The PRC State Administration issued the Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-resident Enterprises, dated December 10, 2009 and circulated to the public on December 16, 2009 ("Circular 698"). An un-official bi-lingual version of Circular 698 is attached.
The beginning of Circular 698 reads innocuously by addressing the PRC capital gains tax with respect to the sale of PRC resident entities by foreign entities. Under the PRC Enterprise Income Tax (the "EIT"), capital gains derived from the direct transfer of PRC resident enterprises by foreign entities are subject to a withholding tax of 10%, subject to reduction by applicable tax treaty (the "Capital Gains Tax"). This Capital Gains Tax is easily collected when the transferee is a PRC enterprise or individual subject to the legitimate jurisdiction of the PRC and who serve as withholding agents according to published law. Administrative collection issues arise in cases of foreign-to-foreign transfers of PRC resident enterprises which the beginning of the circular seeks to address. For example, the circular requires the foreign transferor to file in China to satisfy its Capital Gains Tax and sets out specific calculation methods and other related rules. It should also be noted that publicly listed PRC resident enterprises fall outside the scope of Circular 698.
However, Article 5 of Circular 698 then takes an amazing leap. It states that foreign entities are required to disclose all indirect transfers of PRC resident enterprises to the PRC tax authorities in cases where an intermediate holding company through which such transfers are made are located in a low tax jurisdiction or such jurisdiction exempts income tax on foreign-sourced income. In this case, the foreign enterprise making the indirect transfer must disclose the following documentation to the PRC tax authority in the location of the PRC resident enterprise within 30 days of executing the transfer contract:
- Equity transfer agreement/contract;
- Representations regarding the relationship between the foreign entity and holding company being transferred in terms of "capital, operation, sales and purchase etc.";
- Representation regarding the operation, employees, bookkeeping, and assets of the holding company being transferred by the ultimate foreign entity;
- Representations regarding the relationship between the holding company being transferred by the ultimate foreign entity and the PRC resident enterprise, in terms of "capital, operation, sales and purchases;"
- Representations regarding the reasonable business purpose with respect to the transfer of the holding company; and
- Other materials requested by the tax authority.
While the term "indirect transfer" is not defined, Article 5 suggests that the relevant PRC tax authorities have jurisdiction regarding requests for information over a wide range of foreign entities having no direct contact with China. The drafting could be read to apply to all global M&A activity occurring outside of China provided the transferor indirectly holds some assets in China, no matter how small.
For example, assume Company A is an Italian private company engaging in a global automotive business covering manufacturing, parts, and distribution. Company A owns 100% of three Italian subsidiaries called Company B, C, and D, which each engage in three different lines of the automotive businesses. As a large multinational, the Company B subsidiary, which engages in the distribution business, has over twenty subsidiaries and joint ventures all over the world. Among them, Company B owns 100% of Company E, a Chinese entity which houses a small distribution outlet in Beijing representing 1% of the entire distribution business of Company B. Company A is approached by Company X to buy-out Company A's worldwide distribution business. The transaction will be structured in the most common way by having Company X purchase all of the Company B stock from Company A. Under Article 5, Company A may be required to submit documentation for this transaction, including the global M&A contract with Company X and all other supporting materials stipulated by Article 5, to the Beijing State Tax Bureau for review. This example assumes that Company B qualifies for domestic law relief regarding the foreign source income and is thus "low taxed." Other examples would include Company B established in ordinary tax haven jurisdictions suited for holding companies.
The above is a simplified example and there are more complex transactions which could be subject to Article 5. For example, Company B might own Company E through many levels of intermediary holding companies in different countries. In this case, Article 5 may still apply and disclosure would be required to explain the numerous levels of relationships. Article 5 may also apply outside of the multinational context. It could apply to a transfer of an interest in a fund holding foreign companies, which in turn hold indirect holdings in Chinese resident enterprises. All of these foreign entities could have an obligation to submit their M&A contracts and supporting information regarding relationships to PRC tax authorities for review. Indeed, the number and variety of transactions that Article 5 could apply to is infinite.
Not surprisingly, apart from the disclosure requirement above, Circular 698 goes on to empower local PRC tax authorities at the central government level, through submission to the SAT, to disregard intermediate holding companies, if they determine PRC tax is being avoided without a reasonable business purpose. Thus, the Capital Gains Tax could be imposed on the foreign entity serving as the indirect transferor of PRC resident enterprises. The addition of review by the SAT to the last draft of Circular 698 was welcomed as potentially tempering this second consequence.
However, the broad disclosure requirements which remained intact from prior drafts are extremely troubling at multiple levels.
Is it Legal?
Many questions posed during the drafting process remain unanswered:
- Is there a legal basis under any validly promulgated PRC law or administrative regulation which imposes information reporting obligations and tax with respect to such indirect transferors? How does an interpretive circular like 698 derive its PRC legal authority?
- Does the PRC general anti-abuse rule ("GAAR") in the EIT grant virtually unlimited power to the PRC tax authorities concerning transactions, including matters of extraterritorial jurisdiction? How does one sentence in a quasi-civil law statute encapsulate an entire doctrine?
- Is there a colorable theory under international legal principles to assert extraterritorial jurisdiction over the numerous parties potentially described in Circular 698?
- Will the enormous administrative complexities and burdens created by the disclosure mean erratic compliance and result in grossly unfair application of the rule? Can most foreign entities comply?
- Will local PRC tax bureaus be staffed with the resources, training, and other administrative infrastructure to deal with those disclosure actually submitted?
*The title refers to the Vodafone Essar case currently pending in the Indian court system regarding similarly controversial extraterritorial tax concepts.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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