Post-Acquisition Integration - What You Need to Do?

POST-ACQUISITION INTEGRATION – WHAT YOU NEED TO DO?

We assume a scenario whereby two foreign groups merge overseas.  This is followed by a local (i) merger, or (ii) acquisition of assets, or (iii) the retention of the two separate operating units in your jurisdiction.

1. Are There Alternative Approaches To Local Country Consolidation, Including The Trade-Offs Among (i) Tax Efficiency, (ii) Speed, And (iii) Fees/Costs?

Merger, acquisition of assets and retention of separate operating units are all available in China if the local operating units are subsidiaries of the foreign groups.  If the local operating units are representative offices, which in general is the only form of branch that a foreign company can have in China, only an asset acquisition or retention of separate operating units is possible.

For both subsidiaries and representative offices, the easiest approach is to keep two separate operating units in China after the offshore merger or acquisition.  This approach does not trigger any tax or government approvals in China.  But often it will lead to duplication of functions and other inefficiencies.  Furthermore, because China does not allow consolidated income tax filing among group companies, the profits and losses of different companies cannot be offset for income tax purposes.  Consequently, most foreign companies will wish to integrate the separate operating units post-acquisition. 

1.1 Integration Of Subsidiaries

The integration of subsidiaries may be accomplished by either a merger or an asset transfer followed by a liquidation of the transferor. 

The Notice on Certain Questions Regarding the Enterprise Income Tax Treatment of Enterprise Reorganizations (“the Reorganization Rules”) provide guidance on the income tax treatment of reorganizations.¹  The Reorganization Rules cover six types of enterprise reorganizations: change of legal form, debt restructuring, share acquisition, asset acquisition, merger and de-merger.  Two types of tax treatment are provided for each of the six types of reorganizations: normal tax treatment and special tax treatment.  A taxpayer must recognize gain or loss from reorganizations with normal tax treatment and pay the income tax as applicable.  On the other hand, a reorganization that qualifies for special tax treatment can be carried out without triggering income tax liability.

To qualify for special tax treatment, a reorganization must satisfy all of the following conditions (“General Conditions”):

• The reorganization must have a reasonable commercial purpose, and reduction, exemption or deferral of taxes cannot be a major purpose of the reorganization;

• The assets or shares transferred under an acquisition must meet the prescribed proportion, i.e., no less than 75% (based on net book value and not fair market value of the assets) of the total assets or shares of the target;

• The key business activities cannot be changed within 12 months after the reorganization;

• The equity consideration in the reorganization must meet the prescribed proportion, i.e., no less than 85% of the total consideration; and

• The original main shareholder(s) that receive equity consideration under the reorganization cannot transfer the equity interest(s) within 12 months after the reorganization.

The Reorganization Rules provide a “step transaction rule” under which related transactions carried out within a 12-month period may be treated as one transaction to determine the relevant tax treatment in order to prevent abuse of special tax treatment.  Lastly, where the enterprises being merged and the merged enterprise are under the same control, consideration is not required to be paid.

For cross-border share acquisitions and asset acquisitions to qualify for special tax treatment, the following additional conditions must be satisfied (“Special Cross-Border Conditions”):

• A non-resident enterprise (“NRE”)²  (i) transfers shares of a resident enterprise³ to another NRE over which the transferor has “direct 100% share control”, (ii) the transfer does not change the withholding tax burden on capital gains to be derived from the transferred shares in the future and (iii) the transferor undertakes in writing to the competent tax bureau that it will not transfer the shares of the transferee that it receives as consideration for three years after the reorganization; or

• An NRE transfers shares of a resident enterprise to another resident enterprise over which the transferor has “direct 100% share control”; or

• A resident enterprise invests assets or shares in an NRE over which it has “direct 100% share control”; or

• Other situations as approved by the SAT and the MOF.

1.1.1 Merger

A merger is often more tax-efficient than an asset transfer, although this is not always the case, depending on the type of assets to be transferred.

The Reorganization Rules do not provide that a merger of two foreign invested enterprises (“FIEs”) need to satisfy the Special Cross-Border Conditions to qualify for special tax treatment, but officials have expressed different views on this issue.⁴  Thus, further clarification from the MOF or the SAT is needed. 

If a merger qualifies for special tax treatment, no gain or loss needs to be recognized and the original tax basis of the assets and shares is preserved.  The accumulated losses and other tax attributes can be carried over to the post-merger entity⁵.  If a merger is subject to normal tax treatment, gain or loss needs to be recognized as under a liquidation or asset transfer.  Accumulated losses and other tax attributes cannot be utilized by the post-merger entities.
  
A potential tax advantage of a merger is the carry over of tax incentives to the merged enterprise.  The Reorganization Rules stipulate the following points regarding the preferential tax treatment for a merged enterprise:

• tax incentives will carry over to a merged enterprise only in a merger by absorption;

• only the surviving enterprise’s pre-merger tax incentives will carry over to the merged enterprise, provided that the merged enterprise’s business nature and scope remain unchanged from those of the surviving enterprise before the merger; and

• the amount of income of the merged enterprise that will be eligible for the incentive is limited to the surviving enterprise’s taxable income in the year before the merger.

In relation to the last point, it is unclear whether the amount of eligible income is for each remaining year of the tax incentive period or for the remaining tax incentive period as a whole.  It also appears from the language in the Reorganization Rules that the merged enterprise will not be able to enjoy the surviving enterprise’s pre-merger tax incentives if the surviving enterprise had a loss for the year before the merger.  Moreover, the tax incentives of the non-surviving enterprise cannot be carried over to the merged enterprise.

Under the previous reorganization rules, another potential tax advantage of a merger was the avoidance of a claw-back of tax incentives.  The Reorganization Rules do not clarify whether there will be a claw-back of the tax incentives enjoyed by the non-surviving enterprise upon the merger.  An MOF official has opined that there should be a claw-back of tax incentives enjoyed by the non-surviving enterprise upon the merger because the non-surviving enterprise will no longer exist after the merger.  This view, however, has not been officially confirmed by the Chinese government.  In principle, prior tax incentives should not be clawed back in a merger because one of the major characteristics of a merger is the continuity of business operations.  Although the non-surviving enterprise will no longer exist as a legal entity after the merger, its business will be carried on through the surviving entity.  Until further clarification from the SAT or the MOF, this issue remains uncertain.

Most of the turnover taxes, such as value-added tax (“VAT”) and business tax, that apply to asset transfers can be avoided in a merger.

The biggest disadvantage of a merger is that the regulatory procedures are cumbersome and time consuming, particularly if the parties to the merger are located in different cities.  In addition, the regulatory authorities do not have much experience with FIE mergers.  Consequently, a merger may take nine months to a year to complete.  It may also be difficult to avoid disruption to the business operations during at least part of that time.

1.1.2 Asset Transfer and Liquidation

The transferor in an asset transfer is subject to income tax on any gain, which is included in taxable income for the current period.  It is important to note that a tax-free share for asset swap is not permitted on a cross-border basis.  The general principle for a taxable asset transfer is that the transferor of the asset should recognize the gain and loss from the transfer of the assets at the fair market value, and the tax basis of the relevant assets in the hands of the transferee should be adjusted according to the transaction price.  If the transferor FIE is liquidated following a taxable asset transfer, the liquidating enterprise is required to recognize gains or losses based on the realizable value or transfer price of all assets after deducting their tax basis and other liquidation costs. 

An enterprise must treat the liquidation period as an independent tax year in calculating liquidation income.  Finally, there are two level of taxes from a liquidation, one at the liquidating entity level on liquidation income and the other at the shareholder’s level on distributed assets in the form of dividends, capital gains or both.

Asset transfers are also subject to a number of turnover taxes, mainly including VAT on fixed assets and inventories, business tax on intangible assets and real property, land appreciation tax on land use rights and deed tax on buildings.

Notwithstanding the potentially high tax burdens, the actual tax cost of an asset transfer and liquidation has been relatively low in many of the post-acquisition integration cases we have seen.  Many FIEs in China do not own significant intellectual property or other intangible assets and operate in leased premises.  This means that the main assets to be transferred are used fixed assets and inventories, together with assets such as accounts receivable that generally do not attract tax.  Generally speaking, under the new VAT regime, of the VAT treatment of the sale of used fixed assets depending on whether the assets are purchased before or after 1 January 2009. If the assets were purchased before 1 January 2009, a 4 percent will apply and half of the tax can be exempted.  The applicable formula is: VAT payable = (Gross sales revenue / (1+4%)) * 4% * 50%. If the assets were purchased on or after 1 January 2009, standard VAT rate (normally 17 percent) will apply.  Sale of inventories also trigger a 17% VAT. But the VAT on the sale of inventories, and used fixed assets purchased on or after 1 January 2009 provides an input credit to the purchaser and therefore is not a tax cost.  Typically, used fixed assets and inventories also generate little or no gain for the seller. In these cases, an asset transfer is clearly more favorable than a merger, as it generally does not require government approval and can be accomplished in a matter of weeks.  Although the subsequent liquidation of the transferor FIE can take six months or more, this process does not impact the ongoing operation of the business.

1.2 Representative Offices

Representative offices cannot be transferred from one foreign company to another.  Thus, the only way to integrate two representative offices (or to integrate a representative office into an FIE) is to sell the assets and transfer the employees of the non-surviving office and then deregister it.

Generally speaking, the tax considerations for an asset sale by a representative office are similar to those discussed above in regard to an FIE.  The main difference is that deregistration of the representative office will not give rise to taxation in China of the foreign head office, whereas liquidation of an FIE may result in taxation of the foreign shareholder, as discussed above.

The subsequent deregistration of the representative office can take six months to a year, but again this process does not impact the operation of the business.  The major stumbling block in representative office deregistration is usually obtaining tax deregistration, as the tax authorities will take the opportunity to review the office’s historical tax compliance in great detail.

1.3 Employees

In all of the above scenarios, there is the potential for having to pay severance to employees.  A merger may offer a way to avoid severance on grounds that the employment is not terminated, but the rules are unclear and are subject to different interpretations in different places.  Under the asset transfer approach, the employees of the transferor subsidiary or representative office are terminated and rehired by the surviving entity, and technically this triggers a severance obligation for the transferor.  It may be possible in some situations to obtain a waiver of severance from the employees as a condition to being rehired on the same or better terms and conditions, as well as carrying over the seniority of the employee for future severance purposes.

2. Are There Opportunities To Step Up The Basis Of Assets?

3. An asset purchase gives the buyer a step-up in the basis of the assets.  Under the Reorganization Rules, a taxable merger also gives the surviving entity a step-up in the basis of the assets; but the surviving entity in a tax-free merger has a carry-over basis in the assets, except for the assets corresponding to any boot. Are There Any Leveraging Opportunities That Could Generate Tax-Efficient Interest Deductions?

China’s headline enterprise income tax rate is 25%.  The withholding tax rate on interest is 10%, and some tax treaties further reduce the rate.  For example, the withholding tax rate on interest under the tax arrangement between mainland China and Hong Kong is 7%.  Furthermore, some jurisdictions, such as Hong Kong, do not tax offshore sourced income.  Thus, if a Hong Kong company gives a loan to its mainland China affiliate, the affiliate can deduct the interest expense against the 25% tax rate, and the withholding tax on the interest payment to the Hong Kong company is only 7%.   If the transaction is well planned, the Hong Kong company will not need to pay profits tax on the interest income in Hong Kong. 

China now has thin capitalization rules.  For non-financial institutions, the maximum debt-equity ratio (for related party debt) is 2:1.  If this ratio is exceeded, the interest payments to an offshore affiliate are not tax deductible, even if the loan terms are at arm’s length.

4. What Are The Capital Gains Tax And Stamp Tax Issues And Potential Planning Relating To Transfers Of Shares To Position The Subsidiaries For The Ultimate Consolidation?

Normally, capital gains tax and stamp duty apply when an overseas parent transfers its equity interest in an FIE to another overseas affiliate.  The capital gains tax under both domestic law and most tax treaties is 10%.  Stamp duty is 0.05% of the share transfer price for each of the buyer and the seller.

5. How Can The Tax Losses Of One Entity Be Preserved?

Losses cannot be transferred from one company to another under an asset transfer.

Under the Reorganization Rules, the losses of the non-surviving entity cannot be carried over to the surviving entity in a taxable merger.  In a tax-free merger, a cap on the loss carryover applies.  The cap is equal to the fair market value of the net assets of the non-surviving entity multiplied by the interest rate on the national debt for the longest term debt issued by the central government in the year in which the merger occurs.

6. What Opportunities Exist To Restructure Intellectual Property Rights So As To Generate Tax Efficiencies?

In most cases today, the acquisition of intellectual property (“IP”) rights is not the main purpose for a foreign multinational company to acquire companies in China.

If the target has IP rights in China, the seller sometimes will have transferred the IP rights to an offshore affiliate that will also be acquired by the buyer.  In other cases, the buyer will acquire the IP rights from the target company in China, rather than leave the IP rights in the target (in a share acquisition) or in the buyer’s acquisition vehicle in China (in an asset acquisition).  This is partly because most multinational companies have concerns about China’s IP protection environment.  Another reason may be that they would like to move the IP rights to a low tax jurisdiction to minimize the future tax burden on income streams from the IP.

Any capital gain derived from transfer of the IP rights by the target company in China should be included in the target company’s taxable income and will be subject to income tax at the rate applicable to the target company (normally 25% unless certain tax incentives apply).  The target company should also comply with the technology export control rules.  In many cases we have seen where the target company transfers the IP rights to its overseas affiliate pre-acquisition, it does so at a nominal value or at cost in order to avoid tax in China.  This creates a transfer pricing risk for the target company, but if the buyer is acquiring the target in an asset deal, there is low risk for the buyer.

If the target company or the buyer’s acquisition vehicle in China needs to continue to use the IP rights after they have been transferred offshore, the buyer or its offshore affiliate can license the IP to it.  The licensee can deduct the royalty payments against the 25% income tax rate.  The withholding tax rate on the royalty payment to the offshore licensor is 10% under domestic law and most treaties (some treaties further reduce this rate).

If only the buyer’s acquisition vehicle in China will use the technology, moving the IP rights offshore may not result in material overall tax savings.  Although the licensee in China will obtain tax deductions against the 25% rate, these deductions have to be compared with the deductions for amortization of the IP rights that the licensee would have if it had instead acquired the IP rights.  In this situation, the withholding tax could represent an additional tax burden, although possibly one the buyer would accept because of concerns about IP protection.  If, however, the IP will be licensed to others in China or outside China, moving the ownership to a jurisdiction with a low tax rate may significantly reduce the income tax on the royalty streams from the 25% rate that would apply to a China licensor.

7. What Tax Elections, If Any, Need To Be Made?

8. Generally speaking, there are no elections that need to be made.  A point to note is that the Reorganization Rules stipulate that enterprises which have undergone reorganization and are electing special tax treatments have to submit written information about the reorganization to their competent tax authorities at the time when filing their annual income tax return.   If The Entities Have Different Tax Years, Can This Be Changed?

Starting from January 1, 2008, all companies must use the calendar year as the tax year.

9. Are There Any Obvious Tax-Related Employment Issues That Arise?

Under the asset transfer approach, employees are normally transferred from the seller to the buyer.  It is good practice to have the seller settle all salaries and other compensation with the employees before transferring them to the buyer. 

In China, an employer must withhold individual income tax (“IIT”) for its employees.  If the seller transfers accrued salaries to the buyer, it is unclear which company should withhold IIT on the accrued salaries.  As there is no clear guidance, the buyer and seller need to confirm the practice in advance with the relevant local tax authorities if accrued salaries are transferred in an asset deal.  If the buyer and the seller are located in different cities, it can be very difficult to negotiate a solution acceptable to both tax bureaus.

10. Are There Any Other Obvious Tax Planning Opportunities?

There are still many uncertain issues and a lack of guidance on the interpretation and enforcement of the Reorganization Rules.  The most urging issue to be cleared up for most multinational companies is perhaps whether a tax free cross-border merger is possible under the Reorganization Rules.  As indicated above, a strict interpretation of the Reorganization Rules suggest that cross-border merger can qualify for special tax treatment.  But different opinions have been voiced from officials from the MOF and the SAT.   The language from an earlier draft of the Reorganization Rule suggested that only certain explicitly listed cross border assets and shares transactions can qualify for tax-free treatment.  But such language was revised in the Reorganization Rules.  An argument can be made that the intention of such removal is to leave the door open for other type of cross border reorganizations, including mergers, to qualify for the tax free treatment.  Further guidance from the MOF or the SAT is needed.

 

¹ The Reorganization Rules was jointly issued by the Ministry of Finance (“MOF”) and the State Administration of Taxation (“SAT”) on April 30, 2009 and released to the public on May 7, 2009.  The Reorganization Rules have retroactive effect from January 1, 2008, the same day that China’s current income tax regime came into effect.

² A non-resident enterprise is an enterprise incorporated outside China with its place of effective management outside of China.

³ A resident enterprise is an enterprise incorporate in China, or an enterprise incorporated outside China with its place of effective management in China.

⁴ The difference between a purely domestic reorganization and a cross-border reorganization is that in the latter, a NRE is potentially a taxpayer involved in the transaction.   Most reorganizations involving FIEs will be cross-border reorganizations because they involve a foreign shareholder which is a NRE potentially taxable on the transaction.

⁵ Limitation on loss carry-over under a tax-free merger = fair market value of the net assets of the non-surviving entity x the interest rate on national debt for the longest term debt issued by the State in the year in which the merger occurs.