This article discusses the PRC tax consequences for a foreign investor on the disposal of its interest in a foreign-invested enterprise (FIE) (i.e. a wholly foreign-owned enterprise, an equity joint venture or a legal person cooperative joint venture) or a foreign-invested partnership (FIP). A representative office (RO) cannot be transferred to a third party or a related party; if a foreign investor does not intend to maintain its RO, it must close the RO. Since foreign investors frequently hold their interests in an FIE through an offshore holding company, we focus on the PRC tax implications of direct transfers of FIEs/FIPs, as well as indirect transfers of such entities through the transfer of the offshore company. In both situations, the content will be limited to foreign investors that are corporate entities.

Direct transfer of equity interest in an FIE

Capital gains derived by a foreign parent company from the transfer of its interest in an FIE are considered PRC-source income and subject to a 10-percent PRC withholding tax, provided the parent company does not have a permanent establishment (PE) in China, or if the parent company does have a PE, the income is not effectively connected with the PE.

Capital gains are calculated as the consideration paid for the equity transfer, less the cost of the equity interest. The consideration paid for the equity transfer is the total amount received by the transferor, including cash and non-monetary assets. The cost of the equity interest is the original amount paid by the transferor to the FIE as a capital contribution, or, if the transferor acquired its interest in the FIE in a prior transfer, the amount paid by the current transferor to the previous transferor as the consideration.

An exemption from the withholding tax on capital gains may be available in certain cases.

Direct transfer of interest in an FIP

As mentioned in our last article, an FIP is a relatively new business vehicle available to foreign investors, and the tax rules governing partnerships in China are not yet fully developed. Thus, the tax treatment of gains or losses derived from the transfer of a foreign investor’s interest in an FIP is not covered in the current PRC tax laws and regulations. As foreign investors start to use FIPs more frequently, the issue will need to be addressed.

Indirect transfer of equity interest in an FIE

Gains derived from the transfer of an offshore holding company by a foreign investor are non-PRC source income and, thus, should not be subject to PRC withholding tax, unless China’s general anti-avoidance rule (GAAR) applies. The GAAR was introduced into the Enterprise Income Tax Law in 2008, when the new law took effect, and in 2009, the State Administration of Taxation (SAT) issued guidance on the application of the GAAR in Circular 698.

According to Circular 698, if the actual tax burden in the jurisdiction of an offshore intermediary holding company being transferred is less than 12.5 percent, or if the jurisdiction in which the offshore intermediary holding company is resident grants an income tax exemption for foreign-source income, the nonresident investor will be subject to documentation requirements. Using the “substance-over-form” principle, the Chinese tax authorities can disregard the existence of an offshore intermediary holding company if it lacks business objectives and was established for the purpose of avoiding taxes. Once the offshore holding company is disregarded, the transaction will be re-characterized as a transfer of the underlying PRC company and, thus, the gains derived from the transaction will become PRC-source income subject to PRC withholding tax.

While Circular 698 creates some legal questions as to whether the Chinese Government has the right to tax foreign companies and/or require them to submit information that may or may not be relevant to Chinese enterprises, in a number of cases, the PRC tax authorities have taxed foreign companies on their gains from indirect transfers. Thus, foreign investors, including strategic investors and private equity funds, now have greater administrative and compliance burdens when using offshore companies as vehicles to invest in China.

The SAT is drafting supplemental rules on indirect transfers, which likely will contain two major improvements: (i) the threshold for triggering the documentation requirement will be raised so that fewer foreign companies will be caught by the indirect transfer rules; and (ii) a safe harbor will be provided for qualified intra-group reorganizations, which will exempt such reorganizations from PRC capital gains and require less documentation. These rules are expected to be issued in 2014. CA

For further information, contact Kevin Ng (kevng@deloitte.com.cn) and Delia Ndlovu (delndlovu@deloitte.co.za)