This year will mark a half-decade since the release of Circular
698. The confluence of local enforcement and increased exits
by off-shore investors may make 2014 its most interesting year.
A Circular 698 Refresher
Prior to Circular 698, the PRC relied on cross-border payment
disclosures to initiate investigations for potential tax
evasion. On 10 December 2009, the State Administration on
Taxation ("SAT") issued its "Notice on Strengthening
the Administration of Enterprise Income Tax on Share Transfer
Income of Non-resident Enterprises No. 698" ("Circular
698") to enforce taxation offshore "indirect equity
transfer" contract made to avoid PRC taxation.
Circular 698 requires disclosure by off-shore investors of
certain indirect equity transfers. An "indirect equity
transfer" is the sale of an off-shore company holding
PRC-resident entities. If the transferred entity is in a
jurisdiction with a tax rate lower than 12.5% or does not tax
overseas income, then that entity must disclose the transaction to
local tax administration authority of the Chinese resident entity
within 30 days of its conclusion. The disclosure must
include, inter alia, the equity transfer contract, the
relationship between the off-shore investor and the holding
company's funds and management, and the relationship between
the holding company and the PRC resident's funds and
If the foreign investor cannot show a reasonable business
purpose for the off-shore transaction, then the State
Administration of Taxation may treat the transfer as if it occurred
Why Circular 698 is an issue for 2014
Why bring up old news now? One reason is that the
accounting firm PWC reports that a supplementary circular may
address the difficulty SAT faces in enforcing the Circular
698. Other commentators suggest that it will widen the scope
of the reporting requirements. More pressingly, however, 2014
is likely to see increased exits by off-shore private equity funds
from PRC investments.
While some of these exits may be IPOs that are likely to be
exempt (an IPO on a foreign market is likely a reasonable
business), more exits will to be off-shore sales of off-shore
entities from off-shore sellers. Given the lack of direct
contact with the PRC, enforcement is questionable.
An off-shore seller will argue that there is no obligation for
it to disclose to the PRC that it has made an off-shore sale of an
off-shore entity (e.g., India is the only other major country
taxing indirect transfers that are not related to real
estate). Recognizing this reporting issue, enforcement
efforts beyond SAT's perusal of company year-end reports and
press releases may increase in 2014.
Even when the seller wishes to disregard the disclosure, the
purchaser is unlikely to acquiesce for two reasons. First,
the PRC authorities have taken the position that the tax may be
viewed as a withholding tax for which the purchaser or target
company is liable. Second, purchasers have argued that in the
event that future Circular 698 disclosure is filed when the
now-purchaser disposes of the company, its step-up in basis may
Risk Allocation and Planning
Given these risks, the purchasers are now demanding a covenant
in the purchase agreement obligating the seller to timely comply
with Circular 698. They also require an indemnity to
ensure the seller bears any related liability associated with
While it is to late anticipate exits in 2014, investors
targeting PRC subsidiaries this year may want to ensure that a
reasonable business purpose underlies its off-shore acquisition
structures (e.g., gaining revenue from non-PRC sources and
conducting corporate activity from outside the PRC).
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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