In the past year, global M&A activities have experienced reasonable growth and it is expected that the volume of these activities will continue to grow into 2017. As many M&A transactions are completed in China and the number of outbound M&A transactions undertaken by Chinese enterprises continue to increase at a fast pace, the importance of tax throughout the M&A process should be taken seriously. This is true, in particular, at the early stage to ensure that contentious tax issues are identified as much as possible and resolved as soon as possible before closing. Practically, the identification of contentious tax issues is not a simple task during a tax due diligence (TDD) review. In particular, the Chinese tax rules and the application of these rules by the local tax authorities are often inconsistent between different locations in China. In this article, we will discuss the practicalities of tackling tax-related uncertainties during an M&A transaction in China and how these uncertainties and identified tax issues can be overcome and resolved through an adequate level of planning and the use of appropriate solutions.
For any multinational enterprise (MNE), institutional investor, private equity fund, etc. (collectively referred to as "investors" throughout this article) undertaking M&A transactions, thorough tax planning before making the right investment is often the key to maximising returns through steady income streams (e.g. dividends), or capital gains upon divestment. As most investors would probably agree, planning at the pre-M&A transaction stage is often a challenge.
The art of scoping the TDD review
For investors involved in an M&A transaction in China, the process of going through the entire transaction, especially the due diligence and subsequent transaction agreement negotiations, is often challenging. Due diligence, which mainly includes legal, commercial, financial, tax, human resources, and where applicable, technical due diligence, is an essential and paramount procedure of every M&A transaction in China. The due diligence findings can often influence the decision of the investors to buy, or not to buy, into the investment. Such findings also dictate what protections should be sought and included in the relevant transaction sales and purchase agreement (SPA).
The investors wish to confirm that the target or target group of companies (the target) are fully tax compliant. If the target is not tax compliant, the investors at least wish to confirm that the exposures are manageable, that they have identified all material contentious tax issues through a TDD, and that the issues can be addressed. However, in practice, given the more challenging economy nowadays, investors, particular Chinese investors, are facing increasing budget and time constraints to perform TDD. This can result in the scope of work of the TDD review by M&A tax advisers being tailored to be more limited. This may increase the risk of contentious tax issues at the target level because they have not been properly identified and quantified.
Bearing in mind the tight budget and time constraints faced by the investors, it is important to work with M&A tax advisers, who have the relevant industry experience to assist the investors to identify the key potential tax risk areas in the specific relevant industry of the target. This can help the investors to tailor the right scope of work to focus the TDD review on the industry specific contentious tax issues and key tax risk areas. This allows the M&A tax advisers to perform the TDD work within the investors' budget and time constraints.
In terms of best practice, having an appropriately scoped TDD review should be viewed as advantageous because the identified tax exposures can potentially be used as a very powerful negotiation tool with the vendors, as further discussed below.
Contentious tax issues commonly identified during a TDD review
Contentious tax issues in M&A transactions in China are very common. These could arise for various reasons. Some are a result of target company management intent, while some are simply due to their negligence. This may include the target's responsible tax personnel lacking understanding of the tax rules and compliance requirements to be aware of any tax related issues, or lacking the resources and knowledge to deal with any contentious tax issues. It may also result from the target tax personnel lacking timely communications with the business personnel of their overseas travel or business expansions to adequately deal with any potential overseas tax risks. Some typical examples of contentious tax issues in China that are often observed in practice include:
- Transfer pricing (TP) risk on local and cross-border related party transactions due to the lack of a proper TP policy, benchmarking study, and TP documentation;
- Permanent establishment (PE) risk outside China, or in China for the non-Chinese targets with business operations in China created through the physical provision of services by the target's personnel over a certain period, having a fixed place of business, or the negotiation and conclusion of a contract overseas/in China;
- Non-compliance with tax requirements, such as not registering, filing or paying taxes on time. Another example is not reporting gains arising from an internal restructuring (such as under the Chinese Announcement 7 (2015) on issues relating to corporate income tax on gains from the indirect transfer of assets by non-resident enterprises, which is discussed later in this article) to the local tax authority. This may be due to the lack of adequate understanding of the tax rules or an inability to keep up with the constant changes in tax rules; and/or
- Tax deduction risks as a result of the necessary evidentiary document, such as an invoice, payment records and an agreement, not being properly maintained.
The above examples can generally be detected through a documentation review or a management interview during a TDD review. The resolution is generally not difficult, such as putting a set of proper TP policies in place, conducting internal trainings to raise tax compliance and PE awareness, and maintaining proper supporting documents for tax deductions/tax credits.
However, if the M&A tax advisers' TDD scope of work is greatly reduced, there is a risk that they may not be able to uncover those contentious tax issues that have been concealed by the target's management for the purpose of tax avoidance or minimisation during a TDD review. Some typical examples in China, in practice, include:
- Maintaining multiple sets of books prepared by the target, which show less profits for tax reporting purposes, but higher profits for management reporting purposes, resulting in no/minimal tax paid;
- Deliberately declaring a lower value on assets/goods imported into China to underpay the relevant import duties such as VAT, consumption tax and customs duties, etc.;
- Accessing tax incentives by fabricating supporting documents and false declarations of eligibility to the local tax authorities; and/or
- Establishing trading, service and/or intellectual property (IP) holding companies in tax haven/low tax jurisdictions to channel the target's profits without proper TP support that may have resulted in a very low effective tax rate for the target.
In the above situations, it would be even more important to ensure the TDD review is appropriately scoped and sufficiently detailed to be able to identify these contentious tax issues. Without performing a properly scoped and thorough TDD review (at least on the key tax risk areas), it would almost certainly be impossible to identify some of the above tax issues, particularly if management has an intention to hide the relevant evidence and misrepresent matters at the management interview.
Having considered the contentious tax issues identified, the next step is to seek a resolution for these issues.
Resolving the identified contentious tax issues
In practice, the resolution of the contentious tax issues identified during the TDD review is typically achieved through the drafting of the SPA. Investors can successfully use the results of the TDD review to request the vendors to:
- Reduce the purchase price;
- Provide a tax warranty and/or indemnity in the SPA;
- Modify the deal structure (i.e. from a share deal to an asset deal); and/or
- Suspend the deal until the contentious tax issues are reasonably resolved by the vendors.
The above actions are common remedial tools adopted by investors for M&A transactions in China, where the identified tax exposures and issues are within their tax tolerance level to proceed with the acquisition. However, an investor would need a level of protection from the vendors to insure against unwanted tax consequences that may unexpectedly occur in the future.
While an adjustment to the purchase price is ideal, this is only possible if the investors can accurately estimate the potential tax exposure. Furthermore, this is subject to the agreement of the vendors. However, in practice this can be difficult in China. This is particularly the case for those China-based vendors who often adopt the mind-set that a tax exposure/risk can only be recognised as such when only the local tax authority detects it. It may also be the case that there is a significant inconsistency between the tax rules and local practice on a certain tax exposure which the vendor might use as a reason to reject the tax exposure raised by the investors.
Therefore, it is more common in practice for investors to use a warranty and/or indemnity to insure against any identified or undetected potential tax exposures. The decision to use either a warranty or indemnity is contingent on the specific circumstances of the tax issues(s) and the tax position of the target.
Escrow – where money is held by a third-party on behalf of transacting parties – is also a common tool used in the marketplace by investors to resolve tax related issues with vendors. Under this, a portion of the consideration is held in a trust account until certain conditions are met, or the tax statute of limitation lapses. The funds held in escrow are used to compensate for any tax related damages or to settle tax liabilities in case the agreed tax related conditions or procedures are not met/dealt with, or where a tax liability arises as a result of settling a tax audit. In practice, escrow is commonly and effectively used for M&A transactions in China involving offshore indirect transfers of Chinese assets where Announcement 7 obligations are involved at pre-closing and Chinese tax liabilities may arise post-closing. This is further discussed in the next section.
Realistically, investors would not be able to gain a complete knowledge of the target's contentious tax issues during the limited timeframe of the TDD process. The level of difficulty would also substantially increase for foreign investors investing into China who are inexperienced with the local business and tax practice. Hence, it is important for all investors completing M&A transactions in China to sufficiently cover themselves with a warranty or indemnity and/or enter into escrow arrangement(s) with the vendors before committing to complete the acquisition.
In the worst case scenario, where the identified tax issues are so significant and the investors and vendors could not mutually agree to a resolution via the SPA, the investors can always terminate the deal. This can avoid any unwanted litigation with the vendors in the future and avoid incurrence of further time and other costs required to resolve the tax issues. While rare, tax-related deal breakers do exist in the Chinese marketplace.
Having identified the contentious tax issues and agreed to a resolution with the vendors, the investors may face more dilemmas at the pre-closing stage in terms of what to do next. At this stage, investors generally face a number of dilemmas including the following:
- The acquisition and holding structure to be used for acquiring the target group of companies in China. This should consider the impact on the future taxes throughout the investment lifecycle, from tax exposures on dividend, interest and/or royalty payments during the holding period, to capital gains upon exit. It should also be considered whether treaty benefits under an applicable double tax treaty with China would be available and how this would impact the tax assumptions in the financial model;
- Whether any tax incentives/attributes being obtained by the target would still be available post-acquisition as a result of a change of ownership of the target, and if so, how to ensure the tax incentives/attributes can be sustained;
- Where pre-closing restructuring will be undertaken by the vendor, whether any tax relief (say, in the form of a deferral of tax on the gain from the restructure under Caishui (2009) Notice 59) applied on the restructuring is sustainable at closing and post-acquisition, and if not, what measures or protections should be sought from the vendors; and
- How to sustain the investment cost base and minimise tax upon a future exit, including whether to model, and how to manage, any potential taxes arising on future indirect transfers of the underlying investments at an offshore level, such as Chinese tax under Announcement 7 for indirect transfers of Chinese taxable assets.
How to deal with Announcement 7 issues?
Another dilemma investors commonly face in deals involving the offshore indirect transfer of Chinese taxable assets is the fulfilment of obligations under Announcement 7.
While the vendor is the ultimate taxpayer, the investor (as the buyer) is obligated to withhold any Chinese tax arising from the indirect transfer of Chinese taxable assets. Failure to do so would result in the investor being hit with a penalty imposed by the Chinese tax authorities. Accordingly, the investor and vendor have to agree on whether the indirect transfer of Chinese taxable assets will be reported to the Chinese tax authorities, and if so, who will perform the reporting. In practice, conflict between the vendors and investors is not uncommon due to the vendors not willing to report, or not willing to allow the investors to report, the indirect transfer to the Chinese tax authorities. Such disagreement on reporting has in fact resulted in deal breakers in practice where the quantum of the potential Chinese tax exposure, as well as the potential penalty and interest under Announcement 7, is too significant for the investors to bear.
In practice, even if the vendors refuse to report the transaction to the Chinese tax authorities, they have generally agreed to provide an indemnity to the investors, which means that any tax arising under Announcement 7 is reasonably compensated by the vendors to the investors. Where the investors agree that the risk of tax being imposed under Announcement 7 is not high in their specific circumstances, they have often accepted such resolutions for the matter.
In certain cases, particularly where the risk of Chinese tax being imposed is high, the vendors may also agree to setting up an escrow account. An estimate of the Chinese tax will be held in the account until either the Chinese tax authorities confirm no tax is payable, or a number of years have lapsed (a period of three to five years is common in the marketplace).
However, due to the uncertainty as to how the Chinese tax should be calculated under Announcement 7, there are often disagreements between the investors and vendors on the amount to be withheld in the escrow account to cover the potential Chinese tax. For example, the vendors and investors may disagree on whether the consideration, for the purpose of calculating the indirect transfer gain under Announcement 7, should include the vendors' shareholder's loan. They may also disagree on whether any negative net asset value of overseas holding companies should be adjusted from the consideration. Furthermore, the vendors and investors may disagree on the investment cost base that should be used for calculating the Chinese tax. Given that the amount of Chinese tax payable will not be known until after closing, which is when the tax obligation technically arises, it is ultimately a commercial negotiation between the vendors and investors, and possibly their M&A tax advisers, as to the appropriate amount to be withheld and agreed in the SPA.
What protections should be sought in the SPA?
A noteworthy point to consider at pre-closing is for the investors' M&A tax advisers to review the tax clauses in the SPA to ensure the provisions are properly drafted to protect the investors on the identified and unidentified tax exposures. This is actually becoming an essential part of the contract drafting and execution process. A common practice is for the M&A tax advisers to negotiate with the vendors and/or their legal and tax representatives on the tax clauses on behalf of, and for the benefit of, the investors. The increasing need for a tax clause review is a direct result of the increasing complexity and severity of tax impositions related to M&A transactions. It is also a consequence of the unique characteristics of the Chinese tax environment, where M&A tax advisers' knowledge of local tax rules and practice can offer creative solutions to the issues faced. Ultimately, agreeing to the tax clauses in the SPA relies on intensive commercial negotiation between the vendors and investors, where the results are quite often driven by the bargaining power of either parties.
All in all, the contributions made by the M&A tax advisers in a SPA review can often lead to a beneficial outcome for the investors. This is by contractually shifting any identified/unidentified tax liabilities to the vendors, or at a minimum, by both vendors and investors mutually agreeing on how the contentious and unidentified tax issues can be satisfactorily resolved between both parties. This would at least allow the investors to decide whether to take the risk if no protection can be offered by the vendors under the SPA.
At the post-acquisition stage of the M&A transaction, the dilemmas do not necessarily end for the investors. Quite often, the investors may face risks that the projected values for the target will deviate from the actual values, due to a lack of tax-related awareness post-acquisition.
Is the holding structure sustainable?
After an acquisition, it could occur to the investors that the structure they used to invest into the Chinese target can no longer sustain any treaty benefits. This may be due to the constantly changing and inconsistent assessment practice of the tax authorities in various locations in China. As a result, the tax costs may increase substantially on the distributions flowing through the structure from China back to the investors. This situation is starting to become common in the Chinese marketplace. China is taking a more stringent approach in granting treaty benefits to overseas treaty claimants. At the same time, treaty claimant countries are also becoming more stringent in reviewing and granting tax resident certificates (TRCs) to treaty claimants so they are not regarded as tax haven countries. Without a TRC, the treaty claimants would no longer be able to access treaty benefits in China.
As an example, take investors using a Hong Kong holding company to invest into China. Completing and filing the relevant paperwork with, and responding to rounds of enquiries from, the Hong Kong Inland Revenue Department (IRD) is now a daunting process because the IRD has stepped up its efforts in making in-depth enquiries into the applicant's business status. It is now becoming more common to see the IRD reject the grant of, or prolonging the process for granting, TRCs to applicants where there are only limited business operations in Hong Kong. Hence, the use of Hong Kong as an investment platform for the dominant purpose of achieving treaty benefits, such as reduced withholding tax rates on dividends distributed from China to the Hong Kong holding company, should be reconsidered by investors. This renewed approach from the IRD has particularly impacted those investment structures where Hong Kong has historically been used as the holding jurisdiction for investments into China.
Should investments be made to improve the target's tax profile?
Another dilemma is whether the investors should further invest into the target for the purpose of improving its overall tax profile. This might be, for example, by resolving any previous tax non-compliance issues identified during the TDD review, implementing proper TP policies in light of the OECD Base Erosion and Profit Shifting (BEPS) Project related to tax changes, or improving for any tax inefficiencies of the target's existing operational and/or holding structure. However, the investors would need to consider whether such changes in tax policies/corrections for previous non-compliance practice could result in the Chinese tax authorities performing a tax audit/investigation on the historical open tax period. They would need to consider whether any tax liabilities arising from the historical period (pre-acquisition) could be indemnified by the vendors under the SPA.
Subject to reservations expressed above in relation to the risk of triggering tax audits, improving the tax profile of the target may bring benefits over the longer term. Improving the tax profile of the target not only maximises its after-tax returns, but having a cleaner tax record would also reduce the possibility that future investors might seek to leverage contentious tax issues as a bargaining tool. It may also, where applicable, increase the chance of passing a future initial public offering (IPO) audit. One benefit is that companies in China with excellent tax compliance records may be awarded a "Class A" taxpayer status by the in-charge tax authorities. This recognition not only adds to the tax credentials of the investment companies in China, which may be of benefit to the investors' future disposal plans, but also demonstrates to the general public that the current investors of the award-winning companies in China are managing their investments well.
As for the non-tax reasons, the investors investing more to improve the Chinese tax profile of the target allows the investors to demonstrate their commitment to the target. It shows that the investors are investing in the target's future to improve its after-tax earnings for the benefit of all the stakeholders, and may also enhance the business relationship between the investors and the target's management team.
Uncertainties in the international tax environment impacting on M&A transactions in China
In light of the constantly changing tax environment, it is worth singling out the BEPS Action Plan introduced by the OECD and consider its impact on M&A transactions in China.
BEPS has prompted many organisations' boards to take tax risks seriously as the BEPS changes could greatly impact an organisation's business model and investment structure.
With China taking a very active stance in localising BEPS into its tax rules, we foresee that the following areas of M&A transactions in China could seriously be impacted by BEPS in the future. This is in addition to the BEPS influence on TP, which clearly impacts the identification of TP risks during the TDD and the need to improve TP policies post-M&A. The risks include:
- Investment structuring and treaty shopping – with Chinese tax authorities increasing their efforts to combat tax avoidance and adopting BEPS measures, a low substance investment structure may be much less likely to achieve the treaty benefits on distributions through the structure from China to offshore. Consequently, this may impact the investors' returns; and
- The use of hybrid financial instruments (FIs), such as convertible bonds, which exhibit both the characteristics of a debt and equity, in financing an M&A transaction – such hybrid FIs may result in a mismatch in tax treatment by tax authorities in two different jurisdictions. This could arise where the FI-holder in one jurisdiction, say China, can obtain a tax deduction on the expense while the FI-issuer in another jurisdiction, say Hong Kong, is not taxed on that income. BEPS initiatives are seeking to negate the aforesaid tax advantage through the introduction of "co-ordination rules". Future changes in tax treatment for hybrid FIs would therefore impact how the financing of M&A transactions should be structured in China.
In view of what has been discussed throughout this article, investors will go a long way with their investments in or out of China if they can find a balance between having a properly scoped TDD review, seeking proper protections during the SPA negotiation process, and putting in place a tax efficient and sustainable operational, financing and investment structure that can legitimately maximise after-tax earnings and minimise tax leakage on divestment.
Also, from a non-tax perspective, understanding the Chinese business culture and local practice can often make a difference for the investors in meeting their investment objectives in China.
The authors would like to thank Winson Chan for his contribution to this chapter.
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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 China. 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 China in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.
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Yvette Chan has advised a variety of clients on regulatory and tax issues arising from merger and acquisition (M&A) transactions, including foreign direct investments in China and outbound investments by Chinese companies. She has also assisted clients with transaction structuring and devising tax efficient strategies for implementing 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-initial public offering (IPO) restructuring, leasing, and tax compliance projects in China. She specialises in the tax structuring of investment funds, M&A and financial transactions.
Yvette serves 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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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 China 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.
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