Liu Tianyong is a tax lawyer and director of Hwuason Law Firm in Beijing. He is also executive director of the Fiscal Law and Tax Law Association
Recently, the Ministry of Finance published national public financial data for the first quarter of 2012. National fiscal revenue showed an increase of 14.7%, with the growth rate falling by 18.4 percentage points compared to the same period last year (33.1%). Tax revenue showed an increase of 10.3%, compared to a gain of 32.4% in the same period last year – the lowest in the past three years.
With the backdrop of a domestic economic growth plunge, tax authorities will be taking more stringent measures to intensify their inspection efforts for the purpose of completing the annual taxation task.
In accordance with Major Points of 2012 National Taxation Inspection (JiBianHan  No. 1), capital transactions hit the list of mandatory items for taxation special inspection. Therefore, mergers and acquisitions (M&A) and restructuring of enterprises, as one of the significant ways of capital operation and a key target of taxation inspection, will be confronted with a serious taxation inspection risk.
Tax issues with domestic M&A
According to provisions of the Notice of the Ministry of Finance and State Administration of Taxation on Certain Issues Concerning the Handling of Enterprise Income Tax in Enterprise Restructuring (Cai Shui  No. 59), where an enterprise satisfies the conditions for special restructuring specified in this notice and chooses the application of the special taxation provisions, the parties concerned should, when the filing of the annual enterprise income tax return for the restructuring is completed, submit written material for record-filing to the competent tax authorities to prove that it complies with the conditions for special restructuring. No enterprise may handle taxation by applying the provisions on special restructuring if it fails to complete written record-filing as required.
In accordance with the Announcement of the State Administration of Taxation on the Promulgation of the “Measures for the Administration of Enterprise Income Tax in Enterprise Restructuring” (Announcement No. 4 ), where a domestic equity M&A satisfies the conditions prescribed in Notice 59 and special tax treatment is adopted, material certifying that the M&A satisfies the conditions for special tax treatment, and other equity M&A-related material, should be submitted.
Apart from material certifying that the M&A satisfies the conditions for special tax treatment, the parties involved should, when filing the annual enterprise income tax return in the year following the completion of the restructuring, submit a written statement to the competent tax authority certifying that the conditions of the enterprise satisfying special tax treatment remain unchanged in the 12 months after the restructuring.
In the case of enterprise restructuring, according to the requirements of Item 1 of Article 5 of Notice 59, the enterprise should, when going through record-filing or filing an application for confirmation, state reasonable commercial purposes of the enterprise restructuring from the following aspects:
- Transaction used for the restructuring, i.e. the specific form adopted for the restructuring, transaction background, transaction time, way of operation prior to and after the transaction, and related common practices in business;
- Form and substance of the transaction, i.e. the legal rights and obligations arising from the transaction, as well as the legal consequences; the final results of the transaction actually incurred to the business;
- Possible changes incurred to the tax status of each party to the transaction due the restructuring programme;
- Change of financial status of each party to the restructuring due to the transaction;
- Whether or not the restructuring has brought any abnormal economic benefit or potential obligation to each party to the transaction;
- Participation of non-resident enterprises in the restructuring.
An enterprise that undergoes an equity acquisition prescribed in Article 6 (2) of Notice 59 must prepare these materials:
- Statement on the overall situation with the equity acquisition in which the parties are involved, including the business purpose of the acquisition;
- The equity acquisition contract or agreement signed by the two parties, or multiple parties;
- The fair value of the equity to be transferred or paid, which is issued by the evaluation institution;
- Material certifying that the restructuring satisfies the conditions for special tax treatment, including equity proportion, payment of consideration, and a written pledge that the original substantive operation activities of the assets will not be changed within 12 months, or the original main shareholders will not transfer their equity, etc.;
- Certification material of the department in charge of industry and commerce, and other relevant departments, on verifying and approving the change in equity of the enterprise;
- Any other material required by the tax authority.
Where an enterprise restructuring satisfies the conditions for special tax treatment, the acquirer should apply to the competent tax authority for record-filing. Failing to do so may result in general tax treatment for enterprise restructuring and paying an overdue tax bill.
With regard to enterprises that have completed the restructuring by the time of promulgation of the Measures for the Administration of Enterprise Income Tax in Enterprise Restructuring, if the special tax treatment prescribed in Notice 59 is applicable, the enterprises that fail to prepare the relevant material in accordance with the Measures should supplement the relevant material and apply in accordance with the Measures for confirmation by the tax authority where necessary.
Since Notice 59 became effective on 1 Jan 2008, special enterprise restructurings occurring since 2008 are obligated to apply for record-filing. For the purpose of taxation risk avoidance, parties involved in the restructuring, if such restructuring satisfies the conditions for special tax treatment, should apply promptly.
The parties involved in the same restructuring case should also adopt the uniform tax treatment principle, i.e. they should adopt either general or special tax treatment in a uniform manner.
Therefore, when the acquirer applies for the record-filing of special tax treatment, it should remind the other parties involved in the restructuring to apply for the record-filing, otherwise the party who has performed the record-filing obligation may be exposed to taxation risk and loss due to the non-performance of other parties.
Outbound non-resident enterprises
In accordance with the Notice of the State Administration of Taxation on Strengthening the Administration of Enterprise Income Tax on Gain Derived from Equity Transfer Made by Non-Resident Enterprise (Guo Shui Han  No. 698), where an offshore investor (actual controlling party) indirectly transfers the equity in a Chinese resident enterprise, if the actual tax burden of the country or region in which the offshore holding company transferred is located is lower than 12.5%, or the offshore income of its resident is not taxable, it should within 30 days from the date of signing the equity transfer contract provide related information to the tax authorities at the location of the Chinese resident enterprise whose equity is transferred.
If a non-resident enterprise (actual controlling party) satisfies the relevant conditions, it should be obligated to provide the relevant information to the competent tax authorities at the location of the Chinese resident enterprise whose equity is transferred.
In accordance with provisions of Notice 698, a non-resident enterprise which derives gain from an equity transfer and conforms to the provisions in Notice 59 pertaining to special restructuring conditions, and opts for special taxation treatment, should submit information in written records to the tax authorities to substantiate that it conforms to the conditions stipulated for special restructuring and has been approved by the provincial tax authorities.
Where a non-resident enterprise indirectly transfers domestic equity through special restructuring, restructuring parties are obligated to file records. There is a distinction between material that needs to be submitted for indirect domestic equity transfer through special restructuring and that for domestic special restructuring.
In accordance with provisions of Notice 698, the acquired party must provide the following information to the competent tax authorities at the location of the Chinese resident enterprise whose equity is transferred:
- An equity transfer contract or agreement;
- The relationship between the offshore investor and the offshore holding company transferred in the areas of capital, operations, purchase and sales, etc;
- The situation with production operations, employees, accounts, properties, etc., of the offshore holding company transferred by the offshore investor;
- The relationship between the offshore holding company transferred by the offshore investor and the Chinese resident enterprise in the areas of capital, operations, purchase and sales, etc.;
- An explanation of the reasonable business purpose for establishing the offshore holding company transferred by the offshore investor;
- Any other relevant information tha may be required by the tax authorities
Risks of tax evasion
In accordance with provisions of Notice 698, where the offshore investor (actual controlling party) arranges for indirect transfer of the equity in a Chinese resident enterprise by means of abusing the organisational structure without having a reasonable business purpose, or is evading the obligation to pay enterprise income tax, the tax authorities may report it to the State Administration of Taxation for audit, after which it may re-determine the nature of such equity transfer transaction according to its economic substance and disregard the existence of the offshore holding company which has been used as a tax scheme.
A non-resident enterprise, if indirectly transferring domestic equity, should avoid this predicament. The risks of not doing so are considerable. For instance, the national tax bureau in Jiangsu province identified a Hong Kong company as an offshore shell company for a Yangzhou-based company, which was then subject to tax liability and eventually paid RMB173 million (US$27 million) in enterprise income tax for a non-resident enterprise in arrears.
Reasonable business purpose
In the event of indirectly transferring domestic equity, the crux of risk prevention is to avoid the offshore holding company being determined to be a tax scheme without reasonable business purpose.
In the case of the Yangzhou company, the joint panel, upon in-depth analysis and mutual confirmation of relevant material, identified the Hong Kong company as a shell company without any employment, assets, liability, investment or business operations. This was corroborated by the fact that the US parent company of the purchaser made a public announcement on its website certifying the conclusion of the transaction of acquiring 49% of the Yangzhou company’s equity without any reference to the Hong Kong company.
In another example, the national tax bureau in Chongqing determined an offshore company of a Chongqing company to be a tax scheme without any commercial activities, and disregarded the existence of the offshore company. Consequently, the bureau in Chongqing collected RMB980,000 of withheld income tax.
To avoid being recognised as a shell company without a reasonable business purpose, the restructuring parties must guarantee when designing the transactional structure that the offshore company is a going concern equipped with assets, offices, staff, regular meetings and cashflow.
In order to help the competent tax authority in determining the nature of the offshore company, restructuring parties should take the initiative to contact the authority and provide relevant information concerning the offshore company.
M&A and restructuring usually involve substantial amounts of subject matter, particularly in the case of indirect equity transfer by a non-resident enterprise. In 2011, a Japanese company was required to pay RMB306 million of enterprise income tax for the transaction of indirectly transferring the equity of “Kangshifu the beverages”, a British Virgin Islands (BVI) company. In another example, a record high of RMB403 million of enterprise income tax for a non-resident enterprise involved the transaction of indirect transfer of a Shanxi energy company’s equity by a BVI company. With the prospect of increased taxation inspection risk, M&A and restructuring parties should be fully aware of tax risks, actively adopt measures to prevent such risks, and diligently deal with relevant taxation issues and the particular concerns of the risks deriving from non-resident enterprise indirect equity transfer.