China Issues Long-Awaited Income Tax Rules on Corporate Restructurings

China has published the long-awaited rules on the income tax treatment of corporate reorganizations. The Notice on Certain Questions Regarding the Enterprise Income Tax Treatment of Enterprise Reorganizations (“Final Reorganization Rules”) was issued jointly by the Ministry of Finance (“MOF”) and the State Administration of Taxation (“SAT”) on 30 April 2009 and released to the public on 7 May 2009. The Final Reorganization Rules have retroactive effect back to 1 January 2008.

Six types of enterprise reorganizations are covered by the Final Reorganization Rules: change of legal form, debt restructuring, share acquisition, asset acquisition, merger and de-merger.

Article 75 of the Implementing Rules of the Enterprise Income Tax Law of the People’s Republic of China provides that a taxpayer should recognize gain or loss from reorganizations unless otherwise provided by the MOF and the SAT. The Final Reorganization Rules set out two types of tax treatment for the six types of enterprise reorganizations: normal tax treatment and special tax treatment. A taxpayer should recognize gain or loss from reorganizations with normal tax treatment. On the other hand, a
reorganization that qualifies for the special tax treatment can be carried out without triggering enterprise income tax.

 

I. Baseline requirements for tax-free treatment

To qualify for the special tax treatment, the following conditions must be satisfied:

1. The reorganization has reasonable commercial purposes, and reduction, exemption or deferral of taxes is not a major purpose of the reorganization;

2. The assets or shares transferred under an acquisition must meet the prescribed proportion, i.e. no less than 75% of the total assets or shares of the target;

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

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

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

In addition, the Final Reorganization Rules incorporate the “substance over form” principle such that step transactions carried out within 12 months could be considered as one transaction to determine the relevant tax treatment. This is particularly relevant for potential transactions that would qualify for special tax treatment, only to then have a follow-on transaction to perhaps an unrelated buyer intended to avoid PRC tax.

 

II. Special requirements for cross-border transactions

For cross-border share acquisitions and asset acquisitions to qualify for special tax treatment, additional conditions must be satisfied:

1. A non-resident enterprise (i) transfers shares of a resident enterprise to another non-resident enterprise over which the transferor has “direct 100% share control”, (ii) such a transfer would 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 within the next three years after the reorganization;

2. A non-resident enterprise transfers shares of a resident enterprise to another resident enterprise over which the transferor has “direct 100% share control”;

3. A resident enterprise invests assets or shares in a non-resident enterprise over which it has “direct 100% share control”¹; or

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

Under the above rules, the following reorganizations often contemplated by foreign investors may be able to qualify for tax-free treatment:

1. The transfer of a Chinese subsidiary from one offshore entity to another offshore entity, although some offshore pre-positioning may be necessary to satisfy the “direct 100% share control” requirement. This essentially allows foreign investors to transfer their Chinese subsidiaries to group entities that are set up in jurisdictions with favourable treaty terms with China, such as Hong Kong, Singapore and Ireland in order to enjoy the reduced withholding tax rate on dividend repatriation; and

2. The transfer of a Chinese subsidiary from the offshore shareholder to another Chinese subsidiary (e.g., a Chinese holding company”). This will allow foreign investors to centralize their PRC operations under a Chinese holding company.

Furthermore, the Final Reorganization Rules do not provide that crossborder mergers or de-mergers need to satisfy the additional conditions to qualify for special tax treatment. Therefore, we believe that mergers and de-mergers of Chinese subsidiaries of foreign investors should be able to qualify for special tax treatment as well, provided they meet the baseline conditions listed above.

It is also important to note that the Final Reorganization Rules leave the door open for cross-border reorganizations that do not directly satisfy the conditions #1 – 3 related specifically to cross-border reorganizations in Section II above to qualify for special tax treatment, if they can get special approval from the SAT and MOF.

 

III. Treatment of merger/de-merger transactions

If a merger or a de-merger qualifies for special tax treatment, no gain or loss needs to be recognized and the original tax basis of the assets and shares are preserved. The accumulated losses and other tax attributes can be carried over to the post-merger or de-merger entities². If a merger or a de-merger is subject to normal tax treatment, gain or loss needs to be recognized under a deemed liquidation or asset transfer. Accumulated losses and other tax attributes cannot be utilized by the post-merger or de-merger entities.

The Final Reorganization Rules also clarify the treatment of pre-merger / de-merger tax incentives after a merger / de-merger. This will be of particular interest to Chinese subsidiaries of foreign investors that continue to enjoy transitional tax holidays under the pre-2008 income tax regime.

1. In a merger by absorption, the surviving enterprise can continue to enjoy its unutilized tax incentives³.

2. In a survived de-merger, the surviving enterprise can continue to enjoy its unutilized tax incentives⁴. The tax incentives of the nonsurviving enterprise cannot be utilized by the surviving enterprise.

3. If the surviving enterprise is at a loss position in the year immediately prior the merger / de-merger takes place, the tax incentives to be utilized by the surviving enterprise would be zero.

However, 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.

 

¹ Instead of a complete tax deferral, the gain from the transfer of assets or shares in this scenario will be recognized in equal installments over 10 taxable years.
² Limitation on loss carry-over under a tax-free merger = FMV 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.
³ The amount of income of the surviving enterprise that will be eligible for the incentive after the merger is limited to the surviving enterprise’s taxable income in the year before the merger.
⁴ The amount of income of the surviving enterprise that will be eligible for the incentive after the de-merger is limited to the surviving enterprise’s taxable income in the year before the merger multiplied by the ratio of the surviving enterprise’s assets after the de-merger to the surviving enterprise’s total assets before the demerger.