Chinese venture capital tax and offshore substance requirement developments
China has implemented venture capital (VC) tax rules at the same time economic substance requirements for key offshore centres have been introduced. KPMG’s Michael Wong, Christopher Mak and Alan O’Connor highlight the key considerations for businesses.
Since late 2018, there have been a number of changes in the tax rules relating to venture capital (VC) funds. Most recently on January 10 2019, China's Ministry of Finance, State Administration of Taxation, National Development and Reform Commission, and the China Securities and Regulatory Commission jointly released a notice on individual income tax (IIT) policies for natural person partners in VC partnerships (hereinafter referred to as Circular 8). The notice clarifies the implementation on the IIT policy for properly registered VC partnerships.
Two methods to tax VC partnerships
VC partnerships can now choose from the following two calculation methods for a natural person partners' income.
The first method calculates tax on the basis on the individual investment funds of the VC partnership. Under this, the income derived from equity transfer and dividend income is attributed through the VC partnership to its natural person partners, and they shall be subject to tax at the 20% IIT rate.
The second method calculates tax based on the annual taxable income of the whole VC partnership. A natural person partner's portion of income from the partnership shall be subject to a progressive IIT rate of between 5% and 35%. This falls under the IIT business income category.
Further Circular 8 changes
There are also a number of other salient points to note in the new Circular 8. Non-exhaustively, they include:
Circular 8 is applicable for natural person partners of VC partnerships that comply with record filing requirements;
Regardless of the chosen calculation method, qualified VC partnerships can continue to enjoy certain related tax benefits; and
Once a VC enterprise determines a calculation method, the option cannot be changed within a three-year period.
Prior to the release of Circular 8, for the purposes of taxing investment income, VC funds in the form of partnerships were considered as "tax transparent entities", and the partnerships themselves were not obligated to pay income tax. However, when natural person partners derived dividend income, or equity transfer income through a VC partnership, uncertainty existed in determining the nature of such income.
The enactment of Circular 8 is considered a major breakthrough in partnership tax regulations because it clarifies for the first time that VC partnerships can be treated as an "investment conduit". It clarifies that the tax character of the income derived from investment projects, through the VC partnership, can be preserved at the level of natural person partners. For instance, a natural person partner's income that is derived through a VC partnership can be taxed at 20% under the categories of dividend income and equity transfer income. Alternatively, a natural person partner can choose the second option of applying IIT at progressive business income rates from 5% to 35%.
Circular 8 provides preliminary guidance for the tax treatment of natural person partners in VC partnerships. However, for other types of private fund partnerships, as well as VC fund scenarios not covered in Circular 8, further clarifications may still be needed in the future from the tax authorities.
New economic substance requirements for key offshore centres
In recent years, the EU has taken action through its Code of Conduct Group to identify non-cooperative jurisdictions based on three criteria: tax transparency, fair taxation and compliance with the OECD's BEPS requirements. A number of offshore jurisdictions made commitments to reform their economic substance requirements by the end of 2018 to bring them in line with the EU's 'fair taxation' principles, and to ultimately avoid their inclusion in the EU's list of non-cooperative jurisdictions (EU blacklist). It states:
"A jurisdiction should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction."
Late last year, a number of offshore jurisdictions, including the British Virgin Islands (BVI), the Cayman Islands, Bermuda, Guernsey, Jersey, and Isle of Man enacted legislation requiring local entities conducting specified activities in these countries to have adequate economic substance.
While each jurisdiction has independently drafted and enacted their own economic substance legislation, the requirements are broadly equivalent across each of the offshore jurisdictions. The substance requirements took effect from January 1 2019, with a six-month grace period given to existing entities in order to meet the requirements.
The rules require both local and foreign registered companies and limited partnerships (LPs) which conduct 'relevant activities' in an offshore jurisdiction, and are not a tax resident in another jurisdiction, to comply with the economic substance requirements for such activity in the offshore jurisdiction.
Relevant activities for the purposes of this legislation covers the following nine businesses:
Distribution and service centres;
Finance and leasing;
Intellectual property holding businesses; and
The economic substance that needs to be established and maintained in respect to the relevant activity include:
The entity is to be managed and directed in the offshore jurisdiction;
Core income generating activities are undertaken in the offshore jurisdiction with respect to the relevant activity;
The entity maintains adequate physical presence in the offshore jurisdiction;
There are adequate full-time employees in the offshore jurisdiction with suitable qualifications; and
There is adequate operating expenditure incurred in the offshore jurisdiction in relation to the relevant activity.
Offshore economic substance exceptions
There are certain exceptions to these general economic substance requirements for holding companies, which will only be required to meet a reduced test for economic substance, and intellectual property (IP) companies, which will face more onerous requirements.
Entities will have reporting obligations in relation to their compliance with economic substance requirements to local tax authorities. Penalties can also be imposed for both a failure to provide required information, and for operating a legal entity in breach of the economic substance requirements, which includes fines, imprisonment, and/or strike-off.
Enterprises and individuals that utilise offshore entities for their existing investment and/or operating structures should take action to understand the substance requirements applicable for the offshore jurisdiction(s) in which they operate, and to determine what steps may need to be taken in order to comply with these measures. At the same time, more changes are likely to be in the pipeline.
We expect the economic substance requirements introduced through these legislative provisions to evolve over the coming months. In particular, we expect that offshore jurisdictions will look to issue guidance on the application of their respective substance laws.
For example, in February 2019, the Cayman Islands issued guidelines on its law, and it is understood that there may be further updates to this guidance that can provide greater clarity. For example, further clarity at a practical level is needed around:
The number of substance requirements regarding the income derived from the relevant activity carried out in the Caymans;
The necessary amount of operating expenditure that must be incurred in the Caymans;
What is considered a sufficient physical presence (including maintaining a place of business or plant, property and equipment) in the Caymans;
The number of full-time employees or other personnel with appropriate qualifications needed in the Caymans; and
Whether outsourcing of "core income generating activities" within the jurisdiction is permitted and can count towards satisfying the substance requirements, provided that the entity can monitor and control carrying out the activity by any delegate.
The EU will also be active in monitoring the legislation enacted by the various offshore jurisdictions to determine whether their new substance measures meet the EU's 'fair taxation' principles.
If the EU concludes that the legislation does not meet these principles, offshore jurisdictions risk being included in the EU blacklist. Evidence of this can be seen from the revised version of the EU blacklist released on March 12 2019.
EU's updated blacklist
The countries included in the latest EU blacklist increased from five to 15, with four of those countries added due to insufficient local economic substance requirements. These include Bermuda, the Marshall Islands, the United Arab Emirates, and Vanuatu.
The EU has also retained three jurisdictions (Bahamas, the BVI, and Caymans) on its grey list, specifically in relation to economic substance concerns in the area of collective investment funds. The EU has granted additional time until the end of 2019 to these countries to address these concerns.
Given the potential adverse consequences for countries being on such a list – including higher withholding taxes (WHT), denial of tax deductions, controlled foreign company (CFC) attribution – amendments to the legislation and guidance notes cannot be ruled out.
These changes are a response to recently established EU economic substance requirements, and a parallel new global OECD standard on substantial activities requirements for no-tax or nominal tax jurisdictions.
Reviewing this new global standard will be a key part of the OECD's Forum on Harmful Tax Practices (FHTP) work plan for 2019.
Chinese enterprises and individuals investing overseas, as well as foreign businesses with operations in China, should assess on an ongoing basis the use of such jurisdictions in their structures.
This article was written by Michael Wong, Christopher Mak and Alan O'Connor of KPMG.
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 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.
Tel: +86 10 8508 7521
Alan O'Connor joined KPMG Hong Kong from Australia in 2000 and became a director in 2013. He worked in Hong Kong for more than 10 years before relocating to Beijing in 2011 where he continues to provide tax services to Chinese outbound investors.
Alan has extensive experience providing due diligence and transaction related tax advisory services to major Hong Kong and Chinese based clients, and has been involved in international tax planning projects, merger and acquisition transactions and due diligence exercises involving Asia, Europe and North America.
Tel: +86 10 8508 7085
Michael Wong is a partner and the national head of deal advisory, M&A tax for KPMG China. He is based in Beijing and also leads the national outbound tax practice serving state-owned and privately owned China companies in relation to their outbound investments.
Michael has extensive experience leading global teams to assist Chinese state-owned and privately owned companies conduct large-scale overseas M&A transactions in various sectors including energy and power, mining, financial services, manufacturing, infrastructure and real estate.