China to Tax Offshore Transactions

Tuesday, December 22, 2009 7:56
Posted in category Invest in China, Red Tape

In what might be the regulation that slipped through the traditional media wires, Jay Boyle of EXPAT CFO just forwarded me a potential bombshell of a regulation where China will look to tax all those offshore transactions that investors have come to rely upon when setting up their China vehicles.

… and it went into effect January 1, 2008

In short, the circular is meant to specifically address the offshore sales of China based assets, and Deloitte has already put together their thoughts on what this means for investors (download file here):

Circular 698 makes it clear that the Chinese government intends to tax indirect transfers, many uncertainties still need to be clarified. It is unclear how the 12.5% effective tax rate of the offshore intermediary holding company is to be determined; for example, will the minimum 12.5% rate criterion be met if the jurisdiction of the intermediary company has a tax rate higher than 12.5% but does not tax capital gains? In the case of a direct transfer of a Chinese resident enterprise by a foreign entity, the SAT will easily be able to identify the transferee as the withholding agent; this will be more difficult in the case of an indirect transfer of a Chinese resident enterprise.

It is unclear how the tax bureau will enforce taxation of such offshore transfers in practice. Where transactions involve a large group of companies in a global merger or acquisition, the requirement to disclose all of the information concerning the transaction may create an overwhelming administrative burden and involve the submission of information that will be irrelevant. From the buyer’s perspective, the impact and consequences of a seller’s noncompliance are not entirely clear.

Where I myself am a bit lost in this new “clarification” is the simple fact that the very reason why many firms chose to set up offshore is to effectively dodge authorities who might otherwise block the sale of an asset. That, tax aside, the ability of a firm to sell their HK or BVI shares to another firm without the approvals of Beijing was a huge asset in itself. So much so that those who were able to “clean” a mainland asset and structure it offshore were typically paid a premium for their effort.

An effort that may no longer be enough.

At the same time, my personal opinion is that this clarification will be used as the exception vs. the norm, and that it will be used as a negotiation chip for firms who have found themselves past another red line. Simply getting access to the data in some of the “standard” islands is going to be tough, but if Beijing wanted to force the issue they clearly could under the guise of this law (recognized outside of China or not) as firms would be force to comply or face roadblocks/ fines in other areas.

So, regardless of whether or not we see a team of investigators start opening up the HK books, I think investors would be wise to see that things are getting tighter all around, put down the rose colored glasses, and begin reassessing the risk levels of “traditional” China models.

Any lawyers want to weigh in on this issue?

Update 1: While emailing back/ forth to a Beijing based lawyer, he also was unsure of how the enforcement of this would be possible/ take place, and in my most recent reply to him I asked whether this rule was actually geared for chasing overseas Chinese IPOs vs. domestic M&A.  I do not have his answer yet.

Anyone have thoughts on that possibility?

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7 Responses to “China to Tax Offshore Transactions”

  1. Jay Boyle says:

    December 22nd, 2009 at 8:40 am

    Hi Rich,

    I think Deloitte really did a god job analyzing this one.

    Two things stand out.

    i. The fact that it is a retroactive law that goes back to Jan 1 2008.
    ii. The extraterritoriality of the law.

    The only thing I would say is if your firm was involved with any transactions in the last two years you should have legal council review this law and make a risk assessment on how to proceed.

    Jay Boyle

  2. Matthew says:

    December 22nd, 2009 at 11:34 pm

    Important post Rich. Interesting, given its importance, how this circular wasnt picked up.

  3. Matthew says:

    December 23rd, 2009 at 12:04 am

    Rich,

    In terms of your questions re enforcement I think the answer is that as with any cross-jurisdictional tax matters it will never be easy for the authorities. However,in adopting such a structure (in breach of the law) you will run the risk that such arrangement will come to the attention of the authorities in which you case you may suffer significant penalties and interests. Also, note that earlier this month China signed a Tax Information Exchange Agreement with the BVI. Obtaining information, and enforcing non-disclosure, are challenges that the tax authorities always face. A recent case in Xiamen is a perfect example of this in the conext of transfer pricing – http://chinataxinsights.com/?p=330

    As important as this circular is, it has been a long time coming – the authorities used the GAAR last year to similar effect in Xinjiang and Chonqing in respect of off-shore transactions.

    In terms of your question re Chinese overseas IPOs v domestic M&A I think it is primarily aimed at both. The reality is that the sale of offshore entities as a method of avoiding tax is simply tax avoidance – many jurisdictions contain rules preventing such arrangements. China is now simply catching up in this respect. For example, in Australia such an arrangement would potentially fall foul of Australia’s anti-avodiance rule.

    An important thing to note is that the arrangements will only give rise to tax where there is no reasonable business purpose. Accordingly, a practice tip would be to ensure that there would be a reasonable business purpose for the arrangement. Could it be argued that wanting to avoid the onerous regulatory requirements for transferring companies on the mainland is a “reasonable business purpose”. I think there is an argument that it could be, although it is my understanding that this issue was discussed by tax practitioners and the authorities last year with the indication being that it would not be.

  4. More on Circular 698 | China Tax Insights says:

    December 23rd, 2009 at 12:22 am

    […] excellent All Roads lead to China blog has posted about Circular 698 and posed some questions [see http://www.allroadsleadtochina.com/2009/12/22/china-to-tax-offshore-transactions%5D. Here is my response to his post: In terms of your questions re enforcement I think the answer is […]

  5. R. Minkus says:

    December 26th, 2009 at 5:05 am

    There’s another angle on it here (Nov. 17th) concerning ownership issues from China Briefing who I think broke the story. Possibly the title was too technical for many: http://www.china-briefing.com/news/2009/11/17/china-issues-new-directives-over-offshore-beneficial-ownership.html

  6. Matthew says:

    December 26th, 2009 at 10:05 pm

    Minkus,

    That article is not on Circular 698 but rather Circular 609 see here http://chinataxinsights.com/?p=134. Circular 609 is a relevant circular albeit it relates to a different issue – the withholding tax rate on dividends, royalties and interest. Both Circular’s indicate the SAT’s intention to disregard SPVs where there is no reasonable business purpose. To simplify Circular 609 is relevant to distributions of income of a China company whereas Circular 698 is relevant where that company is sold (directly or indirectly).

    Circular 698 was only issued on 11 December so there was nothing to break on 17 November.

  7. Matthew says:

    December 26th, 2009 at 10:07 pm

    Sorry that should read Circular 601 not 609. That teaches me not to rely on my memory.

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