring. The STT conditions include two tests:
The conditions also set out two threshold tests that aim to ensure the continuity of ownership and the continued integrity of the business following the restructuring. Under these tests:
Although Circular 59 was intended to provide favorable tax treatment to restructuring transactions, STT had not been widely used due to the high thresholds. Caishui  No. 109 (Circular
109) was subsequently issued to lower the 75 percent asset/ equity acquisition threshold to 50 percent. This facilitates the conduct of many more takeovers/restructurings in a tax- neutral manner. Circular 109 also introduces a new condition for STT that removes the 75 percent ownership test. The new condition permits elective non-recognition of income on transfer of assets/equity between two Chinese TREs that are
in a ‘100 percent holding relationship’, provided no accounting gains/losses are recognized. Both the purpose test and the continuing business test from Circular 59 hold, and the tax basis of transferred assets for future disposal is their original tax basis. The supplementary SAT Announcement  No. 40 (Announcement 40) clarifies certain terms used in Circular 109 and spells out in detail the situations to which the relief applies.
Given that China does not, unlike many other countries, have comprehensive group relief or tax consolidation rules, the introduction of this intragroup transfer relief is a real break- through in Chinese tax law. However, the relief does not cover transfers of Chinese assets by non-TREs (whether between two non-TREs or between a non-TRE and a TRE). Taxpayers also need to be aware of the emphasis being placed by tax authorities on the purpose test, particularly as the intragroup transfer relief opens the door to tax loss planning strategies that previously were not possible under Chinese tax law.
SAT Announcement  No. 48 (Announcement 48) also abolishes the tax authority pre-approvals previously needed for STT to be applied, moving instead to more detailed STT filing at the time of the annual CIT filing. The transition from tax authority pre-approval to taxpayer self-determination
on the applicability of STT (and on tax treaty relief claims as discussed earlier) is in line with the broader shift in Chinese tax administration away from pre-approvals. However, while the abolition of pre-approvals potentially expedites transactions, it also places a greater burden on taxpayer risk management procedures and systems to ensure that treatments adopted are justified and adequately supported with documentation.
China’s transition from business tax (BT) to VAT has been a major tax reform initiative, which was designed to facilitate the growth and development of the services sector and to relieve the indirect tax impact in many business-to-business transactions. Since 2012, the VAT reforms have been gradually expanded to sectors which were historically under the BT regime.
As of 1 May 2016, all transactions involving goods and/or services became within the scope of VAT, and BT is no longer in operation. The following sectors are among the last major batch that transitioned from BT to VAT from 1 May 2016:
real estate and construction, financial services, and lifestyle services (which is a general category capturing all other services).
In the context of M&A transactions, the VAT reform rules significantly affect how transactions are undertaken, whether by way of asset or business transfer or equity. Given the significant changes in VAT rates for some industries (compared with the previous BT rates), the ability to recover VAT under contracts that may be acquired or assumed as part of any M&A transactions is a significant area of focus.The funding
of transactions also needs to take into account the VAT implications, given that China’s VAT system applies 6 percent VAT to financial services, including interest income.
The Chinese government issued a number of circulars during 2017 to clarify certain VAT-related uncertainties and adjust certain existing VAT rates. Therefore, it is expected that the Chinese VAT system will continue to evolve in the future,
to further update and clarify various practical aspects of the Chinese VAT reform that remain uncertain.
More recently, as of 1 January 2018, new VAT rules were introduced to reduce the applicable VAT rate for the operation of asset management products, such as trusts and funds,
to 3 percent (from 6 percent) for Chinese asset managers but without the ability to claim input VAT credits. This change
affects interest income derived from such asset management products, as well as gains on trading of financial products (among other things). However, whether the new VAT rate would also apply to foreign investors that qualify as a ‘qualified foreign institutional investor’ or ‘Renminbi qualified foreign institutional investor’ is currently unclear, given that such an investor cannot register itself as a VAT taxpayer for Chinese VAT purposes.
In addition to tax considerations, the execution of an acquisition in the form of either an asset purchase or a share purchase in the Chinese is subject to regulatory requirements and other commercial considerations.
Some of the tax considerations relevant to asset and share purchases are discussed below.
Purchase of assets
A purchase of assets usually results in an increase in the cost base of those assets for capital gains tax purposes, although this increase is likely to be taxable to the seller. Similarly, where depreciable assets are purchased at a value greater than their tax-depreciated value, the value of these assets is refreshed for the purposes of the buyer’s tax depreciation claim but may lead to a claw-back of tax depreciation for the seller.
Where assets are purchased, it may also be possible to recognize intangible assets for tax amortization purposes. Asset purchases are likely to give rise to relatively higher transaction tax costs than share purchases, which are generally taxable to the seller company (except for stamp duty, which is borne by both the buyer and seller, and deed tax, which is borne by the buyer of land and real property). Further, for asset purchases, historical tax and other liabilities generally remain with the seller company and are not transferred with the assets. As clarified in ‘Choice of acquisition funding’, it may be more straightforward, from a regulatory perspective, for a foreign invested enterprise to
obtain bank financing for an asset acquisition than for a share acquisition.
The seller may have a different base cost for their shares in the company as compared to the base cost of the company’s assets and undertaking. This, as well as a potential second charge to tax where the assets are sold and the company is liquidated or distributes the sales proceeds, may determine whether the seller prefers a share or asset sale.
Caishui  No. 116 (Circular 116) allows for deferral of tax on gains deemed to arise on a contribution of assets by a TRE into another TRE in return for equity in the latter. The taxable gain can be recognized over a period of up to 5 years, allowing for the payment of tax in installments. This relief, potentially also extending to the contribution of assets by minority investors into a TRE, complements the intra-100 percent group transfer relief under Circulars 59 and 109 (see ‘Recent developments’).
According to SAT Announcement  No. 33 (Announcement 33), where applicable, taxpayers can elect to apply either the relief under Circular 116 or the intra-100 percent group transfer relief under Circulars 59 and 109.
Further, SAT Announcement  No. 13 (Announcement 13), issued in February 2011, provided a VAT exclusion for the transfer of all or part of a business pursuant to a restructuring. However, certain limitations in the practical applicability of the relief still exist.
For tax purposes, it is necessary to apportion the total consideration among the assets acquired. It is generally advisable for the purchase agreement to specify the allocation, which is normally acceptable for tax purposes provided it is commercially justifiable. It is generally preferable to allocate the consideration, to the extent it can be commercially justified, against tax-depreciable assets (including intangibles) and minimize the amount attributed to non-depreciable goodwill. This may also be advisable given that, at least under old Chinese generally accepted accounting principles (GAAP), goodwill must be amortized for accounting purposes, limiting the profits available for distribution.
Under CIT law, expenditure incurred in acquiring goodwill cannot be deducted until the complete disposal or liquidation of the enterprise.
Amortization is allowed under the CIT law for other intangible assets held by the taxpayer for the production of goods, provision of services, leasing or operations and management, including patents, trademarks, copyrights, land-use rights, and proprietary technologies, etc. Intangible assets can be amortized over no less than 10 years using the straight-line method.
Depreciation on fixed assets is generally computed on a straight-line basis. Fixed assets refer to non-monetary assets held for more than 12 months for the production of goods, provision of services, leasing or operations and management, including buildings, structures, machinery, mechanical apparatus, means of transportation and other equipment, appliances and tools related to production and business operations.
The residual value of certain fixed assets (i.e. the part of the asset value that is not tax-depreciable) is to be reasonably determined based on the nature and use of the assets.
Once determined, the residual value cannot be changed. The minimum depreciation periods for relevant asset types are as follows:
|Assets||Years of depreciation|
|Buildings and structures||20|
|Aircraft, trains, vessels, machinery and other production equipment||10|
|Instruments, tools, furniture, etc., related to production and business operations||5|
|Transportation vehicles other than aircraft, locomotives and ships||4|
Source: KPMG China, 2018
Any excessive accounting depreciation over the tax depreciation calculated based on the above minimum depreciation period should be added back to taxable income for CIT purposes.
Certain fixed assets are not tax-depreciable, including:
Generally, tax attributes (including tax losses and tax holidays) are not transferred on an asset acquisition. They generally remain with the enterprise until extinguished.
Value added tax
As of 1 May 2016, VAT has fully replaced BT, such that any transactions involving the sale of goods or provision of services is potentially within the scope of VAT. VAT is levied at the rates of 3 percent, 6 percent, 11 percent and 17 percent, depending on the good or service. Generally, the sale or importation of goods, or the lease of goods is subject to 17 percent VAT.
Transportation, certain telecommunication services as well as sales and lease of real estate are subject to 11 percent VAT. Most other services are subject to 6 percent VAT.
Certain business reorganizations, including certain transfers of a business where all assets are disposed of, employees transferred and liabilities assumed, are currently outside the scope of VAT, provided certain conditions are met.
However, the scope of the concession is more limited in China compared with equivalent concessions for the sale of a going concern in other countries. A sale of assets, in itself, may not be regarded as a transfer of a business and should
not benefit from the concession. Announcement 13, issued in February 2011, clarified that a VAT exclusion may be available for the transfer of part of a business, though in practice it can be difficult to access. Given that in China there is generally
no ability for a buyer to obtain a refund of excess VAT credits (instead, excess credits may be carried forward, potentially for an indefinite period), the cash flow implications can be significant and long-lasting.
Stamp duty is levied on instruments transferring ownership of assets in China. Depending on the type of assets, the transferor and the transferee are each responsible for paying stamp duty of 0.03 to 0.05 percent of transfer consideration for the assets in relation to their own copies of the transfer agreement (i.e. a total of 0.06 percent to 0.10 percent
stamp duty payable). Where the assets transferred include immovable property, deed tax, land appreciation tax and VAT and local surcharges may also need to be considered.
Purchase of shares
The purchase of a target company’s shares does not result in an increase in the base cost of that company’s underlying assets; there is no deduction for the difference between underlying net asset values and consideration. There is no capital gains participation exemption under Chinese tax law,
therefore a Chinese seller is subject to CIT or WHT on the sale of shares; however, tax deferral relief may be available if the consideration consists of shares in the buyer and the various conditions for attaining the reorganization relief (discussed earlier) can be satisfied.
Tax indemnities and warranties
In a share acquisition, the buyer assumes ownership of the target company together with all of its related liabilities, including contingent liabilities. Therefore, the buyer normally needs more extensive indemnities and warranties than in the case of an asset acquisition. An alternative approach is for the seller’s business to be moved into a newly formed subsidiary so the buyer can acquire a clean company. However, for
tax purposes, unless tax relief applies, this may crystallize any gains inherent in the underlying assets and may also crystallize a tax charge in the subsidiary to which the assets were transferred when acquired by the buyer.
As noted earlier (see ‘Recent developments), a pressing new issue that must be dealt with through warranties and indemnities concerns the impact on buyers of shares in offshore holding companies where the seller has not
complied with the Announcement 7 (previously Circular 698) reporting and filing requirements. Purchasers are subject
to WHT obligations in the case of an Announcement 7 enforcement and could be subject to potential penalty where the seller fails to report the transaction and pay the taxes. The buyer may ask the seller to warrant and provide evidence that they have made the reporting or indemnify them for tax and/or penalty ultimately arising.
To identify such tax issues, it is customary for the buyer to initiate a due diligence exercise, which normally incorporates a review of the target’s tax affairs.
Under the CIT law, generally, a share transfer resulting in a change of the legal ownership of a Chinese target company does not affect the Chinese tax status of the Chinese target company, including tax losses. However, in light of the introduction of the GAAR, the buyer and seller should
ensure that there is a reasonable commercial rationale for the underlying transaction and that the use of the tax losses of the target is not considered to be the primary purpose of the transaction, thus triggering the GAAR’s application.
Provided that the GAAR does not apply, any tax losses of a Chinese target company can continue to be carried forward to be offset against its future profits for up to 5 years from the year in which the loss was incurred after the transaction. China currently has no group consolidation regulations for grouping of tax losses.
There is a limitation on the use of tax losses through mergers.
Crystallization of tax charges
China has not yet imposed tax rules to deem a disposal of the underlying assets under a normal share transfer, but the buyer should pay attention to the inherent tax liabilities of the target company on acquisition and the potential application of GAAR. As Chinese tax law does not provide for loss- or
VAT-grouping, there is no ‘degrouping’ charge to tax (although care must be taken on changes of ownership where assets/ shareholdings have recently been transferred within the group and reorganization relief has been claimed).
The tax authorities may seek to impose VAT/LAT on a ‘disguised’ property transfer under the cover of an equity transfer. As discussed, however, the imposition of LAT and VAT based on the look-through of the equity transfer is not explicitly supported by existing LAT or VAT laws.
In certain circumstances, the seller may prefer to realize part of the value of the target company as income by means of a pre-sale dividend. The rationale is that the dividend may be subject to a lower effective rate of dividend WHT than capital gains, where treaty relief is available. Hence, any dividends paid out of retained earnings prior to a share sale would reduce the proceeds of sale and the corresponding gain arising on the sale, leading to an overall lower WHT leakage. The position is not straightforward, however, and each case must be examined based on its facts.
The transferor and transferee are each responsible for the payment of stamp duty of 0.05 percent of the transfer consideration for the shares in a Chinese company in relation to their own copies of the transfer agreement (i.e. a total of
0.10 percent stamp duty payable).
Tax filing requirements for STT on special corporate reorganizations
The STT on special corporate reorganizations is elective. To enjoy the tax deferral under a corporate reorganization, applicants must submit, along with their annual CIT filings,
relevant documentation to substantiate their reorganizations’ qualifications for the STT. Failure to do so results in the denial of the tax-deferred treatment.
Currently, the Chinese tax authorities do not have any system in place for providing sellers of shares in an offshore holding company, where the sellers have made their Announcement 7 (previously Circular 698) reporting, with a written clearance to the effect that the arrangement will not be attacked under the GAAR. Consequently, as noted above, buyers should seek to protect themselves through appropriate warranties and indemnities in the SPA.
Choice of acquisition vehicle
The main forms of business enterprise available to foreign investors in China are discussed below.
Foreign parent company
The foreign buyer may choose to make the acquisition itself, perhaps to shelter its own taxable profits with the financing costs. However, China charges WHT at 10 percent on dividends, interest, royalties and capital gains arising to
non-resident enterprises. So, if relevant, the buyer may prefer an intermediate company resident in a more favorable treaty territory (WHT can be reduced under a treaty to as low as
5 percent on dividends, 7 percent on interest, 6 percent on royalties and 0 percent on capital gains). Alternatively, other structures or loan instruments that reduce or eliminate WHT may be considered.
Non-resident intermediate holding company
If the foreign country taxes capital gains and dividends received from overseas, an intermediate holding company resident in another territory could be used to defer this tax and perhaps take advantage of a more favorable tax treaty with China.
As outlined in ‘Recent developments’, the buyer should be aware of the rigorous enforcement of the anti-treaty shopping provisions by the Chinese tax authorities — especially against the backdrop of the OECD BEPS Action Plan, which may restrict the buyer’s ability to structure a deal in a way designed solely to obtain such tax benefits.
Further, in setting out the Chinese interpretation of BO for tax treaty relief, Circular 601 (which is replaced by Announcement 9 as of 1 April 2018) effectively combines a BO test (which
in most countries is a test of ‘control’ over income and the assets from which it derives) with an economic substance- focused treaty-shopping test. Application of the treaty- shopping test as an element of the BO test, rather than as an application of the Chinese GAAR, prevented taxpayers from arguing their ‘reasonable business purposes’ in using an overseas holding, financing or intangible property leasing company, as the GAAR procedures would allow them to do so. The public discussion draft on ‘special tax adjustments’ (not yet finalized at the time of writing) reiterates that the Chinese tax authorities are empowered to initiate general anti-avoidance investigations and apply the GAAR on
treaty shopping. Hence, the development of the BEPS implementation in China and the potential issuance of the draft ‘special tax adjustments’ rules should continue to be observed under the new tax treaty relief system.
Announcement 7 should also be kept in mind where an offshore indirect disposal is contemplated. However, even in the absence of treaty relief, the 10 percent WHT compares favorably with the 25 percent tax that would be imposed if the acquisition were held through a locally incorporated vehicle.
Further, as explained in ‘Debt’ later in this report, debt pushdown at the Chinese level may be difficult and the Chinese corporate law requirement to build up a capital reserve that may not be distributed until liquidation might also favor the use of a foreign acquisition vehicle (however, see ‘Chinese partnership’ below). Where the group acquired has underlying foreign subsidiaries, the complexities and vagaries of the (little-used) Chinese foreign tax crediting provisions must also be taken into account.
Wholly foreign-owned enterprise
Chinese holding company
Generally, an acquiring company may fund an acquisition with equity or a combination of debt and equity. Interest paid or accrued on debt used to acquire business assets may be allowed as a deduction to the payer. Historically, under the State Administration of Foreign Exchange (SAFE) Circular 142, if a Chinese-established entity is used as the acquisition vehicle, the entity may not be allowed to borrow money
or obtain registered capital from abroad to fund an equity acquisition in China. This prohibition has been removed by SAFE Circular 19, which was issued in 2015, although it may still need to be observed in practice. Borrowing locally for acquisition is normally not possible because the People’s Bank of China (PBOC) generally prohibits lending to fund equity acquisitions (and local banks have limited interest in using
the legal exceptions that do exist to lend to foreign invested enterprises). However, a CHC may be in a position to borrow or obtain registered capital from abroad to fund an equity acquisition.
The amount of foreign debt that Chinese companies can borrow is now subject to a number of new rules issued by the PBOC in the past 24 months.
PBOC issued Yinfa [ 2016] No.18 (Circular 18) (effective from January 2016) and Yinfa  No.132 (Circular 132, effective from May 2016) to set out the relevant rules (including
new foreign debt limits) for Chinese companies borrowing foreign debts with the aim of easing their foreign exchange settlement restrictions. These circulars were superseded by Yinfa  No.9 (Circular 9, effective as of January 2017), which revised the foreign debt limits that were prescribed under Circular 18 and Circular 132.
Under Circular 9, the revised foreign debt limit for various types of Chinese entity are as follows:
Circular 9 provides for a 1-year transitional period from the date it was issued (i.e. it expires on 12 January 2018), during which, a foreign invested enterprise (FIE) financial institution and a FIE non-financial institution can opt for the above revised foreign debt limit or remain under the previous foreign debt limit prescribed under the foreign debt management guideline jointly issued by the National Development and Reform Commission (NDRC), MOF and SAFE.
After the end of the 1-year transitional period, FIE financial institutions are mandated to adopt the foreign debt limit prescribed under Circular 9. However, FIE non-financial institutions will have to wait for further clarification from PBOC and SAFE on whether they will follow suit.
Foreign debt limits for CHCs, which are set out in MOC Order  No.22 (Order 22), are normally higher than those for FIEs. Specifically, for a CHC with registered capital of not less than USD30 million, its foreign debt quota is limited to 4 times its paid-up capital. For a CHC with registered capital of not less than USD100 million, its foreign debt quota is limited to 6 times of its paid-up capital.
Further, according to Guofa  No.5 (Notice 5), the minimum registered capital requirement for FIEs have been abolished. However, the relevant government authorities (e.g., NDRC, MOFCOM and the State Administration for Industry and Commerce) have not yet updated their implementation guidance on the requirements for setting up FIE. In practice, the below ratios of registered capital to total investment are still valid:
|Registered capital||Registered capital as a percentage of total investment|
|Equal to or under US$2.1 million||70|
|Over US$2.1 million but equal to or less than US$5.0 million||50|
|Over US$5.0 million but equal to or less than US$12.0 million||40|
|Over US$12.0 million||33|
Source: KPMG China, 2018
The foreign debts should be registered with the local SAFE in order for the Chinese companies to remit foreign currency overseas to pay interest or settle the loan principal to the foreign lender(s).
Any related-party loans also need to comply with the arm’s length principle under the Chinese transfer pricing rules.
Deductibility of interest
Under the CIT law, non-capitalized interest expenses incurred by an enterprise in the course of its business operations are generally deductible for CIT purposes, provided the applicable interest rate does not exceed applicable commercial lending rates.
The CIT law also contains thin capitalization rules that are generally triggered, for non-financial institutions, when a resident enterprise borrows money from a related party that results in a debt-to-equity ratio exceeding the 2:1 ratio stipulated by the CIT law. Interest incurred on the excess portion is not deductible for CIT purposes. The arm’s length principle must be observed in all circumstances.
Where a CHC has been used as the acquisition vehicle, it should have sufficient taxable income (from an active business or from capital gains; dividends from subsidiaries are exempt) against which to apply the interest deduction, as tax losses (created through interest deductions or otherwise) expire after 5 years. Alternative approaches to utilizing the losses are not available as loss grouping is not provided for under the Chinese law. Thus, CHCs generally are not able to merge with their subsidiaries (precluding debt pushdown), and problems may arise for a non-CHC in obtaining a tax-free vertical merger.
Withholding tax on debt and ways to reduce or eliminate it
Payments of interest by a Chinese company to a non- resident without an establishment or place of business in the Chinese are generally subject to WHT at 10 percent. The
rate may be reduced under a treaty. Under the VAT reforms implemented for the financial services industry as of 1 May 2016, VAT at 6 percent is levied on interest income earned by non-residents from a Chinese company and the VAT charged is not creditable to the Chinese company.
Under Announcement 60, a taxpayer or its withholding agent is required to submit the relevant documents to the Chinese tax authorities when making the tax filing for accessing treaty benefits (e.g. reduced interest WHT rate). As discussed above, while no pre-approval is required for enjoying the treaty benefits, the tax authorities may conduct post-filing examinations. Where it is discovered that treaty relief
should not have applied and tax has been underpaid, the tax authorities will seek to recover the taxes underpaid and may launch anti-avoidance proceedings.
Checklist for debt funding
A buyer may use equity to fund its acquisition, possibly by issuing shares to the seller, and may wish to capitalize the target post-acquisition. However, reduction of share capital/ share buy-back in a Chinese company may be difficult in certain locations where pre-approval from the relevant Chinese authorities is still required, and the capital reserve rules may cause some of the profits of the enterprise to become trapped. The use of equity may be more appropriate than debt in certain circumstances, in light of the foreign debt restrictions highlighted above and the fact that,
where company is already thinly capitalized, it may be disadvantageous to increase borrowings further.
Provided that the necessary criteria are satisfied, Circular 59 provides a tax-neutral framework for structuring acquisitions under which the transacting parties may elect temporarily to defer recognizing the taxable gain or loss arising on the transactions (a qualifying special corporate reorganization).
One of the major criteria for qualifying as a special corporate reorganization is that at least 85 percent of the transaction consideration should be equity consideration (i.e. stock-for- stock or stock-for-assets). Other relevant criteria include:
For qualifying special corporate reorganizations, the tax deferral is achieved through the carryover to the transferee of tax bases in the acquired shares or assets but only
to the extent of that part of the purchase consideration comprising shares. Gains or losses attributable to non-share consideration, such as cash, deposits and inventories, are recognized at the time of the transaction.
In addition to the relief under Circular 59, Circular 109 introduced a new condition for STT that permits elective non-recognition of income on transfer of assets/equity between two Chinese TREs that are in a ‘100 percent holding relationship’, provided no accounting gains/losses are recognized. Both the purpose test and the continuing business test in Circular 59 hold, and the tax basis of
transferred assets for future disposal is their original tax basis.
Certain cross-border reorganizations need to meet conditions in addition to those described earlier to qualify for the special corporate reorganization, including a 100 percent shareholding relationship between the transferor and transferee when inserting an offshore intermediate holding company.
SAT Announcement  No. 72 (Announcement 72) addresses situations where a cross-border reorganization involves the transfer of the Chinese enterprise from an offshore transferor that does not have a favorable dividend WHT rate to an offshore transferee that has a favorable dividend WHT rate with China. Announcement 72 clarifies that the retained earnings of the Chinese enterprise accumulated before the transfer are not entitled to any reduction in the dividend WHT rate even if the dividend is distributed after the equity transfer reorganization. This measure is designed to prevent any dividend WHT advantages for profits derived before a qualifying reorganization.
Share capital reductions are possible but difficult in certain locations where the pre-approval from the relevant Chinese authorities is still required. As Chinese corporate law only provides for one type of share capital, it is not possible to use instruments such as redeemable preference shares. Where a capital reduction was to be achieved and was to be financed with debt, in principle, it is possible to obtain a tax deduction for the interest.
Consideration may be given to hybrid financing, that is, using instruments treated as equity for accounts purposes by one party and as debt (giving rise to tax-deductible interest) by the other. In light of the OECD’s anti-BEPS recommendations on hybrid mismatch arrangements, this may become more difficult in the future. There are currently no specific rules or
regulations that distinguish between complex equity and debt interest for tax purposes under Chinese tax regulations.
Generally, the definitions of share capital and dividends for tax purposes follow their corporate law definitions, although re-characterization using the GAAR in avoidance cases is conceivable. In practice, hybrids are difficult to implement in
China, particularly in a cross-border context. China’s restrictive legal framework currently does not provide for the creation of innovative financial instruments that straddle the line between debt and equity.
Chinese company law prescribes how the Chinese companies may be formed, operated, reorganized and dissolved.
One important feature of the law concerns the ability to pay dividends. A Chinese company is only allowed to distribute dividends to its shareholders after it has satisfied the following requirements:
For corporate groups, this means the reserves retained by each company, rather than group reserves at the consolidated level. Regardless of whether acquisition or merger accounting is adopted in the group accounts, the ability to distribute
the pre-acquisition profits of the acquired company may be restricted, depending on the profit position of each company.
Where M&A transactions are undertaken, the MOC rules in Provisions on the Acquisition of Domestic Enterprises by Foreign Investors (revised), issued in 2009, should be considered. Also bear in mind the national security review regulations issued by MOC in March 2011, which affect
foreign investment in sectors deemed important to national security. The consent of other authorities, such as the State Administrations of Industry and Commerce, and specific sector regulators, such as the China Securities Regulatory Commission, may also be needed.
There are currently no group relief or tax-consolidation regulations in the Chinese.
Where an intercompany transaction occurs between the buyer and the target following an acquisition, any failure to conform with the arm’s length principle might give rise to transfer pricing issues in China. Under the Chinese transfer pricing rules, the tax authorities are empowered to make tax adjustments within 10 years of the year during which the transactions took place and recover any underpaid Chinese taxes. These regulations are increasingly rigorously enforced.
There are currently no dual residency regulations in the Chinese.
Foreign investments of a local target company
China’s CFC legislation is designed to prevent Chinese companies from accumulating offshore profits in low-tax countries. Under the CFC rules, where a Chinese resident enterprise by itself, or together with individual Chinese residents, controls an enterprise that is established in a foreign country or region where the effective tax burden is lower than 50 percent of the standard CIT rate of 25 percent (i.e. 12.5 percent) and the foreign enterprise does not distribute its profits or reduces the distribution of its profits for reasons other than reasonable operational needs, the portion of the profits attributable to the Chinese resident enterprise is included in its taxable income for the current period. Where exemption conditions under the rules are met, the CFC rules would not apply.
Advantages of asset purchases
Disadvantages of asset purchases
Advantages of share purchases
Disadvantages of share purchases
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