Profitable or potentially profitable PRC domestic enterprises are now very sought-after acquisition targets for foreign investors and venture capital funds.  Pursuant to China’s WTO obligations, more such acquisitions will become possible and an increase in such activity is expected.  The Tentative Provisions on Acquisitions of Domestic Enterprises by Foreign Investors (7 March 2003) provide the following legal forms for foreign investors to acquire domestic enterprises :-

Equity Acquisition

  1. direct purchase of equity interest in a domestic enterprise;
  2. subscription for increased registered capital of a domestic enterprise.

Assets Transfer

  1. establishment of a foreign investment enterprise ("FIE") and purchase of assets of a domestic enterprise and operating such assets;
  2. purchase by agreement of the assets of a domestic enterprise and use of such assets to invest in and establish an FIE to hold such assets.

After the acquisition, the new FIE is required to pay taxes according to the tax laws and regulations applicable to FIEs.  The State Administration of Taxation recently clarified certain tax issues in connection with foreign investors’ acquisitions of equity interests under items 1 and 2 above with the issuance of the Tax Issues Relevant to Acquisition of Equity Interest in Domestic Enterprises by Foreign Investors Circular (the "Circular") (28 May 2003) that is retroactively effective from 1 January 2003.

Prior to the issuance of the Circular, tax preferences were granted only to green field FIEs.  However, the Circular confirms that FIEs restructured as a result of M&A activity will be treated in the same way as a green field FIE for purposes of enterprise income tax if the proportion of equity held by foreign investors exceeds 25%.

Under existing law prior to the issuance of the Circular, production oriented FIEs with operations of 10 years or more enjoy certain preferential tax treatment.  Now, as indicated above, even though restructured FIEs have commenced business prior to the restructuring, for the purposes of the FIE related tax laws and regulations, the business operation period shall commence from the date of issuance of the business licence for the restructured FIE. 

Thus, production oriented restructured FIEs are entitled to an exemption from income tax for the first 2 years and a 50% reduction of income tax for the following 3 years starting from the first profit-making year.  For the purposes of establishing eligibility for tax preferences, the first profitable year will be the first year in which profits are earned after deducting losses carried forward.

In relation to losses carried forward, under the relevant FIE income tax laws operation losses incurred by an FIE may be made up in the following tax year.  If the following tax year’s income is insufficient, then the balance may be made up in the next year and so on for a maximum period of 5 years.  The Circular clarifies that a restructured FIE can continue making up any balance of cumulative losses existing immediately prior to restructuring for any remaining years within the 5 year period.

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.