China: Notice 698 – the death of offshore holding structures?

The PRC tax authorities recently issued Notice 698, which sets out the basis on which they may tax a foreign company that “indirectly” transfers an equity interest in a subsidiary in China. An indirect transfer occurs when a foreign company transfers the shares of a subsidiary outside China that in turn holds a subsidiary in China. If the subsidiary outside China whose shares are transferred is established in a low-tax jurisdiction, the seller must report the transaction to the local tax authorities where the Chinese subsidiary is located. Where certain factors indicating the avoidance of Chinese tax are present, the tax authorities may treat the transaction as a direct transfer of the Chinese subsidiary and tax the seller on its capital gain from the transfer.

Notice 698 also covers a number of other issues, but the provisions affecting indirect share transfers have generated the most concern and therefore will be the focus of this article. Notice 698 presents a major challenge to the typical holding structures that overseas investors have adopted for investments in China historically. Investors throughout the world commonly establish intermediate holding companies for investments outside of their home countries, often in low-tax jurisdictions and sometimes as special purpose vehicles (“SPVs”) that hold a single operating company or multiple operating companies in the same line of business. Many of the intermediate holding companies for investments in China have been located in Hong Kong, Singapore, the British Virgin Islands, Barbados, the Cayman Islands and Mauritius.

Although investors often have legitimate commercial reasons for locating an intermediate holding company in a particular jurisdiction, the use of such a holding company, particularly an SPV, can be viewed as abusive in two situations. First, it might be established in a jurisdiction that has a favourable tax treaty with China that either reduces the withholding tax (usually 10 percent) on dividends paid by the Chinese subsidiary to the SPV or reduces or exempts capital gains tax when the SPV disposes of the Chinese subsidiary. Second, by interposing an offshore SPV between the investor and the Chinese subsidiary, the investor can dispose of its investment in China by selling the SPV, and thus can convert what would have been a taxable onshore sale into a tax-free offshore sale.

Notice 698 is aimed at the latter abuse. Where it applies, the PRC tax authorities may disregard the intermediate holding company and treat the investor as having disposed of the Chinese subsidiary directly. This means that capital gains tax will be payable.

The taxation of indirect share transfers was foreshadowed in 2008, when the tax bureau in Chongqing disregarded the existence of a Singapore SPV that held a Chinese subsidiary and levied tax on the capital gain derived by the parent company from the sale of the Singapore SPV as a direct sale of the Chinese subsidiary. The bureau justified its decision by applying the new general anti-avoidance provision in China’s Enterprise Income Tax Law (“EIT Law”) on the grounds that the Singapore SPV had no economic substance. Notice 698 has now formalised the general approach taken in the Chongqing case and further provides a reporting mechanism to allow for the enforcement of the same. Enjoying this article? To continue reading you need to take out a FREE trial to the Transfer Pricing Library.




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