Indirect Transfer of Property in China

Public Notice 7 (2015) addresses the taxation of indirect transfers of Chinese taxable assets by non-resident enterprises. It substantially replaces both Circular 698 and Bulletin 24, introducing new tax liabilities and responsibilities that differ significantly from previous rules.

Chinese taxable assets now include assets attributable to an establishment in China, immovable property in China, and shares in Chinese resident enterprises. If a foreign investor sells or reorganizes shares in a foreign company holding Chinese taxable assets, and this has a similar effect to directly transferring the Chinese assets, any gain attributable to the Chinese assets is subject to Chinese income tax if the transfer lacks bona fide commercial purpose. Factors to consider in determining bona fide commercial purpose include equity value, assets and income sources, economic substance, foreign income tax, organizational history, and alternative direct investments. Indirect transfers without a reasonable commercial purpose and is a means to avoid enterprise income tax (EIT) can be recharacterized as direct transfers, and local taxes assessed.

Gains from an indirect transfer of assets related to an establishment in China is subject to a 25% income tax rate, whilst gains from an indirect transfer of real property in China or equity interests in Chinese resident companies is treated as China-sourced income and subject to a 10% withholding tax. Exemptions apply to indirect transfers involving public exchange-listed foreign enterprises and when tax treaties or arrangements would provide exemptions for direct transfers.

Four conditions that, if met, deem an indirect transfer lacking a reasonable commercial purpose (unless safe harbor rules apply):

1) more than 75% of the value of foreign enterprise equities comes from Chinese taxable property;

2) over 90% of the foreign enterprise’s assets or income is connected to investments in China around the time of the indirect transfer;

3) functions and risks of the foreign enterprise and its subsidiary holding Chinese taxable property are too limited to show economic substance, despite legal registration, and;

4) tax collected outside China on the indirect transfer is less than the potential tax on a direct transfer of Chinese taxable property within China.

There are safe harbor rules for qualifying internal reorganizations involving an overseas indirect transfer (OIT) of Chinese assets, provided certain conditions are met:

Safe Harbor Rule 1: OIT taxation doesn't apply to buying and selling listed securities of the same offshore enterprise in an open market.

Safe Harbor Rule 2: OIT taxation doesn't apply if the non-resident enterprise would be exempted from CIT liabilities in a direct transfer under applicable tax treaties.

Safe Harbor Rule 3: Certain conditions related to buyer-seller relationships exempt OITs from taxation.

Notice 7 no longer imposes an obligation on the transferor to report the transfer to the Chinese tax authorities. However, failure to report the transfer (if subject to income tax due to lack of bona fide commercial purpose) can result in severe penalties for the transferor. Purchasers now have withholding and reporting obligations, and they can be held liable if the seller does not pay the income tax on the indirect transfer. The buyer is the withholding agent and should withhold the tax at the time of the equity transfer. Sellers are the taxpayers and may handle taxation in their best interest, which can lead to differing positions between parties. If the withholding agent fails to withhold and the equity seller fails to pay the tax due and fails to declare for payment of such tax within seven days after the tax payment obligation comes into being, there is a penalty. If reported within 30 days, the buyer may be partially or fully relieved from liabilities for failure to withhold taxes.