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A new era for M&A tax in China

The 2015 enhancements to China’s restructuring tax relief rules, the challenging new indirect offshore disposal rules in SAT Announcement 7, developments in financial instrument tax classification and the revamped tax treaty relief procedures are the focus of this chapter by John Gu, Paul Ma, Josephine Jiang, Chris Mak and Yvette Chan

Over the last few years, M&A tax rules had not seen significant development in China. The previous most significant M&A tax developments were the release of Special Restructuring rules under Circular 59 and Circular 698 governing indirect transfers of PRC equity interest back in 2009. However, since 2014, the Ministry of Finance (MOF) and State Administration of Taxation (SAT) have been going to great lengths to put new regulations into effect for the better management and facilitation of M&A. These new measures broadly fit into three categories:

  • the extension of the scope of M&A transactions that qualify for tax free or tax deferral treatments;

  • the transition of tax administrative procedures from a pre-approval to a self-assessment and reporting approach; and

  • enhanced anti-avoidance rules.

The acceleration of the development of M&A tax rules is a direct result of the central government's determination to use M&A as an effective way to revitalise the economy, optimise the industrial structure and help absorb the excess capacity in the manufacturing sector.

These new measures came with good timing and are generally welcomed by the taxpayers. In the latest M&A statistical information available, in the first half of 2015, outbound M&A volumes surged 67% (to $55 billion) compared with to the first half of 2014, while inbound M&A was up 14% (to $19.5 billion) over the same period. These regulatory changes mean that Chinese M&A tax rules, while still at a developmental stage compared with equivalent rules in the US or Europe, are increasingly capable of facilitating more complex transactional arrangements and allow for more tax efficient structures to be put in place.

Restructuring reliefs

In the course of 2014 and 2015 a number of key improvements to the Chinese tax restructuring reliefs were made, both lowering the thresholds for enjoying the Special Tax Treatment (STT), which results in tax deferral treatment for corporate restructurings, and introducing new ways in which STT can be accessed.

It is worth having a brief recap of SAT Circular 59 [2009), the principal tax regulation on restructuring relief, which sets out in what circumstances companies undergoing restructuring can elect for STT. Absent the application of STT, the general tax treatment (GTT) requires recognition of gains/losses. The STT conditions include a 'purpose test' akin to the PRC general anti-avoidance rule (GAAR) (that is, the transaction must be conducted for reasonable commercial purposes and not for tax purposes) and a 'continuing business test' (that is, there is no change to the original operating activities within a prescribed period after the restructuring) as well as two threshold tests directed at ensuring the continuity of ownership and the continued integrity of the business, following the restructuring. The first threshold test is that consideration must comprise 85% of equity. The second threshold test was that 75% of the equity or assets of Target must be acquired by the transferee.

Though the purpose of Circular 59 was to provide favorable tax treatments in restructuring transactions, STT had not been widely used due to the high thresholds. SAT Circular 109 [2014] lowers the 75% asset/equity acquisition threshold to 50%. This facilitates the conduct of many more takeovers/restructurings in a tax neutral manner. In addition to the ratio relief, Circular 109 introduced a new situation for STT which removes both the 75% ownership and the 85% equity consideration test. The new situation permits elective non-recognition of income on transfer of assets/equity between two Chinese tax resident enterprises (TREs) which are in a '100% holding relationship' provided no accounting gains/losses are recognised. Both the purposes test and the continuing business test from Circular 59 hold, and the tax basis of transferred assets for future disposal is their original tax basis. The supplementary SAT Announcement 40 [2015] spells out in detail the situations to which the relief applies.

Given that China does not, in contrast to many other countries, possess a comprehensive set of group relief or tax consolidation rules, the institution of this intra-group transfer relief is a real breakthrough in Chinese tax law. However, the relief notably does not cover transfers of Chinese assets by non-TREs (whether between two non-TREs or between a non-TRE and a TRE). Taxpayers would also need to be aware of the emphasis being placed by tax authorities on the purposes test, particularly in light of the fact that the intra-group transfer relief opens the door to tax loss planning strategies that previously were not possible under Chinese tax law.

The tax deferral treatment of non-cash contribution

A third novel provision, introduced under SAT Circular 116 [2014], allows for deferral of tax on gains deemed to arise on a contribution of assets by a Chinese TRE into another TRE in return for equity in the latter. The taxable gain can be recognised over a period up to five years so allowing for payment of tax in instalments. This relief, potentially also extending to the contribution of assets by minority investors into a TRE, sits alongside and complements the intra-100% group transfer relief outlined above, which SAT Circular 33 [2015] confirms may be elected for in preference to the Circular 116 relief, where applicable.

Aside from lowering the STT thresholds and providing for new means to access STT, SAT Announcement 48 [2015] also abolishes the tax authority pre-approvals previously needed for STT to be applied, moving instead to more detailed STT filing at the time of the annual CIT filing. The transition from tax authority pre-approval to taxpayer self-determination on the applicability of STT is in line with the broader shift in Chinese tax administration away from pre-approvals, as discussed in the chapter in this volume, New Challenges to Tax Risk Management in China. As noted in that chapter, the abolition of pre-approvals, while it potentially expedites transactions, also places a greater burden on a taxpayer's risk management procedures and systems, to ensure that treatments adopted are justified and adequately supported with documentation.

It might be noted that these enhancements to the tax rules for M&A and restructuring transactions occur against a backdrop of a significant improvement in the Chinese regulatory framework within which such transactions take place. Limitations on foreign investment into the various Chinese economic sectors have been steadily reduced under successive 'Catalogues Guiding Foreign Investment'. A shift to a more streamlined 'Negative List' system (setting out a limited number of sectors off-limits to foreigners), on the model of the free trade zones (FTZ) anticipated in the not too distant future. MOFCOM Decree No. 8 [2012] had already eased the use, by foreign investors, of equity in foreign-invested enterprises (FIEs) as M&A transaction consideration in place of cash, facilitating transactions and the set-up of onshore holding entities; SAFE [State Administration of Foreign Exchange] Circular 19 [2015] more recently abolished SAFE Circular 142 [2015] to allow FIEs to convert F/X capital to Rmb at their discretion, so further facilitating use by foreign investors of onshore acquisition vehicles. Given the degree to which the enhanced STT and tax restructuring treatments rely on all parties to the transaction being Chinese TREs, the regulatory changes facilitate the greater use of the enhanced tax treatments.

New offshore indirect disposal rules with reorganisation exemption

In a further highly significant 2015 tax change impacting China M&A and restructuring transactions, China's existing indirect offshore disposal reporting and taxation rules were completely revamped, with SAT Announcement 7 [2015] supplanting the earlier Circular 698 [2009]. The rules seek to ensure that the China tax imposition cannot be avoided through the interposition of an offshore intermediary holding entity, which holds the Chinese assets. Compared with Circular 698, Announcement 7 expanded the scope of the transactions covered, enhanced the enforcement mechanism, and provided more certainty with the introduction of the safe harbour and the "black list":

  • A much broader range of 'Chinese taxable property' is potentially subject to indirect transfer case assessment. Whereas Circular 698 solely caught transfers of offshore holding companies that ultimately own China assets such as shares, Announcement 7 now also scopes in those holding Chinese real estate, and assets belonging to Chinese permanent establishments of foreign companies. The types of offshore transaction which can trigger the rules are also expanded from simple offshore equity transfers to also cover transfer of partnership interests/convertible bonds, as well as restructurings/share dilutions.

  • A withholding tax (WHT) mechanism is introduced, coupled with a new approach to reporting transactions. Whereas Circular 698 made the seller responsible for reporting transactions and for paying any additional tax which the tax authorities regarded to be due, Announcement 7 requires the buyer to apply 10% WHT to the purported transfer gain. The WHT agent faces stringent penalties for failure to pay tax within the allotted timeframe, though can mitigate penalties, by making a timely reporting of the transaction. It might be noted that the seller is still on the hook for tax not withheld by the buyer.

  • Extensive new guidance on whether a transaction lacks 'reasonable business purposes' and thus should be subject to tax under the PRC GAAR, as well as provision of safe harbour rules. This includes a "7 factors test" which holistically considers:

  • whether the offshore company's principal value or source of income is derived from China;

  • the functionality, duration of existence and "substitutability" of the offshore holding company; and

  • the overseas taxation position of the offshore transfer, including the application of double tax treaties.

A parallel "automatic deeming" test applies to treat a transaction to be without reasonable business purpose if, amongst others reasons, more than 75% of the value and 90% of the income or assets of the offshore holding company are derived from China. Safe harbours apply to:

  • foreign enterprises buying and selling securities on the public market;

  • where a tax treaty would apply to cover a transaction re-characterised as a direct disposal; and

  • for an intra-group reorganisation undertaken within a corporate group which meets the group ownership tests.

In practice, Announcement 7 is challenging in application due to the difficulties with aligning buyer and seller positions in an M&A transaction. In the absence of referrable precedents it is difficult to know whether a transaction would be considered to lack reasonable business purposes and therefore whether it is at risk of being subject to tax. Given the stiff penalties which could apply, particularly to buyers as WHT agents, and given the potentially mitigation of penalties through timely voluntary reporting, there is great potential for disputes between transacting parties over whether transactions should be reported at all and whether, and how much, tax needs to be paid or withheld. In practice, escrow and indemnity arrangements have historically been used, although we are seeing buyers increasingly require sellers to timely settle the tax or report the transaction to the tax authorities as a condition for the closing of the deal.

Since its issuance, Announcement 7 has since been supplemented by SAT Circular 68 [2015] which provides implementation guidance. Taxpayer reporting will be given a formal receipt (so giving assurance in relation to the penalty mitigation measures), single reporting for transferred Chinese assets in multiple tax districts is provided for, and GAAR procedures (including SAT review and appeal procedures) are embedded in Announcement 7. This being said, there is still a need for a clarified refunds process, confirmation on applicability of safe harbours, and timeframes on GAAR investigation conclusion.

Hybrid instruments

Financial instruments with both debt and equity features including preference shares, convertible bonds, debt with attached warrants, mandatory convertible notes, contingent payment debt, participating loans or perpetual debt are commonly used in M&A transactions. In China, however, company law as well as financial sector regulation has long limited the variety of debt and equity instruments which can be created, and the rules for distinguishing debt and equity have commensurately been underdeveloped. However, this is now changing, with Chinese enterprises now permitted to issue preferred shares and perpetual debts. It is also common in China for debt investments to be structured as equity investments in practice. The SAT is consequently moving to fill the gap on debt-equity classification guidance.

SAT Announcement 41 [2013] provides that an instrument must possess all of the following features to be considered as debt financing:

  • The company has the obligation to pay interest (or equivalent payment) periodically at the rate stipulated under the investment contract;

  • There is a definite investment term or specific investment condition, and the company has the obligation to redeem the investment or repay the principal;

  • The investing company has no ownership interest in the net assets of the company;

  • The investing company has no right to vote or to be elected to governing bodies of the company; and

  • The investing company does not participate in the ordinary operating activities of the company.

If any one of these features is missing, then the instrument will be treated as an equity financing and payments on the instrument will not be tax deductible as interest.

In a recent private ruling, the SAT recharacterised a structured equity investment by an insurance company with a fixed and guaranteed return as debt investment. As such, the income received by the investor will be taxable as interest rather than a non-taxable dividend. These developments show that the SAT is increasingly focused on the use of hybrid instruments and will take a substance over form approach in asserting tax treatments on hybrid instruments.

Treaty relief

The chapter in this volume, China at the forefront of global BEPS implementation, provides a detailed overview of the new China double tax agreement (DTA) relief system being rolled out from November 1 2015 in SAT Announcement 60 [2015]. Depending on how this is implemented in practice this could allow for more efficient access to DTA relief and might aid the conduct of M&A and restructuring transactions. The new DTA relief system abolishes the tax authority pre-approval system for DTA relief, providing instead that the taxpayer self-determines whether DTA relief applies. The taxpayer then informs the WHT agent (or the tax authority directly where no WHT agent is involved) that it will be using the DTA relief supplying a detailed form and extensive supporting documentation. The WHT agent is obliged to review the form and observe that the taxpayer makes assertions corresponding to the DTA relief criteria, and is expected to review that the supporting documentation does not directly contradict the taxpayer's assertions on the form, after which the WHT agent may use the lower DTA WHT rates. Documentation is passed on to the tax authorities who are to apply enhanced follow-up procedures to review claims, and launch GAAR challenges where appropriate.

It remains to be seen in practice how the tax authorities deal with the administrative complexities arising from the new system, including the interaction of the new rules with the existing system of tax recordals and the interrelationship of the new system with the foreign exchange remittance rules. It also remains to be seen how local tax authorities interpret the due diligence obligations of the WHT agent, and how the WHT refunds system works in practice.

Reforms help transactions

The surge of investment flows in and out of China, and the ramp-up in the number of M&A and restructuring transactions has called for more responsive tax rules, and MOF and SAT have been moving to meet those calls with more responsive, better tailored rules. The new measures recognise that corporate restructuring transactions play an important role in optimising industrial structure and enhancing business competitiveness, and seek to facilitate them through lowered thresholds for merger and share swap relief, an intra-group transfer relief and a capital contribution relief, as well as potentially better treaty relief rules. At the same time, tax avoidance is being safeguarded against by coming anti-hybrid mismatch rules and enhanced indirect offshore disposal rules, which are at the same time also sensitive, in the latter case, to the needs of business restructuring. The changes mean that Chinese M&A tax rules, while still at a developmental stage compared to equivalent rules in the US or Europe, are increasingly capable of facilitating more complex transactional arrangements, and allow for more tax efficient structures to be put in place.

The authors would like to thank Conrad Turley for his contribution to this chapter.



John Gu

Partner, Tax

KPMG China

8th Floor, Tower E2, Oriental Plaza

Beijing 100738, China

Tel: +86 10 8508 7095

John Gu is a partner and head of deal advisory, M&A tax and private equity for KPMG China. He is based in Beijing and leads the national tax practice serving private equity clients. John focuses on regulatory and tax structuring of inbound M&A transactions and foreign direct investments in the PRC. He has assisted many offshore fund and Rmb fund formations in the PRC and has advised on tax issues concerning a wide range of inbound M&A transactions in the PRC in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.



Paul Ma

Partner, Tax

KPMG China

8th Floor, Tower E2, Oriental Plaza

Beijing 100738, China

Tel: +86 10 8508 7076

Paul Ma is a China tax partner and experienced M&A adviser, based in the KPMG Beijing office. He has extensive experience in advising on regulatory and tax issues relating to cross-border investments, repatriation, financing, exits and post-deal integration. He has been involved in a large number of high profile transactions covering a wide range of industries including financial services, technology, media and telecommunications (TMT), energy, real estate and consumer markets. He is also an expert in onshore and offshore private equity fund structuring.

Paul previously worked at Morgan Stanley as an in-house tax counsel for the private equity and real estate funds. He also worked in New York as a US tax specialist. He has a master of accounting degree from the University of North Carolina at Chapel Hill, an MA in economics from Kent State University and a bachelor's degree in economics from Nankai University. He is a member of the American Institute of Certified Public Accountants.



Josephine Jiang

Partner, Tax

KPMG China

8th Floor, Tower E2, Oriental Plaza

Beijing 100738, China

Tel: +8610 8508 7511

Josephine Jiang is a Beijing based tax partner. She has been practising tax for more than 15 years.

Josephine has an extensive background in Chinese domestic and international tax. She has served many large multinational companies, state-owned enterprises (SOEs), venture capital companies and private equity firms. She has significant experience in dealing with various tax issues including global tax minimisation, tax efficient financing, tax risk management, and domestic tax issues such as pre-IPO restructuring. She has worked extensively on M&A including due diligence, designing and implementing complex takeover transactions and reorganisations.

From 2008 to 2009, Josephine spent one year practising international tax in the New York office of another big fours firm, with a focus on China inbound investment by US multinationals.

Josephine also participated in the effort in providing commentary to China tax authority on their recent international tax and M&A related regulations.



Christopher Mak

Partner, Tax

KPMG China

50th Floor, Plaza 66

1266 Nanjing West Road

Shanghai 200040, China

Tel: +86 21 2212 3409

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 proposed business activities in Australia and China. Since joining the Shanghai office, he has been heavily involved in assisting foreign companies on PRC tax issues arising from their investment into China including proposed global restructuring, company set-ups, tax due diligence, foreign exchange remittance issues and M&A transactions.



Yvette Chan

Principal, Tax

KPMG China

8th Floor, Prince's Building

10 Chater Road, Central, Hong Kong

Tel: +852 2847 5108

Yvette has assisted a number of clients undertake investments in the PRC with regard to transaction structuring and devising tax efficient strategies for implementing PRC business operations and arrangements.

Yvette has also advised on a number of tax structuring, tax due diligence, tax modelling review, M&A, corporate restructuring, pre-IPO restructuring, leasing, and tax compliance projects in the PRC and specialises in the tax structuring of investment funds, M&A and financial transactions.

Yvette services clients in a wide range of industries including private equity, investment fund, real estate, infrastructure (including toll roads, water treatment, electric power, and gas distribution), consumer and industrial markets (including chemical products), and financial services.

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