Francisco A. Laguna & Jimmy Wang
This week, we begin a two-week series on taxation of indirect share transfers in China. In 2009, the State Administration of Taxation (SAT) issued Circular Guoshuihan No. 698 (Circular 698) empowering China’s tax authorities to tax indirect share transfers that take place outside the country.
Indirect share transfers occur when an offshore holding company (Holding Company) sells its stock in an intermediate offshore holding company, often established in a low / no tax jurisdiction (Intermediate Holding), which holds 100% equity of a company in China (China Target), to another offshore company (Buyer). As a consequence, the Holding Company indirectly transfers the equity in the China Target (PRC Equity) by selling the Holding. Because the Intermediate Holding exists in a tax haven, little or no tax is imposed on the transfer. Diagram 1 depicts the typical transaction with structures.
Circular 698 allows China to tax indirect share transfers, despite the fact that they take place outside the country. The Circular establishes various rules that directly affect foreign investors: it obligates non-residents to report and supply information and documents regarding indirect sales; it allows China to treat the Intermediate Holding as a disregarded entity, for tax purposes, if its existence lacks business substance (Look Through Rule); and it clarifies how to compute taxes in the case of an indirect sale of PRC Equity.
• Reporting Duty
Circular 698 imposes a duty to report on offshore enterprises. These enterprises are obliged to report any indirect transfer of equity interests in a Chinese resident enterprise to the SAT if the Intermediate Holding is located in a jurisdiction where the effective tax rate on capital gains is lower than 12.5%.
• Look Through Rule
One of the most significant impacts of the Circular is the look-through mechanism. If the Chinese tax authorities, upon reviewing the information and documents supplied by the Holding Company, conclude that the non-resident sellers are involved in an “abusive” tax structure, they are entitled to disregard the Intermediate Holding and redefine the transaction.
Next week, we will examine some landmark cases under the Circular.
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