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By Matthew, February 17, 2010 11:31 am

As I mentioned a week or so ago, the SAT has prepared a draft of new detailed M&A rules. These have not been issued yet, but Hwuason managed to get  a copy of the draft. I will outline some of the more salient points over two separate posts:

Reasonable business purpose

The draft rules provide further details on the M&A Tax Rules (财税(Caishui) [2009] 59) that were issued mid last year. Caishui 59 provided a basis on which tax in respect of equity and asset acquisitions could be deferred where the transaction was in substance a reorganisation as opposed to a true sale of the company or asset. In Caishui 59 such a reorganisation is referred toas  a “special reorganisation”. One of the conditions for the special reorganisation deferral relief was that it must have a “reasonable business purpose”. The draft rules now provide a expanded definition of this term. In particular, the draft rules provide that the following factors will be relevant for determining if a transaction has a reasonable business purpose:

1. Transaction methods for restructuring activities. That is, the specific form of restructuring activities, trading background of restructuring activities, time for setting up transaction, other purposes that objectively can be classified as taking part in establishing the transaction, whether the transaction is facilitated by professional consultants and the operation methods before and after the transaction, and relevant commercial common practice.
2. The form and substance of the transaction. That is, the legal rights and liabilities derived from the transaction, what is the legal consequences of the transaction, and the final result of the transaction practically or commercially.
3. The changes of tax status to each parties brought by the restructuring activities.
4. The changes of financial status to each parties brought by the restructuring activities.Whether the restructuring activities brought to each party abnormal economic benefits or potential obligations that would not happen under normal market principles.
5. Non-resident enterprises to participate in restructuring activities.

What is clear from both Caishui 59 and the new draft rules is that tax will never be a legitimate basis for a restructure for the purpose of obtaining the special reorganisation relief. So, for example, if a group was to restructure their operations in light of Circular 698 so as to avoid the imposition of tax on any future equity transaction, then such a restructure would not be entitled to the relief unless legitimate reasons can be posed for the transaction. However, the point I have highlighted in bold above suggests how far the authorities intend to take such a principle. It is my guess that this wording will be removed from the final draft that is released but that it will nonetheless be a fairly influential factor.

Main shareholder

Under Caishui 59 entitlement to the special reorganisation relief required that the “main shareholder” of the transferred enterprise is not able to sell its  equity in the acquirer for 12 months. The term “main shareholder“ has now been defined in the draft rules to mean any shareholder that had more than a 20% interest in the transferred enterprise.

Common equity control

Under Caishui 59 a merger can receive special reorganisation relief, inter alia, if there is “common equity control”. This has now been further clarified to mean “ultimate control from the same party or multi-parties that the merged enterprises are subject to before and after the merger occurred and the control is not a temporary arrangement”. It appears that such control interests will need to be held for at least 12 months before and after the reorganisation to not be a “temporary arrangement”.

Reporting requirements

Firstly, under the draft rules all parties must be agreed as to whether a reorganisation is ordinary or special. This is obviously to avoid one party from later disputing a particular characterisation. The material in relation to the reorganisation must be submitted with the enterprises annual tax filings at the end of the tax year in which the transaction took place. The material submitted must be “consistent” with the “dominant party” responsible for organising the collection of the material. In both equity and asset transactions the dominant party is the transferor.

Where the transaction is between two non-resident enterprises, the transferred non-resident enterprise itself must report the transaction within 30 days of the contract being. This mirrors the requirements under Circular 698.

(to be continued)

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By Matthew, February 4, 2010 1:09 pm

I have just got my hands on a copy of new draft M&A procedural tax rules that should be released in the very near future. The copy I have has not been formally released at this stage so it may be subject to some changes, although this is doubtful. I havent had a chance to properly review the rules yet but I will try and give an outline of some of the salient points later today/tomorrow.

For a taste test, from my quick glance it appears that there is a new explanation of the reasonable business purpose test. These new draft rules are basically a further explanation of Caishui [2009] 59 (财税[2009] 59) which are the current tax rules governing M&A transactions in China.

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By Matthew, January 29, 2010 5:25 pm

This is the first post in a series on some of the more common tax problems that I have seen in my time in working in China. A lot of these problems were, at one stage, not problems. But the changing tax environment has meant that many such arrangements are now outdated. Others were always problems, but persisted because of an environment of non-enforcement.

The following scenario is one that I have seen a lot. This relatively simple structure arose out of a lack of vigilance by the tax authorities in respect of cross-jurisdictional transactions. However, the current tax environment is markedly different from when this structure became popular. There are some aspects of this structure which are quite justifiable, meaning it wouldnt take much to make it tax compliant. The major concern with this structure is that it is unlikely to result in any major tax savings as the US corporate tax rate is higher than the Chinese rate (particularly if the company is entitled to high tech incentives).

The scenario:

Parent company is located in the US (for example) (“Parent Co”). Parent Co undertakes services for Multinational Group, a company with its head office in the US. Multinational company sets up operations in China. Parent Co sets up a WFOE to provide similar service to those operations. Multinational Group pays parent company in the US. Parent Co then “hires” the WFOE to undertake the services in China. Parent Co pays the WFOE a service fee that is sufficient to cover expenses and no more. WFOE makes no profit and pays no taxes in China. It should be noted that in most cases the client has no option but to utilise the Parent Co/WFOE structure because of the requirements set out by the Multinational Group i.e. the Multinational Group wishes to contract with the Parent Co and not via the Chinese enterprises.

This structure has been quite common in China in the past because the tax authorities did not aggressively attack off-shore income nor greatly utilise the transfer pricing provisions. There are several potential problems with this scenario in light of the current tax environment:

Transfer pricing problem: structuring a service fee between related parties so that the fee merely covers the expenses of the WFOE is not an acceptable method of transfer pricing. On a general level, service fees between related party needs to be provided at a rate comparable to the market rate for the provision of such services. The SAT has indicated early last year that it will particularly target companies that are not making profits (or are making losses) in China.

Solution: To remedy this structure from a transfer pricing perspective there is a need to impose an appropriate fee between the two companies. In practice, this can actually be quite difficult. It is important to keep extensive documentation establishing the basis on which any pricing decision is made. This includes the manner in which the business is operated. China’s transfer pricing regulations contain 5 different methods for determining the appropriate price. Which method should be used is dependent upon the various circumstances and such selection can greatly impact upon the price adopted. Transfer pricing heavily depends on comparable factors. A comparability analysis examines the functions and risk of a particular enterprise and seeks to find comparable.

Anti-avoidance problem: China’s General Anti-Avoidance Rule (GAAR) permits tax officials to make a tax adjustment where an arrangement has been entered into for the purpose of tax avoidance. The rule was only introduced as part of the 2008 changes. The GAAR has been relatively under utilised at this stage and an exception to its application is where a transaction has a reasonable business purpose. Here, the fact that the multinational company is requiring Parent Co to adopt such a structure should be provide a sufficient basis to argue that it is has a reasonable business purpose for entering into the transaction.

Solution: The best solution to this problem is to ensure that the transfer pricing is appropriate in line with point 1 above as this will likely remove any avoidance argument. Secondly, it is important to document that the transaction was entered into for commercial reasons as opposed to tax avoidance – the fact that such a structure was required by the non-related party. If these approaches are taken then the risk here if effectively eliminated.

Permanent Establishment Problem: there is a relatively small risk that the tax officials will deem the WFOE to be a permanent establishment of Parent Co in China and therefore the income of Parent Co will arguably be taxable in China. This is a very slight risk given current practices of the tax authorities in China. The fact that it is separate entity will generally, although not completely, negate the argument of a permanent establishment.

Solution: There is little that can be done to avoid such a problem other than to document that the two companies operate independently. It would be beneficial if the WFOE was doing other business in addition to what it does for Parent Co, although that would not be determinative. The risk here is very small if the transfer pricing has been done appropriately.

Business Tax: It is highly likely that no business tax is being paid on money paid between the two US companies. Presumably, business tax is paid on the services provided between Parent Co and the WFOE, although the turnover is lower than what it should be because the agreement is merely to cover the WFOE’s expenses. The problem here is that Article 7 of the Business Tax Regulations provides the tax authorities with the power to make an adjustment where taxable services are provided at significantly low prices without justifiable reasons. The authorities can also impose penalties and interest.

Solution: The problem can be resolved by adopting an appropriate transfer pricing policy in accordance with point 1. In such a case, it will be difficult for the tax authorities to argue that the price is significantly low and the risk is removed.