Not-so-old wine, in a not-so-new bottle – perennial tax challenges for M&A
John Gu, Chris Mak and Fiona He explore the key tax issues and considerations of China inbound M&A deals, especially in the education and real estate sectors, including practical challenges for cross-border transactions in these hot sectors, and how an investor can best get prepared.
As the Chinese tax authorities continue to clarify the tax treatment of cross-border merger and acquisition (M&A) transactions, close monitoring of tax policies and appropriate tax planning are crucial.
In recent years, there has been a considerable increase in China M&A market activity. According to the Ministry of Commerce, foreign direct investment (FDI) into mainland China for the first three quarters of 2018 has risen by 6.4%, relative to the same period last year, to $98 billion. This may be partly because of a series of measures introduced by the Chinese government to open up China, such as revising the negative lists for foreign investment. Activity was particularly notable in hot sectors such as education, real estate, and high-tech related sectors in 2018, and is set to continue to soar for the rest of the year. However, the introduction of stricter policies on outbound investment and the tightening of capital remittance controls continues to affect outbound M&A from China, as discussed further in the chapter, Tax opportunities and challenges for China in the BRI era.
In terms of sectoral developments, the following is notable:
While the growth rate of real estate M&A transactions in China has slowed down in the past few years, it has certainly revived in the period 2017 to 2018. This was due to a variety of reasons including tightening of credit controls, new business transformation, and the fact that a number of private equity (PE) funds entered their exit phase and disposed of assets. In addition, from a financing perspective, many property developers are turning to offshore mezzanine loans as the Chinese government tightens credit controls.
Investment in education has played a substantial role in driving China's domestic economic transformation. Public and private market demand for education services has led investment in the education sector to become a noted trend, and we have seen remarkable growth in M&A and financing activities in this sector. However, with increased regulatory scrutiny and investment rule changes, investing in China's lucrative education industry is challenging for foreign investors, who may face restrictions, depending on the education subsector in question.
Turning to the tax issues of most interest and concern:
The Chinese government has introduced various investment incentives in order to attract foreign investment into China. One of these incentives includes Caishui  102 (Circular 102) in 2018, which provides foreign investors with a withholding tax (WHT) deferral incentive for profit reinvestments in China. Foreign investors, especially multinational companies intending to make further investment in China, have shown much interest in the incentive.
From a transaction structure perspective, we have continued to see an increase in the number of foreign investors exiting their investments via direct transfers of China wholly-foreign owned enterprises (WFOEs) to other Chinese entities or onshore funds. While this eliminates Announcement 7 indirect transfer issues (which are further discussed below), this could potentially result in the foreign seller having a lower tax cost base and, consequently, a higher capital gain tax liability on the sale.
For those M&A transactions undertaken by way of offshore indirect transfer of Chinese assets (i.e. disposal of an offshore company which holds Chinese assets), Announcement 7 continues to be a contentious topic. This is mainly due to the uncertainty in the calculation of the tax cost base, which is still determined in an inconsistent manner across tax districts in China. In some instances, the local Chinese tax bureaus may allow the full offshore acquisition cost, originally paid by the disposer, to be deducted in determining the disposal tax on the capital gain. However, in other cases, only the China WFOE's registered capital (which is typically lower) can be deducted.
In this article, we will discuss typical tax due diligence (TDD) issues, including the challenges and opportunities in the real estate and education sectors, with a particular focus on the challenges with offshore indirect transfers. We will also discuss the Circular 102 WHT deferral incentive and share practical insights on securing it with the local tax authorities.
Typical TDD issues in the real estate and education sectors
Typical TDD issues in the real estate sector
Over the past two years, we have seen a rebound in M&A activity in the real estate sector. Domestic and foreign investors who are keen to partake in the explosive growth of this hot sector should give due consideration to the following tax issues when conducting a TDD:
Lack of tax invoices to support the property's tax cost base: It is not uncommon with old or poorly managed properties, in particular, that the original tax invoices and payment receipts pertaining to the purchase or construction of the real estate assets are not properly kept, or have been lost. In this case, there is a potential risk that, for Chinese corporate income tax (CIT), land appreciation tax (LAT) and value-added tax (VAT) purposes, the buyer may not be able to deduct the tax cost base of the property upon future disposal, resulting in additional tax exposures for the seller. In addition, the continuing depreciation allowances on the land and property could also be challenged where tax invoices are not available. Therefore, a sample vouching of tax invoices in respect of the property costs is typically performed as part of the TDD procedures, to check whether the tax cost base of the real estate asset costs can be supported.
The State Administration of Taxation (SAT) has, in 2018, provided further guidance on the supporting documents that are required for CIT deduction purposes. SAT Announcement  28 clarified that external documents such as payment vouchers, obtained from other enterprises or individuals, including invoices and tax payment receipts, are the most crucial for supporting CIT deductions. The worst that could happen, if the China tax authorities were to disallow the cost of the property due to a lack of valid support, would be that any future transfer of the property could be subject to additional CIT and LAT. The potential additional CIT and LAT exposure would be the consequently non-deductible cost of the property, multiplied by the CIT rate of 25% and the top LAT rate of 60%, respectively. In any event, as the TDD vouching test is normally only done on a sample basis (for practical reasons), for prudence, the buyer should request a tax indemnity from the seller. This should cover the potential tax exposures from any loss in tax cost base due to the acquisition/development cost of the property not being supported by valid tax invoices and other valid tax supporting documents.
Calculation of real estate tax (RET): Owners of properties located in China are subject to RET using the following calculation methods:
The discounted original cost method is designed for self-use, vacant and/or unleased areas. RET is charged based on 1.2% of the property's adjusted historical cost; or
The rental method is used for leased areas. RET is charged based on 12% of rental income received.
Technically speaking, rental property owners who derive rental income from their properties should adopt the rental method for RET calculation and filing purposes. However, as the RET liability is generally lower using the discounted original cost method (particularly for older properties, which may have a very low historical cost), in practice, many rental property owners seek to adopt the discounted original cost method for RET calculation and filing purposes. This is typically achieved through case-by-case negotiation and agreement with the local tax authorities, unless it is blocked by specific local regulations requiring the use of the rental method for rental properties (e.g. in Beijing). Therefore, when performing TDD, buyers should check the RET calculation method and assess whether there are any potential RET exposures as a result of the adoption of a different RET calculation method in the historical period.
Permanent establishment (PE) risk in China: Another common tax risk area particularly relevant for grandfathered structures (i.e. where the Chinese property is directly held by a foreign entity) is that the offshore real estate holding entities could be regarded as having a taxable agency PE in China. This could be due to the way the Chinese property is being managed and operated, for example, due to the appointment of a property manager in China with broadly defined authority to act and contract. Where the offshore real estate holding company has a PE in China, it could be subject to a 25% CIT on its actual profits, or on deemed profits calculated by applying a deemed profit rate to the gross rental income.
What was formerly seen as a technical risk has become a real risk in practice in recent years. We have seen tax authorities, such as those in Beijing and Shanghai, increasingly presenting PE challenges to such grandfathered structures. They have gone ahead and imposed tax in several cases, particularly where the foreign holding company is located in a jurisdiction which does not have a double tax treaty with China and thus could not obtain treaty PE protection. In these cases, the Chinese tax authorities have generally applied a deemed profit rate of 40% to 50%; with the application of the 25% CIT rate which results in an effective CIT rate of 10% to 12.5% of gross rental income.
It is noted that there could be an even more substantial tax impact on investment exit, when the foreign holding company which is deemed to have a PE in China is subject to disposal under an offshore indirect transfer. This is because instead of applying a 10% WHT rate on any gain derived from the offshore indirect transfer of the China properties, there is a risk that the Chinese tax authorities could impose CIT at a rate of 25%, imposed on an actual or assessment basis. This risk arises because Announcement 7 includes a provision calling for 25% PE taxation where indirectly disposed of assets are attributable to an existing Chinese PE.
While we have not yet seen such cases in enforcement practice, in view of the potential tax risk during the holding period and upon future offshore disposal, it is crucial for buyers to analyse and assess the Chinese PE position of the offshore real estate holding companies during the TDD. They should also carefully review how their Chinese assets are structured and managed going forward. In any event, given this is an area that is increasingly being scrutinised by the Chinese tax authorities, a buyer should obtain appropriate tax indemnities to cover any potential CIT, penalties and surcharge exposures that may arise from a potential successful challenge by the Chinese tax authorities.
Typical TDD issues in the education sector
Since 2014, the education sector has been a hot topic in both the capital and M&A markets. Although financing activities of the companies in the education sector have been decreasing since 2016/2017, the China education sector, especially K-12 education, international education, on-line education and early education, still presents huge opportunities for investors and international operators. The typical tax issues in China education sector include:
Tuition fees on diploma education, and qualified education fees received by kindergartens, can avail of specific exemptions from VAT. However, some of the schools or education institutions may have been claiming VAT exemption for non-qualified income (such as after-school class income);
Some education institutions may pay salaries or service fees to tutors in cash or via the founder's personal bank account, without properly withholding any individual income tax (IIT). The institution could be held liable for the underpaid IIT if the tax authority cannot locate the tutor and this may also lead to penalties being imposed on the education institution; and
Some tutorial education institutions which run overseas education programmes (such as overseas summer camps) may use their overseas entity (e.g. Hong Kong entity) to receive overseas school commission income and service fees and at the same time use their Chinese entity to receive fees from their Chinese clients (e.g. parents of Chinese children attending the overseas programmes). For the education institutions with the above structure, it is common practice that a limited number of employees or even no employees are actually working overseas but most of the revenue was recognised in the overseas entity to reduce the tax cost at group level. Consequently, the Chinese tax authorities may challenge recognition of this income in the overseas company; they may re-attribute the income to the Chinese entity based on the general anti-abuse rule (GAAR) which would lead to potential CIT exposures.
The government has also been making efforts to attract private sector capital to develop non-compulsory education. The new Law on Promotion of Non-Government Education, and its implementation rules for 'non-profit' schools and 'for-profit' schools, which came into effect on September 1 2017, present challenges and opportunities for investors and operators. Schools that do not teach compulsory education in China can be registered as for-profit schools, and given flexibility on their operating, dividend, and tuition fee policies. Before the issuance of the new law, foreign investors in existing schools could only repatriate profits through royalty fees and/or service fee arrangements, which are under stricter control in the education sector. Some foreign investors are considering changing their existing schools from non-profit to for-profit schools, which are eligible to distribute dividends.
In August 2018, the proposed amendments to the implementation rules on the Law on Promotion of Non-government Education were released. The key amendments include:
Non-profit schools cannot be acquired or controlled through M&A, franchise chain and/or variable interest entity (VIE) arrangements; and
State-run schools are not allowed to run for-profit private schools. State-run schools are allowed to run non-profit private schools but are not allowed to receive management fees and royalties from non-profit schools for use of the state-run schools' brand names.
Investors looking at targets in the education sector should consider the challenges of the target's business model under the new regulatory environment and the potential costs of changing their business model, post-deal.
WHT deferral regime for dividend reinvestment in China
With a view to encouraging overseas investors to expand their investment in China, the Ministry of Finance (MOF), SAT, National Development and Reform Commission (NDRC), and Ministry of Commerce (MOFCOM) on December 28 2017 jointly released Caishui  88 (Circular 88). Circular 88 states that profits derived by a foreign investor from resident companies in China may be entitled to a tax deferral incentive. Under this, dividend payments will temporarily not trigger WHT obligations, provided that they are reinvested in encouraged projects and where other conditions are met. On September 29 2018, Circular 88 was replaced with Circular 102, which expanded the incentive to reinvestment in all sectors (not just encouraged sectors), except for those included in the negative lists for foreign investment.
In order to qualify for the tax deferral concession, foreign investors must use distributed profits from China resident companies for new China equity investment in the form of capital increase, capital injection or share acquisition in enterprises engaged in projects which are not included in the negative lists for foreign investment. Profit reinvestment must be transferred directly to the bank account of the invested enterprise or equity transferor rather than by transferring via a third party.
This tax deferral measure is designed to incentivise multinational enterprises (MNEs) to retain their earnings in China for further investment. Under the rules, foreign investors can provide documentation supporting their satisfaction of the Circular 102 conditions, and the profit-distributing enterprise should automatically provide the relief. If the profit-distributing enterprise is of the view that the foreign investor meets those conditions after reviewing the relevant documentation, the profit-distributing enterprise can complete the recordal filing procedures with the relevant tax authority and tentatively defer withholding the relevant WHT. The relevant tax authorities will conduct follow-up administration in respect of the incentive.
In practice, given how the new regulation is written, it is unclear how it should be implemented. Some of the uncertainties include how the WHT would be clawed back from future disposals. In practice, local tax authorities may have different interpretations of the rules regarding the tax deferral benefit. Therefore, in order to enjoy the tax deferral, it is important for enterprises to proactively communicate with their relevant tax authority, as well as with other authorities such as the State Administration of Foreign Exchange (SAFE), MOFCOM and the banks.
Offshore indirect transfers of Chinese taxable assets
Lastly, as noted in the introduction, the calculation of the tax cost base for offshore indirect transfers of Chinese assets remains an area of uncertainty. We have seen cases where local tax bureaus (for example, in Beijing, Wuhan and Guangzhou) do not allow a step up in the tax cost base if no China tax has been paid on the previous transaction (i.e. on the acquisition of the offshore indirect investment structure by the disposer). Specifically, they would tax the gain on an offshore indirect transfer of Chinese assets based on the sales proceeds less the paid-up capital of the Chinese WFOE, instead of using as base cost the acquisition price paid for the previous offshore indirect acquisition of the Chinese WFOE, which is generally higher. This lower tax cost base would be applied even if there were valid reason(s) to not pay tax in a previous transaction, for example, even if the Chinese tax authorities had agreed that the previous transaction could be considered to have had reasonable business purposes and was therefore not taxable.
Based on our informal discussions with SAT officials, it appears that they are also of the view that if the previous transaction has not been taxed, the acquisition price of the previous transaction should be disregarded as the tax cost base. Consequently, only the Chinese WFOE's paid-up capital could be deducted in calculating the taxable gain. This would result in a higher tax liability for the offshore seller.
In view of the above, sellers would generally report to the Chinese tax authorities if there was a high risk that the offshore indirect transfer would be taxable under Announcement 7. However, there are instances where sellers may not have reported the offshore indirect transfers of Chinese assets for Announcement 7 purposes. In some of these cases, the Chinese tax authorities have been alert to these transactions through reporting in the media. For example, the Shenzhen tax bureau was alerted through media reports to an offshore indirect disposal of a Chinese WFOE (located in the Longgang district) to an offshore buyer. As the transaction was not reported by the seller, the Shenzhen tax bureau gathered information on the Chinese WFOE and imposed 10% Chinese WHT of RMB 322 million ($46.2 million) on the Chinese WFOE.
It is therefore becoming even more important for the buyer to ensure the seller reports and pays tax under Announcement 7. Otherwise, the buyer should reserve the right to report the offshore acquisition to the Chinese tax authorities and obtain a tax indemnity against any potential WHT liability from the vendor's failure to pay the WHT liability arising from the offshore transaction.
Going forward, in light of the Chinese government's revised foreign investment policy and recent regulatory reforms, we are optimistic and expect a further increase in inbound M&A activity.
In the course of such transactions, careful TDD and tax planning will play a key role. With the changing global tax landscape, it will be increasingly important for companies to understand the target's business models and the potential tax costs that may arise post acquisition and on integration of the target's business.
While the Chinese government is stepping up its tax measures to attract foreign investment into China, clarifications and guidance from the Chinese tax authorities are still needed to deal with uncertainties in respect of the interpretation of rules. In particular, further clarifications are much needed in respect of the implementation of Circular 102 and the calculation of the tax cost base for offshore indirect transfers.
The authors would like to thank Elaine Chong and Stella Zhang for their contributions to this chapter
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John Gu is a partner focusing on M&A tax and private equity. He is based in Beijing. John focuses on regulatory and tax structuring of inbound M&A transactions and foreign direct investments in China. He has assisted many offshore fund and RMB fund formations in China and has advised on tax issues concerning a wide range of inbound M&A transactions in China in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.
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Christopher Mak has more than 15 years experience in advising multinational clients across a wide range of sectors such as the consumer, industrial and manufacturing, real estate, technology, media and telecommunications (TMT) industries in relation to appropriate corporate holding and funding structures to conduct their business activities in Australia and China. Since joining the Shanghai office, he has been heavily involved in assisting foreign companies on China tax issues arising from their investment into China including global restructuring, company set-ups, tax due diligence, foreign exchange remittance issues and M&A transactions.
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Fiona He joined KPMG's Guangzhou office in 2004 and became a tax partner in 2016.
Fiona has extensive experience in assisting multinational and Chinese clients on their domestic and cross-border M&A activities, including deal structuring, tax due diligence, tax efficiency planning, corporate restructuring, tax-related forex management and other M&A-related tax advisory services.
Fiona received her Master of Commerce degree in professional accounting. She is an FCPA of CPA Australia, and a member of Hong Kong Institute of Certified Tax Agents.