China has tightened its rules governing the sale of domestic assets by foreign entities in a two-pronged assault on tax avoidance and the overheating property market.
As a result of the changes, which took effect from February 3 but have only now been published, foreign groups owning assets in mainland China through Hong Kong-based companies will face more scrutiny and liability if they wish to sell those assets.
The move, which could yet be applied retrospectively where a tax liability has not been settled, solidifies into regulation what was unofficial since 2009 but also expands it to include ownership of Chinese properties and property rights rather than just companies.
“There have been cases where a Chinese real property has been transferred as part of a transaction, as opposed to a company, and now this is reportable and potentially taxable,” Christopher Xing, China tax partner at KPMG, told FinanceAsia.
Chinese property prices have soared over the past 10 years, leading to fears of a valuation bubble. This year has seen some of those fears realised with Shenzhen-based property developer Kaisa coming close to a default.
China's government has been keen to take the sting out of the market, both by restricting speculation and by making it more difficult for homebuyers, but clearly there is more to be done.
The original draft "rules" circulated in 2009 placed scrutiny on a foreign entity that owned and sold an offshore group holding mainland Chinese assets or a Chinese company.
This ownership model has typically been a way for foreign entities to purchase and hold assets in mainland China through the back door – typically via a Hong Kong-based group.
After 2009, liability was placed on the seller to report the sale of such assets to China’s State Administration of Taxation but the guidelines were ambiguous.
It has, for example, been unclear whether properties or other assets were included under the guidelines and what the role of the buyer was in reporting the transaction.
The potential penalties were also unclear in spite of there being a 10% tax due on any gains from the transaction.
Greater clarity
The purpose of these regulations is to ensure the offshore entity has a valid commercial purpose and is not merely a shell company that allows the foreign group to avoid paying taxes on Chinese assets.
What's changed is that the repercussions are now clearer if a transaction is not reported to the appropriate tax authority and that body later finds something worth investigating.
“Announcement 7 [the updated regulation] is a much more comprehensive provision that has more specific guidance on when reporting has to be done and by whom,” Xing said.
It clearly places liability on the buyer, the target Chinese company as well as the seller, with all parties encouraged to contact the tax authorities.
If the tax authorities feel the transaction lacks a valid business purpose, the buyer is required to withhold a 10% tax from the gains realised by the seller. Non-compliance could see the seller fined up to five times the tax payable plus a daily charge, while the buyer can be fined up to three times the tax payable.
For some legal experts, the tougher new rules could have repercussions for mergers and acquisitions activity.
“It’s not entirely aimed at discouraging investment in China [but] will have a lot of implications for M&A transactions," Doris Ho, a partner at law firm DLA Piper, told FinanceAsia.
"For example, the seller (as the taxpayer with the primary tax liability) might not want the buyer to withhold the tax monies from the consideration, say, in a share acquisition deal. The seller normally opts to have more control of the tax payment process,” she added.
At the very least, there will likely be much more discussion between the relevant parties, which could drag out transactions, she said.
The regulation is effective February 3 but is retrospective to include any transaction in which the tax liability has not been settled. It is unclear how many deals might be affected and to what extent.
“The tax authorities have been more aggressive in recent years,” Ho said. “It could also be because of the overheating property market. There could be a huge amount of money involving a real property investment in China and thus a significant tax implication.”
Case Study
An example provided by DLA Piper of how the original guidelines were used to levy taxes involves a well-known multinational foreign investment group (the Seller), which held a 49% interest in a joint venture (JV) in Jiangdu, Jiangsu Province.
The JV was acquired in 2007 through a Hong Kong holding company (“Holdco”) wholly owned by the Seller. In January 2010, the Seller transferred its 100% interest in the Holdco to a US company (“Buyer”), meaning the Buyer now held a 49% interest in the JV through the Holdco.
The Seller anticipated that the capital gains derived from the transaction should not be subject to Chinese Enterprise Income Tax (“EIT”). The Jiangdu State Tax Bureau disagreed.
Based on the information collected, the JSTB noticed that the Holdco had no employees, no assets, no liabilities, no investment and no business other than the investment of the JV, and thus the Holdco did not have any “economic substance.”
The JSTB disregarded the Holdco and collected a tax payment of Rmb173 million on the gain realised by the Seller on the disposal.
