On December 14, 2010, the State Administration of Taxation
("SAT") promulgated an Announcement on Issues Concerning
the Verification of Taxation Basis of Individual Income Tax Payable
on Equity Transfer Income ("Announcement"). The
Announcement came into effect on January 14, 2010.
The Announcement only applies to sales of equity interest by
individuals and seeks to combat situations in which companies are
sold very cheaply on paper. Experience has shown that Chinese
entrepreneurs are very strong in negotiating prices (i.e. selling
foreigners the Chinese dream) and it is very rare for a
company's equity to be sold at a price below its net asset
value unless there is some other transaction taking place outside
of the share documentation (i.e. offshore payment, consulting fees
etc.) which makes up for the shortfall.
The Announcement provides that the income a PRC individual
derives from selling equity (i.e. shares or registered capital) in
an enterprise will not only be based on the contract price but
shall also take into account its fair trade price. The term
"fair trade price" is more specifically defined in the
Announcement. If the tax authority determines that the transfer
price is artificially low it may decide upon a "fair trade
price" and tax the seller on such basis.
The Announcement provides details as to which factors they will
take into consideration when determining whether the taxation basis
(i.e. sales price) is artificially low:
Transfer price is lower than the original investment, or lower
than the combination of the price and taxes and fees paid for the
Transfer price is lower than the value of the target's net
Transfer price is lower than the price at which the equity
would normally be transferred in an arm's length
Transfer price is lower than the industry standard; or
However, the Announcement also provides that there may be
justifiable reasons for a low price. Examples given include:
Target is loss making for more than three (inclusive)
consecutive years; or
The investor is selling equity at an artificially low price due
to an adjustment in state policy; or
As part of a family re-structuring ( i.e. where the
equity-holder transfers equity to a spouse, parent, child,
grandparent, grandchild, sibling or any relative that has a right
to support or maintenance); or
Other justifiable reasons as may be provided by the competent
In addition, the Announcement also provides some details as to
possible verification methods that may be adopted:
Comparing the transfer price against the value of net assets
corresponding to the equity in the target held by the seller.
If the aggregate of intellectual property rights, land use
rights, real estate, right of prospecting, right of mining and
equity accounts for more than 50% of the total assets of the
target, then the value of net assets of the target should be
assessed by a third-party valuer; or
Benchmarking the transfer price against other deals in a
If a seller objects to any of the above verification methods
adopted by the tax authority, he or she will need to provide
supporting evidence for the objection.
The Announcement illustrates that the PRC tax authorities are
taking actions against taxes which are being evaded by Chinese
entrepreneurs when they sell their companies. The direct
consequence is that local sellers may face increased tax burdens
when selling their equity interest. However, foreign buyers may
also be indirectly affected. Although it is unlikely that the
Announcement's implementation would directly affect a
transaction after its approval, there may be an indirect affect. We
have seen increasing numbers of cases where the approval
authorities will not approve a transaction if the price seems
artificially low. In this case, the Announcement may be helpful in
that it provides guidance as to which argument may support a price
which at a first glance appears to be too low. As a suspiciously
low price may impact approval it is in all Parties' interests
to consider such issue early or in the process.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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