China: taxing offshore transactions

Practical Law UK Articles 5-505-6503 (Approx. 13 pages)

China: taxing offshore transactions

by Julie Zhang and Kevin Wang, Mayer Brown JSM

Background

Although China's previous tax law for foreign-invested enterprises and foreign enterprises imposed a 10% withholding tax on capital gains derived by foreign enterprises from the transfer of equity interests in their Chinese subsidiaries, few foreign enterprises actually paid withholding tax on capital gains derived from China before 2008. A common tax planning strategy was to use an offshore holding company to invest in China, and then to exit from China by transferring the ownership of the offshore holding company without paying any Chinese withholding taxes.

Without an offshore holding company, a foreign investor that directly invested in a Chinese company could still find ways to avoid paying Chinese withholding tax on capital gains. For example, this could be achieved by using a jurisdiction (such as Mauritius and Barbados) which had concluded a favourable tax treaty with China, under which China was prohibited from taxing capital gains derived by residents of the other jurisdiction. Chinese tax might also be avoided through a step transaction, whereby the investor initially transferred the Chinese subsidiary to a newly established offshore holding company, and then transferred the new offshore holding company to the buyer. Under Guo Shui Han Fa [1997] No. 207 (Circular 207), the first share transfer could be considered as a group restructuring and therefore could be conducted at cost, as the transferor and transferee were within the same group (in which one party directly or indirectly wholly owned the other party, or both parties were directly or indirectly wholly owned by a third entity). Although Circular 207 imposed a business purpose test for group restructurings, such a test was rarely applied to crack down on abuses. The second share transfer which was conducted offshore, was also not subject to Chinese tax.

These old practices were ended by two cases, the Chongqing Case and the Xinjiang Case. In these two cases, the Chinese tax authorities successfully challenged the conventional tax planning scheme and imposed withholding taxes on offshore share transfers.

Chongqing case: substance over form

In a news release on a tax case in late November 2008, in its crack down on an offshore share transfer by disregarding a special purpose vehicle (SPV) for tax purposes, the Chongqing State Tax Bureau set a precedent of considering economic substance over legal form.

The case involved a Singapore company (Singapore HoldCo) which owned a Singapore special purpose vehicle (SPV), which in turn held a 31.6% equity interest in the Chinese target company (Chinese Target JV). In 2008, the Singapore HoldCo sold the Singapore SPV to a Chinese buyer, and the Chongqing State Tax Bureau noted this case in its contract registration system.

Based on the legal form of the transaction, the target company being transferred was not a Chinese entity and therefore the capital gains from this transaction were not China source income. (The source of income from a share transfer is determined by the place of the underlying company whose shares are transferred.) China should not generally have the power to tax these capital gains.

The Chongqing tax authorities, however, found that the SPV had no real business operation other than holding 31.6% equity interest in the Chinese Target JV. In addition, the total capital of the SPV amounted to only S$100. (As at 1 March 2011, US$1 was about S$1.3.) Therefore, the Chongqing tax authorities held that the economic substance of this transaction was a transfer of an equity interest in the Chinese Target JV, and therefore constituted China-source income. That is, the Chongqing tax authorities disregarded the SPV for tax purposes, deemed the transaction as a transfer of the Target JV and imposed withholding tax on the capital gains accordingly.

Image 1 within China: taxing offshore transactions

Xinjiang case: anti-treaty shopping

In 2008, the Xinjiang tax authorities also refused to honour the provisions of the China-Barbados income tax treaty in relation to tax benefits and levied tax on a Barbados-based SPV.

The case involved the purchase and sale back of an equity interest in a joint venture company:

In 2006, the Barbados SPV, established by a US company, paid US$33.8 million and purchased 33.32% (diluted after the capital increase of the selling shareholder) of the equity interest of a Chinese company from one of the company's two shareholders and converted the Chinese company into a joint venture.
Within one month, the selling shareholder injected the equivalent of US$33.8 million in Chinese Yuan into the joint venture.
In June 2007, Barbados SPV sold its equity interest in the joint venture back to the original selling shareholder for US$45.968 million, deriving a gain of US$12.17 million.

Image 2 within China: taxing offshore transactions

As at 1 March 2011, EUR1 was about US$1.4.

These capital gains are generally protected by the China-Barbados income tax treaty and should not be taxed in China. Gains from the alienation of any property other than that referred to in paragraphs 1, 2 and 3 (that is, immovable property, moving property forming part of the business property of a permanent establishment, ships or aircraft) are only taxable in the contracting state of which the alienator is a resident (Article 13(4), China-Barbados tax treaty). In this case, however, the Xinjiang tax authorities denied the benefits to which the company was entitled under the China-Barbados income tax treaty and imposed tax on the SPV, alleging the seller had no substance in Barbados.

The challenge raised by the Xinjiang tax authorities was based on the following facts:

The Barbados SPV purchased the equity interest in the Chinese company only one month after its formation and paid the share purchase price through a Cayman Islands bank account.
The capital gains from the Barbados SPV's divestment of its equity interest in the Chinese joint venture was not based on the actual operations of the joint venture, but instead were based on a pre-agreed contractual arrangement.
The Barbados SPV did not provide a tax resident certificate issued by the proper authority. It only submitted documentation issued by the Chinese embassy in Barbados stating that it was a Barbados resident.
All three directors of the Barbados SPV were US citizens, and their residential addresses were in the US.

After an exchange of information with the Barbados authorities, the Chinese tax authorities concluded that the Barbados SPV did not qualify as a Barbados tax resident and therefore was not entitled to protection under the China-Barbados tax treaty. As a result, the Barbados SPV's income derived from the share transfer became subject to withholding income tax in China.

Both the purchase and the sales transactions took place before 2008, the year when China's new income tax law and the general anti-avoidance rule (GAAR) became effective. Therefore the GAAR technically did not apply to the case. However, the State Administration of Taxation (SAT) took the opportunity to issue a public notice, which commented on the details of the case and encouraged local tax authorities to learn from the experience of the Xinjiang tax authorities in combating tax-avoidance transactions.

Legislation: GAAR and Circular 698 reporting

There has been considerable debate over the legality of the Chongqing case and the Xinjiang case, mainly because these two cases were the first cases in which the Chinese tax authorities had applied the GAAR. The GARR was introduced in China's new Enterprise Income Tax Law in 2008.

Enterprise Income Tax Law and implementation rules

Article 47 of the Enterprise Income Tax Law empowers the tax authority to make a tax adjustment where a transaction has been entered into without a reasonable business purpose and has resulted in a reduction in taxable revenue or profit. Article 120 of the Implementing Regulations of the Enterprise Income Tax Law clarifies that "without a reasonable business purpose" means that "the main purpose of the transaction is to reduce, avoid or defer the payment of taxes".

However, the rules of the Enterprise Income Tax Law and its implementation regulations are general and vague. In the year after the new tax law took effect, there were no rules explaining the particulars of the term "business purpose" and no formalised procedures for tax authorities to follow when launching a GAAR investigation. This lack of guidance intensified the debate over the new rule and its applications. (Another debate concerns whether China's tax law should have extraterritorial effect. This debate is beyond the scope of this article.)

Implementation Measures on GAAR

The debate slowed to some extent when the SAT issued the Implementation Measures for Special Tax Adjustments (for Trial Implementation) (Circular 2) on 8 January 2009. Among other issues, Circular 2 addresses the preconditions and procedures for launching GAAR investigations.

The types of avoidance arrangements that GAAR investigations should target include (Article 92, Circular 2):

Abuse of tax incentives.
Abuse of a tax treaty.
Abuse of corporate organisational forms.
Avoidance of tax through a tax haven.
Any other arrangement which lacks a reasonable business purpose.

The principle of "substance over form" should be followed and the following matters should be considered in GAAR cases (Article 93, Circular 2):

The form and substance of an arrangement.
The date of conclusion and the term of execution of an arrangement.
The means for realising an arrangement.
The connections between different steps or components of an arrangement.
The changes in the financial status of each party involved in an arrangement.
The tax results of an arrangement.

Circular 2 also stipulates the detailed procedures that the tax authority should follow in GAAR investigations. Specifically, local tax authorities must obtain SAT approvals to launch GAAR investigations and make adjustments.

Circular 2 empowers the tax authority, based on the economic substance doctrine, to re-characterise the nature of tax-avoidance transactions and deny taxpayers the right to obtain tax benefits derived from these transactions. Specifically, the tax authority can deny the existence of enterprises that lack economic substance, particularly enterprises that are established in tax havens and that resulted in tax avoidance by their associated or non-associated parties.

Circular 2 is fairly detailed in terms of the implementation of GAAR and provides substantive rules and procedures for investigations and adjustments under GAAR. With Circular 2 in place, the tax authorities have a legal basis to challenge the substance of offshore transactions once these transactions are detected. The question is how the tax authorities can discover more offshore transactions.

Circular 698

Traditionally, tax authorities relied on cross-border payment information and disclosures by listed companies to track offshore transactions so that they can determine which targets should undergo GAAR investigations. In late 2009, the SAT created a method to track offshore transactions more easily by issuing a circular requiring sellers to report offshore transactions under certain conditions.

The Notice on Strengthening the Administration of Enterprise Income Tax on Share Transfer Income of Non-resident Enterprises (Guo Shui Han [2009] No.698, Circular 698), issued on 10 December 2009, is retroactively effective from 1 January 2008. If a non-resident enterprise transfers an offshore holding company with underlying Chinese resident enterprises, and the jurisdiction of the offshore holding company has an effective tax rate lower than 12.5% (half of China's 25% income tax rate) or does not tax its residents on overseas income, the non-resident transferor must, within 30 days of the transfer, provide certain documents and information to the competent tax authority at the place(s) where the underlying Chinese resident enterprise is located (Circular 698). These documents and information must include:

The share purchase agreement.
The relationship between the transferor and the offshore holding company in relation to cash flow, operations, purchase and sales activities.
The business operations, personnel, financial accounts and properties of the offshore holding company.
The relationship between the offshore holding company and the Chinese target enterprise in relation to cash flow, operations, purchase and sales activities, and so on.
An explanation of the reasonable business purpose of the transferor setting up the offshore holding company.
Other documents required by the authorities.

The competent tax authority assesses the offshore transaction for Chinese tax purposes. If the transferor is found to be abusing the business structure (setting up holding companies without a business purpose) to indirectly transfer the Chinese underlying enterprise to avoid Chinese tax liabilities, the competent tax authority can, on approval of the SAT, re-characterise the transaction under the doctrine of substance over form. If the competent tax authority is successful in challenging the transaction, the existence of the offshore holding company can be disregarded and the offshore transfer is then treated as a transfer of the underlying target, which becomes taxable in China.

After Circular 698: high-profile transactions

After the issue of Circular 2 and Circular 698, local tax authorities began to actively scrutinise offshore transactions to boost their tax revenue. There are a number of well-known cases where China's tax authorities successfully challenged offshore transactions.

Jiangdu case

This case involved Carlyle (the Seller), the leading private equity house. Carlyle owned a subsidiary in Hong Kong (HoldCo), which in turn owned a 49% interest in a joint venture in Jiangdu (Yangzhou Chengde Steel Tube Co., Ltd), Jiangsu Province (as a result of a US$80 million private equity investment made in 2007). In January 2010, Carlyle exited the joint venture by transferring the HoldCo to the subsidiary of a US company (Precision Castparts Corp) (the Buyer) for US$350 million, and the substance of this transaction was later successfully challenged by the Chinese tax authorities.

Image 3 within China: taxing offshore transactions

The local tax authority in Jiangdu (Jiangdu Tax Authority) learned of Carlyle's intention to transfer its interest in the joint venture as early as the beginning of 2009. Afterwards, the Jiangdu Tax Authority formed a team of experts to track the potential transfer. At the beginning of 2010, the Jiangdu Tax Authority discovered that an indirect transfer had occurred outside China and requested information about the transaction from the Buyer and the Seller, including the share transfer agreement. The Jiangdu Tax Authority even visited the website of the Buyer's US parent company to find out more information about the transaction.

Based on the information it had gathered, the Jiangdu Tax Authority concluded that HoldCo had no employees, no assets, no liabilities, no other investments, and no business operations (which is probably typical of SPVs used in the private equity industry). Essentially, HoldCo had no economic substance. Accordingly, the Jiangdu Tax Authority asserted that the transfer of HoldCo was in substance a transfer of the China joint venture company and should be subject to Chinese withholding tax.

Carlyle argued that it should not be obliged to pay China any tax since the Buyer, the Seller and the immediate target company (that is, Holdco) were all located outside China. However, this argument was rejected by the Jiangdu Tax Authority. On approval of the SAT, the Jiangdu Tax Authority notified Carlyle to pay China withholding tax on the transfer. After multiple rounds of negotiation, Carlyle filed a tax return on 29 April 2010 and settled the payment of CNY173 million on 18 May 2010 (as at 1 March 2011, US$1 was about CNY6.6).

Source of information

In both the Chongqing case and the Xinjiang case, the buyers were Chinese enterprises, and cross-border payments were made. In the Xinjiang case, the last share transfer of the onshore China target company was required to be registered with the Chinese tax authority. Therefore, the tax authorities were able to discover the two transactions after they were completed.

In the Jiangdu case, however, there was no cross-border payment since the buyer was also a foreign company, and there was no need to register the offshore transfer in China. This would usually have meant the Chinese tax authorities would have difficulty discovering the transaction even after it had been completed. However, the tax authority had already been informed of the Seller's intention to exit one year before the transaction actually occurred. This demonstrates the extent to which the tax authorities have expanded their information network, and should cause parties to ponder whether carrying out each and every transaction offshore is sufficient to shield them from the scrutiny of the Chinese tax authorities.

Formalised administrative procedures

Officials from the SAT were involved in the Jiangdu case from the outset, and the local authorities obtained the SAT's approval before notifying the Seller to pay the tax. This administrative procedure complies with Circular 2, which requires the approval of the SAT before applying GAAR. This reflects the progress which has been made by local tax authorities in terms of their improved compliance with administrative procedures and closer co-operation with the national authorities.

Fuzhou case: piercing the corporate veil

In October 2009, the Fuzhou Tax Bureau disregarded the existence of an intermediary holding company and denied capital gains benefits to a Hong Kong company. The case involved a wealthy individual, Mr Cao Dewang, who was named Ernst & Young World Entrepreneur Of The Year in 2009, and ranked number 43 on the 2010 Forbes Global China Rich List.

Mr Cao was born in mainland China but is now a Hong Kong resident. He indirectly held 38.09% of the shares in a listed Chinese company, Fuyao Glass Industry Group Co., Limited, located in Fujian Province, through two wholly owned Hong Kong subsidiaries, Hongqiao Overseas and Sanyi Development, which respectively owned 15.6% and 22.49% of Fuyao's shares. The following diagram illustrates Fuyao's holding structure.

Image 4 within China: taxing offshore transactions

From October 2009, Mr Cao gradually disposed of shares of Fuyao held by Hongqiao Overseas and realised a gain of over CNY3 billion. However, no China tax was paid because the double tax arrangement between Hong Kong and mainland China (Double Tax Arrangement) allocates the right to tax capital gains to Hong Kong if a Hong Kong company holds less than 25% equity interest in its China subsidiary. The tax authority denied the existence of the intermediate holding company (established purely for tax avoidance purposes) and Mr Cao consequently settled a tax liability of CNY379 million with the competent tax authority in Fujian.

This case created considerable debate. According to a news report, the mainland tax authorities cited a clause in the Second Protocol between Mainland China and Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes (the Protocol), which revises the capital gain clause in the Double Tax Arrangement and empowers China to tax capital gains provided the "recipient of the gain" directly or indirectly holds no less than 25% equity interest in the target at any time during the 12 months before the transfer.

The focal point is the concept of "recipient of the gain", which is a literal English translation of the text in Chinese. The "recipient of the gain" should refer to the transferor (the party which receives the income) and the use of this wording was probably to avoid the complicated wording of "a resident of a contracting state" and "resident of the other contracting state". However, the mainland tax authorities treated Mr Cao as the "recipient of the gain" in this case. It appears that they have used the term "beneficial owner" to replace "recipient". That is, while Hongqiao Overseas was the recipient of the capital gains, Mr Cao was considered to be the beneficial owner, and the mainland authorities measured the equity interest in the Chinese company through Mr Cao's holding, rather than Hongqiao Overseas' holding. This is a deviation from the capital gains clause in the Protocol, which did not use the term "beneficial owner" in the context of capital gains, even though this term was used in the context of dividends, interest and royalties.

An explanation for the challenge by the Chinese tax authorities is that they applied the GAAR to the transaction. Article 25 of the Double Tax Arrangement allows the contracting states to apply anti-tax avoidance rules under their respective domestic laws. However, if the existence of Sanyi Development and Hongqiao Overseas are disregarded, the seller would become Mr Cao. Technically, GAAR should not be extended to individuals, as it is only a clause in the Enterprise Income Tax Law. Although Article 47 of the Enterprise Income Tax states that, if an enterprise implements a tax-avoidance transaction, the Chinese tax authority can make special adjustments, in the Fuzhou case, it is an individual who put in place the tax-avoidance arrangement.

Tianjin Case and Xuzhou Case: GAAR and Tax Treaty

The Tianjin case and Xuzhou case are similar to the Fuzhou case in that the tax authorities in both instances challenged the conventional way of using a favourable tax treaty to avoid capital gains tax.

In the Tianjin case, a US investor invested in a Chinese joint venture (the investment amounted to 40.48% equity interest) through a Mauritius company. The Mauritius company transferred the interest in the joint venture to a Bermuda company in 2008. After conducting an investigation, the Tianjin tax bureau in March 2010 concluded that the Mauritius company did not have business substance and treated the Mauritius company as a conduit company. The tax authorities held that the ultimate beneficiary of the capital gain was the US parent, and therefore China had the right to tax the gain (under the China-US tax treaty).

It was unnecessary for the Chinese tax authority to apply GAAR in this case. The capital gain clause of the China-Mauritius tax treaty was revised by a protocol signed in 2006 and became effective on 1 January 2008 in China. While the old tax treaty exempted capital gains tax, the new treaty empowers China to tax capital gains derived from China where a Mauritius transferor directly or indirectly holds at least 25% of the target during the 12-month period before the transfer.

In the Xuzhou case, the tax authority challenged the business substance of a Barbados company and denied the Barbados company an exemption under the China-Barbados tax treaty from Chinese tax on capital gains derived from exiting a joint venture in China. The Xuzhou case is different from the Fuzhou case because the China-Barbados tax treaty effective at the time of the transfer did not have the equivalent of Article 25 of the Double Tax Arrangement. That is, the China-Barbados tax treaty did not empower the Chinese tax authority to apply GAAR in the presence of a treaty, but the Chinese tax authority applied GAAR regardless.

The Fuzhou, Tianjin and Xuzhou cases seem to indicate that the Chinese tax authorities have become more aggressive in challenging treaty benefits, particularly in relation to conduit companies, which did not have real economic substance. Further, the Chinese tax authorities have applied GAAR to individuals as well as to companies in situations when the relevant treaty did not allow for the application of GAAR under domestic law.

Goldman Sachs: the pork case

On 18 August 2010, Goldman Sachs was reportedly challenged for an indirect transfer of equity in Henan Shuanghui Investment Development Co., Ltd. (Shuanghui), facing a potential tax liability of about CNY420 million.

Shuanghui is China's largest pig producer and pork processor. Goldman Sachs' investment in Shuanghui in 2006 caught considerable attention, raising concerns about China's economic security. There was considerable debate over whether the Ministry of Commerce should have approved this deal, given Shuanghui's leading status and brand name in the industry. Goldman Sachs eventually obtained approval from the Ministry of Commerce by involving a China-based private equity investor, CDH Investment, as a co-investor.

Initially, Goldman Sachs and CDH Investment bought out 100% of the equity of Shuanghui Group, the controlling shareholders of Shuanghui, as well as 25% equity interest in Shuanghui.

In the years following the investment, Goldman Sachs gradually disposed of its direct and indirect interest in Shuanghui by conducting a series of offshore restructuring and transferring the shares of intermediate holding companies. The intermediate holding companies were ShineB Holdings I Limited (ShineB) registered in the British Virgin Islands and Rotary Vortex Limited (Rotary Vortex) registered in Hong Kong. In 2006, Goldman Sachs indirectly held 31% of Shuanghui's shares while by the end of 2009, these holdings had dropped to only 3.3%.

The disposal of these shares, which was not disclosed until late 2009, created a storm of debate over whether Shuanghui and Goldman Sachs had breached China's securities law. The tax authorities then stepped in and demanded that Goldman Sachs pay taxes on the offshore transactions. Presently, this case is still pending, but it will be interesting to see how this case will ultimately be resolved.

New weapon: Chinese residency status of an offshore company

Besides relying on GAAR to target offshore companies that lack business substance, Chinese tax authorities are also using another powerful tool to tax foreign investors, namely the concept of tax resident enterprise (TRE) introduced under the new Enterprise Income Tax Law.

Under the new tax law, Chinese tax-resident enterprises include enterprises established in China in accordance with Chinese law as well as enterprises that are established in accordance with the laws of the relevant foreign jurisdiction but whose de facto management and control is exercised in China.

A common way to invest in Chinese companies is to invest in companies that are registered overseas but are controlled by Chinese individuals or entities. These overseas companies could be Hong Kong window companies of large state-owned enterprises (SOEs) or special purpose vehicles established by private entrepreneurs for the purpose of obtaining overseas financing and listing the companies overseas. Chinese tax authorities can treat such an overseas company as a Chinese tax resident if its de facto management and control is exercised in China. If that is the case, income from the transfer of such an overseas company is considered as Chinese-source income and therefore becomes subject to Chinese withholding tax. China used this concept of TRE in a recent case to tax a foreign investor on the transfer of an overseas company.

According to a news report published by China Tax News, a quasi-official newspaper of the SAT, a UK company disposed of its equity interest in a listed China-based company in 2010 and paid China tax of CNY2.196 billion on its capital gains. This amount is said to be the largest single sum of withholding tax collected in China from an equity transfer in 2010. Based on publicly available information, it is believed this case is Vodafone's sale of its shares of China Mobile Limited.

China Mobile Limited is a Hong Kong-registered company duly listed on the NYSE and the Hong Kong Stock Exchange (HKEx). Its major controlling shareholder is a large SOE, China Mobile Communications Corporation. Since its effective place of management is located in China, China Mobile Limited applied to the SAT and obtained a Deemed People's Republic of China (PRC) TRE status for China tax purposes in accordance with a Circular issued by the SAT: Guo Shui Fa [2009] No.822 (Circular 82).

According to public information, the key facts of the above case are as follows:

China Mobile Limited (China Mobile), a Hong Kong-registered company, was listed on the NYSE and HKEx on 22 and 23 October 1997 respectively.
On 4 October 2000, China Mobile and Vodafone entered into a strategic investor subscription agreement, whereby Vodafone Group Plc. acquired new shares of China Mobile for US$2.5 billion.
On 18 May 2002, Vodafone Holdings (Jersey) Limited purchased 236,634,212 ordinary (new) shares of China Mobile for HK$5.85 billion under a Subscription Agreement. (As at 1 March 2011, US$1 was about HK$7.8.)
On 18 September, 2010, Vodafone sold its entire 3.2% stake in China Mobile in a block trade arranged by several leading investment banks (which is reported to be Asia's biggest-ever block trade) for US$6.5 billion.

The following diagram illustrates the overall holding structure of China Mobile Limited before the block trade.

Image 5 within China: taxing offshore transactions

The capital gain derived by the two Vodafone entities was US$3.25 billion, which was consistent with the tax amount (CNY2.196 billion) reported by China Tax News.

There are a number of interesting factors in this case:

This case may be the first published case whereby China tax was imposed on the disposal of a Deemed PRC TRE by a foreign investor.
This case may be the first published case where China tax was imposed on the sale of a minority interest (less than 25%) in a company listed on an overseas stock exchange (the purchase and sale of the company's shares took place after China Mobile had been listed). China has not begun to collect tax on foreign investors' trading of B shares (shares dominated in foreign currency) listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Under a qualified foreign institution investor (QFII) regime introduced in 2002, foreign investors can also trade A shares (shares dominated in RMB) listed on the Shanghai Stock Exchange and the Shenzhen Stock Exchange. China has not yet started to collect income tax on QFII's income from trading of A shares (except for the case of Lehman Brothers' liquidation of its QFII assets), though the SAT is expected to clarify the tax policy for QFIIs in the near future.
Vodafone was unfortunately unable to enjoy any tax exemption under a treaty. Jersey does not have a tax treaty with China. The China-UK tax treaty is a very old version (signed in 1984), which does not contain a clause that prohibits the source country from imposing withholding tax on capital gains derived from an investment in a minority interest (less than 25% equity interest), although most of China's newer tax treaties do contain such a clause. The China-UK tax treaty is under re-negotiation, and such a clause may be added.

This case is potentially significant to foreign investors as a number of SOE-controlled foreign-registered companies listed on the Hong Kong Exchange have indicated in their public disclosures that they have applied for and obtained the deemed Chinese TRE status from the SAT. Presumably, the China tax authorities would not have taxed Vodafone if it had used a vehicle located in a jurisdiction whose tax treaty with China has an exemption for a disposal of a minority interest (less than 25% equity interest), subject to any applicable GAAR. However, investors should carefully monitor any new developments in this area and consider their tax position before investing in an overseas company that could potentially be treated as a deemed tax resident of China.

The taxing choice of China?

In its annual work guide (Key Points of National Tax Work) issued to local tax authorities in 2008 and 2009, the SAT repeatedly urged local authorities to strengthen their administration of taxes levied on non-resident enterprises. In addition, in 2011, the SAT required local tax authorities to conduct special investigations into capital transactions (transfers involving listed and non-listed shares) and non-resident enterprises in the financial sector.

Equipped with SAT's mandate and a general set of rules on combating avoidance of taxes, China's tax authorities are confidently extending their reach to non-resident enterprises and are particularly targeting big-ticket transactions. For example, withholding tax revenues on capital gains increased in 2010 by 198.44% over 2009.

Given this new legislative and administrative landscape, conventional offshore transactions are faced with more and more challenges, and it is no longer an easy job to achieve a tax-free exit from China. Dealmakers should adjust their expectations and pay more attention to tax matters when structuring and executing China-related transactions. Particular attention should be paid to the establishment of business substance for offshore holding structures in order to withstand potential challenges by China tax authorities.

Contributor details

Julie Zhang

Mayer Brown JSM

Image 6 within China: taxing offshore transactions

T +86 10 6599 9299
F +86 10 6598 9266
E [email protected]
W www.mayerbrown.com

Qualified. California, 2003; New York, 2000

Areas of practice. Tax; M&A; private equity.

Recent transactions

Advising a leading Asia real estate fund in buying an office in Beijing, including deal structuring, analysing impact of tax factors on pricing, and negotiating Circular 698 filing for an offshore transaction.
Advising several global investment funds in structuring and forming RMB funds targeting investments in China.
Representing China Resources Cement Holdings Limited in acquiring a 50% interest in a cement business in Guangzhou and Hong Kong from Yue Xiu Enterprises (Holdings) Limited.

Kevin Wang

Mayer Brown JSM

Image 7 within China: taxing offshore transactions

T +86 10 6599 9321
F +86 10 6598 9266
E [email protected]
W www.mayerbrown.com

Qualified. China

Areas of practice. Tax; private equity.

Recent transactions

Advising a leading Asia real estate fund in buying an office in Beijing, including deal structuring, analysing impact of tax factors on pricing, and negotiating Circular 698 filing for an offshore transaction.
Advising several global investment funds in structuring and forming RMB funds targeting investments in China.
Representing China Resources Cement Holdings Limited in acquiring a 50% interest in a cement business in Guangzhou and Hong Kong from Yue Xiu Enterprises (Holdings) Limited.

China: taxing offshore transactions | Practical Law