The Jincheng State Tax Bureau in Shanxi province recently collected RMB430 million (US$68 million) in income tax on the capital gain from a single offshore indirect transfer, the largest amount for an indirect transfer of a Chinese target by a non-resident enterprise to date.
According to China Taxation News, a newspaper produced by the State Administration of Taxation, the case was complicated in that it involved a complex holding structure and multiple transfers. The tax bureau and the taxpayer had difficult negotiations on key issues, such as how to determine the revenue from the transfer and the taxpayer’s tax base.
The details of the case, such as whether the offshore target company had economic substance and how the value of the underlying Chinese subsidiary was appraised, were not released to the public. Therefore, the case is not a valuable reference for the difficult substantive legal questions, such as what constitutes sufficient economic substance and reasonable commercial purpose, or how to properly value a business as a going concern. However, the case did raise some interesting procedural questions that may have a significant impact on both sellers and buyers in offshore transactions.
China Taxation News reported that the Jincheng State Tax Bureau, during its regular monitoring of information about potential tax cases, discovered that a Hong Kong company holding 56% of a large power company in Jincheng had been transferred by its British Virgin Islands (BVI) parent to a Hong Kong buyer. Apparently, the offshore seller did not report the indirect transfer to the Jincheng State Tax Bureau in accordance with Guo Shui Han  Circular No. 698. The Jincheng State Tax Bureau issued tax matter notification letters to the seller and the buyer requesting information about the transfer.
Initially, the Jincheng State Tax Bureau and the BVI seller failed to reach agreement on the amount of taxable revenue from the transfer, or about the seller’s tax base. The bureau then contacted the Hong Kong buyer and asked it to be prepared to withhold the income tax on the BVI seller’s capital gain from the unpaid consideration for the transfer. At that point, the BVI seller finally agreed to the amount of income tax payable as determined by the bureau, and paid it before the bureau made a formal withholding request to the Hong Kong buyer.
There is a debate about whether an offshore buyer has a withholding obligation in offshore transactions. Guo Shui Fa  Circular No. 3 provides that the non-resident seller has the obligation to report and to pay tax directly to the competent tax bureau in an offshore transaction, where both the seller and the buyer are non-resident enterprises.
As a result, some tax practitioners believe that an offshore buyer does not have a withholding obligation in either a direct offshore transfer or an indirect offshore transfer. The Enterprise Income Tax Law, however, imposes a general withholding obligation on payers without distinguishing between payers that are resident enterprises and payers that are non-resident enterprises. Circular 3 does not explicitly relieve an offshore buyer (payer) that is a non-resident enterprise from the withholding obligation. Therefore, some tax practitioners believe that the Chinese tax authorities may enforce the withholding obligation on offshore buyers based on the Enterprise Income Tax Law.
The Enterprise Income Tax Law also allows the PRC tax authorities to collect income tax from payers of other China-sourced income of the taxpayer if neither the withholding agent nor the taxpayer pays the tax. This could be another potential ground for the tax authority to collect income tax from offshore buyers in direct and indirect offshore transactions. The Hong Kong buyer may be required to pay the income tax on the capital gain of the BVI seller, not as a withholding agent for the specific transaction but as one of the payers of China-sourced income to the BVI seller.
Regardless of the legal basis in the Jincheng case, offshore buyers in future direct or indirect equity transfers may face an increased risk of being asked by the Chinese tax authorities to withhold income tax payable by the offshore seller. Therefore, it is more important than ever for an offshore buyer to ensure that the offshore seller fully complies with its tax filing and payment obligations.
The other interesting procedural question raised by this case is whether late payment surcharges and penalties are applicable to circular 698 cases, or more generally, to special tax adjustment cases. The Tax Collection and Administration Law generally imposes a late payment surcharge of 0.05% per day (i.e. 18.25% per year) on taxpayers who fail to properly and promptly pay tax. It also gives the Chinese tax authorities discretion to impose a penalty ranging from 50% to 500% of the unpaid tax in certain cases.
Conversely, the Enterprise Income Tax Law and its implementing regulations provide that in special tax adjustment cases, such as transfer pricing and tax avoidance cases, the tax authorities can collect interest equal to the basic lending rate of the People’s Bank of China, plus 5%.
Tax adjustments made on indirect equity transfers under circular 698 are classified as special tax adjustments. Therefore, unless fraud is involved, the tax authorities should not impose a late payment surcharge or penalty. The Implementation Measures of Special Tax Adjustments (Guo Shui Fa  No. 2) clarify that once a special tax adjustment notice is issued, the Chinese tax authorities can impose a late payment surcharge if the taxpayer does not pay the tax in accordance with the notice. This clarification strengthens the view that the late payment surcharge generally does not apply to special tax adjustment cases.
The China Taxation News reported that the Jincheng State Tax Bureau looked into the issue of how to impose a late payment surcharge and a penalty in the Jincheng case, but did not report whether the bureau concluded that a late payment surcharge and a penalty were applicable. It appears that no late payment surcharge or penalty was imposed.
But since this issue has not been formally clarified, there is a practical risk that the tax authorities may use the threat of late payment surcharges and penalties to increase the pressure on non-resident sellers in negotiations. A similar risk may exist for non-resident buyers, as the Tax Collection and Administration Law also imposes a penalty ranging from 50% to 300% of the unpaid tax on withholding agents that fail to withhold.
Business Law Digest is compiled with the assistance of Baker & McKenzie. Readers should not act on this information without seeking professional legal advice. You can contact Baker & McKenzie by e-mail at: Zhang Danian (Shanghai) email@example.com