Avariable interest entity (VIE) structure is an arrangement where an offshore holding company is jointly established between Chinese founders and foreign investors under which they establish a wholly foreign-owned enterprise (WFOE) in China. That WFOE then controls a domestic enterprise via a series of contractual agreements. Through these agreements, the holding company can consolidate the financial statements of the domestic company into the group’s overall financial statements.
VIE structures have been commonplace for emerging industries where foreign investment is restricted or prohibited such as online technologies or the operation of medical institutions. The holding company being acquired or merged into another firm, or the holding company going public tends to be the exit mechanism for investors and founders. In the case of merger and acquisition transactions, it is important to be mindful of the tax risks and take effort to reduce them.
The exit methods for investors and founders are many and complex, e.g. going public, dividend distribution, share transfers, buy-backs. Further, the parties involved may arrange different approaches per the type of transaction to optimize their taxes.
This article will primarily focus on potential tax issues in transactions wherein shares of a holding company, e.g. a Cayman Island company, are indirectly transferred between a foreign institutional investor and the domestic individual founder.
The applicable legislation on the transfer of Cayman Island companies shares by foreign institutional investors are the Enterprise Income Tax Law and its implementing regulations, both issued in 2007. Also applicable are the Notice on Strengthening the Administration of Enterprise Income Tax on Non-resident Enterprises’ Equity Transfer Income and the Announcement on Several Issues concerning the Enterprise Income Tax on Income from the Indirect Transfer of Assets by Non-Resident Enterprises issued by the State Administration of Taxation (SAT) in December 2009 and February 2015, respectively.
Per articles 2-4 and 27 of the Enterprise Income Tax Law and article 91 of its implementing regulations, non-tax resident enterprises are those established in accordance with the laws of a foreign jurisdiction and which the actual managing entities are not in China but which have an establishment in China or which receive revenue from China. Their Chinese revenue should be taxed at a rate of 10%.
SAT’s notice and announcement provide that where non-tax resident enterprises transfer foreign company shares holding taxable assets in China which produce a result identical or substantially similar to a direct transfer of Chinese taxable assets, the transfer shall be subject to a 10% withholding tax per article 3, paragraph 3 of the Enterprise Income Tax Law, which concerns taxes to be paid by non-tax resident enterprises on taxable income sourced in China.
The notice and announcement further expand the scope of the reporting obligors of share transfers. Article 9 of the announcement sets out that the two parties to the indirect transfer of China-taxable property and the China resident enterprise whose shares are indirectly transferred may report the share transfer to the competent tax authority. They are obligated at that time to include all parties to the transaction. The tax issues related to the indirect transfer of shares by foreign investors evidently cannot be ignored by the parties of the transaction.
In practice, the transferee generally will agree to deduct withholding tax from the consideration in the transaction document in order to avoid their risk. They will also defer the payment of the amount in equivalent of the withholding tax until the transferor provides proof of duty paid, compelling the transferor to report the relevant taxes as per the announcement.
Indirect share transfers by domestic founders lack applicable tax rules such as the notice or announcement. The legislation applicable to cases where Cayman Islands company shares held beneficially by founders through, e.g., a British Virgin Islands company are indirectly transferred are the Individual Income Tax Law and its implementing regulations, as revised in 2011, and the Notice from the State Administration of Taxation on Several Issues Involving the Collection of Individual Income Tax on Foreign Earnings and Provisional Measures for the Administration of Individual Income Tax Collection on Foreign Earnings issued in 1994.
In 2014, Nanjing municipal tax authorities stipulated that transferors of the indirect transfer pay individual income tax at rate of 20% in accordance with the Individual Income Tax Law provisions on the resident taxpayer’s obligation of tax payment for proceeds resulting from transfer of domestic or foreign property.
It should be noted that SAT’s Notice on Several Issues Involving the Collection of Personal Income Tax on Foreign Earnings provides that a domestic employer can only withhold the personal income tax of a Chinese taxpayer who is working outside the country when the employer is a mainland Chinese company, enterprise, or other economic organization or government office and the employee has been sent to work outside the country. Taxpayers who have obtained foreign income and lack withholding agents or tax collectors shall file and pay tax themselves.
The remittance of foreign currency proceeds resulting from offshore share transfers by domestic founders must be registered as per the State Administration of Foreign Exchange (SAFE) Notice on Issues Concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and in Return Investment via Overseas Special Purpose Companies. SAFE may require that a tax return or proof of duty paid be submitted at the time of registration as well.
Parties to a VIE exit transaction should give Chinese tax issues their full consideration when structuring the transaction and formulating its terms. Parties to the transaction should consult with legal and tax counsel to ensure that the transaction is completed smoothly and that interests of all parties are maximized.
Amy Deng Hua is an attorney at law of PacGate Law Group.
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