On 28 December 2017, the Ministry of Finance, the State Administration of Taxation (SAT), the National Development and Reform Commission and the Ministry of Commerce jointly released Cai Shui  No. 881 (Notice 88). Notice 88 allows a non-resident enterprise to defer payment of tax on dividends derived from a Chinese enterprise if, among other things, the non-resident enterprise directly reinvests the dividends into industries "encouraged" by the Chinese government.
The concept of the dividend tax deferral regime was first introduced by the State Council in a circular (i.e., Guo Fa  No. 39) dated 8 August 2017 as a measure to attract foreign investment.2 After four months of silence, the four ministries released the dividend tax deferral implementing rules on the last working day of 2017. The timing does not appear to be coincidental, given the recent conclusion of the legislative process on US tax reform. While the US tax reform may have removed a principal disincentive of US multinational companies (MNCs) to repatriate earnings from their Chinese subsidiaries back to the US, Notice 88 appears to encourage MNCs to keep those earnings in China.
In this alert, we will first examine what benefits MNCs can obtain from the Notice 88 tax deferral regime. We will then discuss the substantial requirements to receive the tax deferral. Finally, we will share some views about how MNCs may be impacted by this new regime. As we will discuss below, Notice 88 creates some uncertainties or issues that need to be clarified or managed. We expect the SAT will soon issue a bulletin to provide implementing guidelines for Notice 88, and such a guideline could clear some of these ambiguities. Also, MNCs should carefully manage the transaction structure and documentation in order to avoid pitfalls created by Notice 88.
1. Deferral regime overview
Under the Chinese tax rules, dividends distributed from a Chinese subsidiary to a non-resident enterprise shareholder are subject to 10% income withholding tax, subject to possible treaty relief. According to Notice 88, when a non-resident enterprise meets certain conditions as discussed below, it can defer tax payments on dividends from a Chinese resident enterprise if it directly uses the dividends to fund equity investment into industries encouraged by the Chinese government. That is to say, the non-resident enterprise does not need to pay the 10% (or less under an applicable tax treaty) dividend withholding tax at the time of dividend distribution.
The dividend tax deferral under Notice 88 applies to dividends derived on or after 1 January 2017. A non-resident enterprise that has paid withholding tax on dividends distributed after this date but prior to the issuance of Notice 88 may claim a tax refund within three years from tax payment if the dividends qualify for tax deferral.
The tax deferral regime is reminiscent of the pre-2008 dividend withholding tax exemption rules, which permanently exempted a foreign investor from withholding tax on dividends received from a foreign-invested enterprise. However, unlike the pre-2008 rules, Notice 88 requires the non-resident enterprise to pay back the deferred dividend withholding tax after the non-resident enterprises recovers the reinvestment by way of share transfer, redemption, liquidation, etc. An exception is provided for a recovery of reinvestment due to a restructuring of the reinvested enterprise if the restructuring qualifies for and actually enjoys the Notice 59 special tax treatment.3
2. Substantial requirements
A non-resident enterprise can enjoy the dividend tax deferral treatment if:
- The non-resident enterprise uses the dividends for direct investment. Direct investment refers to equity investments such as capital increase into an existing resident enterprise, formation of a new resident enterprise and share acquisition of a resident enterprise from an unrelated party. The invested enterprise should not be a listed company unless the investment constitutes a qualified strategic investment.
- The dividends are actually distributed from the accumulated earnings of the distributing enterprise. Although Notice 88 only applies to dividends derived on or after 1 January 2017, the earnings from which the dividends are distributed do not necessarily have to be realized after 1 January 2017.
- Cash dividends are directly transferred from the distributing enterprise's bank account to the bank account of the invested enterprise (in the case of equity increase in an existing Chinese enterprise or formation of a new Chinese enterprise) or the transferor (in the case of acquiring a Chinese target enterprise in an equity purchase). For in-kind dividends or dividends in the form of negotiable securities, the title of the respective properties or securities should be directly transferred from the distributing enterprise to the invested enterprise or the transferor.
- The invested enterprise conducts business activities in an industry encouraged by the government during the non-resident enterprise's investment period. Industries encouraged by the government are those listed in the Catalogue of Encouraged Industries for Foreign Investment under the Foreign Investment Catalogue or in the Catalogue of Priority Industries for Foreign Investment in Central and Western China.
Notice 88 specifically provides that acquiring shares of a resident enterprise from an unrelated party qualifies as a "direct investment". However, potential issues may arise affecting whether the dividends may enjoy the tax deferral treatment in such an acquisition scenario.
First, "unrelated party" is not a defined term under Notice 88. Query whether the tax authorities will refer to the definition of "related party relationship" under the transfer pricing rules (i.e., SAT Bulletin  No. 42). "Related party relationship" for transfer pricing purposes can be reached by a variety of factors in addition to shareholding relationship (e.g., substantial ownership interests in common, business control, etc.) and its determination can be quite complicated.
Second, the transactional parties in a share acquisition may sometimes need to first transfer equity consideration into an escrow account before the closing of the equity transfer. As Notice 88 strictly limits the fund flow and requires the dividends to be directly transferred from the distributing entity to the transferor, the seller and the buyer need to carefully negotiate the payment provisions in the share purchase agreement and structure the fund flow for the buyer to enjoy the dividend tax deferral.
Third, Notice 88 does not differentiate between a foreign seller and a domestic seller, so presumably both scenarios would be acceptable based on the current regulatory language. This is a little surprising because if the seller is a foreign entity, the dividend will be paid out of China as equity acquisition consideration and this is contrary to the purpose of the notice. Furthermore, if the seller is a foreign entity, the remittance of the dividends as the equity acquisition consideration to the seller’s offshore bank account may encounter certain foreign exchange difficulties as there is no underlying transaction between the distributing enterprise and the seller. MNCs should plan, manage and document the fund flow carefully in order to mitigate such foreign exchange difficulties.
3. Impact on MNCs
MNCs are most directly impacted by Notice 88's tax deferral regime by being provided with an opportunity to avoid immediate withholding tax upon distribution of certain dividends received from China. However, the dividend tax deferral under Notice 88 is not a permanent tax exemption and therefore mainly provides a tax benefit equal to the time value of the deferred tax. This tax deferral measure may be designed to incentivize MNCs to keep their earnings in China long-term. In contrast, a withholding tax exemption would not achieve the same result if an MNC's reinvestment of the dividend in China is only temporary.
Notice 88 reflects a global trend that local country jurisdictions are taking steps one after another to enhance the competitiveness of their tax regimes to attract investment. In the official interpretative language accompanying Notice 88, the Chinese government states that the new measure was rolled out mainly due to two reasons: (1) foreign investment is recognized to play an ever-increasing role in the Chinese economic growth; (2) other countries have issued policies designed to encourage domestic investment. The second point may hint at the recent US tax reform, which contains elements to encourage earnings repatriation from foreign subsidiaries to their US headquarters in the form of dividend. Therefore, when a US MNC considers whether to repatriate earnings from Chinese operations under the new US tax law, Notice 88 complicates the decision process by adding a Chinese tax factor into the equation.
MNCs that have accumulated profits in Chinese subsidiaries and plan to increase investment in China should consider strategies to enjoy the dividend tax deferral. This is especially important for MNCs whose home country tax systems provide participation exemption on foreign sourced dividends and who may not be able to utilize the Chinese withholding tax imposed as foreign tax credits. Under these circumstances, if an MNC plans to reinvest China-sourced dividends in China, Notice 88 can provide cash flow benefits.
A key condition of the tax deferral is that the reinvested enterprise should engage in encouraged industries. MNCs should assess whether the reinvested enterprise's current and contemplated business activities are in an encouraged industry before making the dividend distribution. Furthermore, the dividend tax deferral is subject to stringent fund flow conditions. An MNC that intends to claim the dividend tax deferral should plan, manage and document the fund flow carefully. Finally, Notice 88 will require further clarification on certain issues, such as the revenue percentage threshold to determine whether the reinvested enterprise operates in an encouraged industry, the indirect tax treatment if properties are transferred from the distributing enterprise to the reinvested enterprise, and the calculation of the recaptured dividend withholding tax due if an MNC uses both dividends and other funds in the equity of a reinvested enterprise and partially recovers such equity investment later. MNCs should work closely with their tax advisors to monitor these issues.
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1 Notice of the Ministry of Finance, the State Administration of Taxation, the National Development and Reform Commission and the Ministry of Commerce Concerning the Deferral of Withholding Tax on Dividends Directly Invested by Foreign Investors, Cai Shui  No. 88, dated 21 December 2017, retroactively effective from 1 January 2017.
2 Other major measures to attract foreign investment include (i) expanding the technologically-advanced service enterprise tax incentive nationwide (implemented under Cai Shui  No. 79 dated 2 November 2017), and (ii) encouraging provincial governments to issue regional headquarters incentive rules.
3 The gains from the restructuring will be exempted from enterprise income tax with the historical tax basis is carried over.