Taxation of Indirect Share Transfers in China: Landmark Cases under Circular 698

Francisco A. Laguna & Jimmy Wang

This week, we conclude our series on taxation of indirect share transfers in China by examining two landmark cases decided under Circular Guoshuihan No. 698 (Circular 698) issued by the State Administration of Taxation (SAT) in 2009.  The Circular allows China’s tax authorities to tax indirect share transfers that take place outside the country.

Landmark Case I

This case was decided by the Yangzhou tax authority and reported in the China Taxation News on 6 June 2010.  It involved an offshore U.S. holding company that transferred 100% of its shareholdings in a Hong Kong intermediate holding company, which held 49% of the equity of a Chinese company, to a U.S. buyer. The U.S. buyer, thus, indirectly acquired 49% of the equity interest in the Chinese company.

Screen shot 2013-10-08 at 12.35.23 PMThe Yangzhou tax authority applied the Look Through Rule of Circular 698 and held that the H.K. holding company had no business substance besides functioning as an instrument to hold the equity in the Chinese Target.  The basis for its conclusion was that the H.K. holding company had no office, staff or assets other than the equity in the target.  As such, the tax authority disregarded the H.K. holding company and treated the U.S. holding company, i.e., the seller, as having disposed of the Chinese company directly.

The capital gain derived from the transaction was treated as Chinese source income and subject, in China, to withholding tax at the rate of 10%. The U.S. buyer settled the case for 173 million Chinese Yuan (~ USD $28.3 million).

Landmark Case II

A second landmark case was decided by the Kunshan tax authority.  It involved a subsidiary of a Taiwanese group that disposed of its 50% shareholding in a Mauritius company that owned 100% of a Chinese company to an U.S. holding company. The U.S. holding company, which previously owned the other 50% of the Mauritius company, acquired 100% ownership of the Mauritius company as a result of the transfer, thereby indirectly acquiring 100% ownership of the Chinese company.

Screen shot 2013-10-08 at 12.35.02 PM

The Kunshan tax authority held that the Mauritius company had no business substance other than holding the equity of the China Target company. Therefore, based on Circular 698 and applying the Look Through Rule, it disregarded the Mauritius company and assumed that the Taiwan Holding sold its interest in the Mauritius company directly. The authority ruled that the entire capital gain of the Taiwan holding company should be treated as China source income and subject to withholding tax at 10%.  Ultimately, 44 million Chinese Yuan (USD $7.2 million) was collected.

In the cases above, the intermediate holding companies were disregarded for the same reason—lack of business substance, i.e., no business operations, assets, liabilities or employees other than the investments in Chinese companies. Taxpayers who intend to undergo corporate restructuring or investors who are looking at target investments with previous restructuring should pay special attention to this trend and the potential tax liabilities that may arise if the commercial reasonableness at the intermediate holding company level is not well demonstrated.

TransLegal helps clients navigate the often-complex system of doing business in China and assure full compliance with applicable Chinese laws and regulations. Call us with your questions concerning China.

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