Over recent years, the Chinese regulatory authorities have introduced a suite of measures that, on the whole, have made it easier for foreigners to invest in China. Such measures include the loosening of regulations allowing for foreign investors to gain access to a wider range of industrial sectors that are permissible for foreign investment, quickening the vetting of cross-border M&A proposals, as well as the expansion of the Qualified Foreign Institutional Investor (QFII) investment quota in China's listed markets. As a result of these positive changes in the regulatory environment to make it more foreign investor-friendly, we have seen an increase in the number of inbound investments by foreign investors.
There have, of course, been certain setbacks in regulatory developments which apply to foreign investments in certain sectors, such as the national security review measures, which have increased regulatory scrutiny of inbound M&A transactions into China and the limitations imposed on the use of Variable Interest Entities, but the general trend has been to facilitate greater foreign investment.
In tandem with the growth in inbound M&A transactions, we also see a greater volume of corporate restructures taking place to facilitate or accommodate the foreign investors' tax or commercial requirements. However, the tax rules on corporate restructuring remain less flexible and in some circumstances impose unreasonable conditions for corporate restructures to obtain tax relief. This has created challenges and sometimes resulted in significant tax liabilities being crystallised for legitimate corporate restructure transactions in China, which is unhelpful to inbound M&A into the country.
Reasons for undertaking pre-acquisition or post-acquisition restructuring
Restructuring transactions may involve the incorporation of new subsidiaries or holding companies, the transfer of assets or companies from one group company to another, spinning off assets/splitting companies, the merger of several entities and the liquidation of legal entities.
Companies typically carry out internal group restructuring transactions before or after the investments by foreign investors, for a variety of commercial reasons, including:
- The foreign investor may only want to acquire a certain division(s)/part(s) of the group's China business (for example, if the group has various business divisions) or certain specific assets (for example, real estate properties) of the People's Republic of China (PRC) company. Or due to inherent historical tax liabilities, the foreign investors may just want to acquire the business assets and operations, but not the business entity. Hence, a spin-off or carve-out of the target business division(s) or asset(s) will be required to be carried out by the seller before the acquisition by the potential foreign investor to enable the potential foreign investor to acquire only the target business division(s) or asset(s).
- To introduce strategic investors into the business operations, it may be necessary for shareholders to create an onshore or offshore platform to allow co-investments by strategic investors (such as private equity funds).
- The existing shareholders and/or the potential foreign investor(s) may want to list the group offshore and eventually exit from their investments after the initial public offering (IPO). However, the group structure may (and in fact, is often) not be readily listable/suitable for listing; this could be the case if, for example, the group to be listed does not have a company that is incorporated in a jurisdiction which is acceptable to serve as the listing vehicle under the relevant listing rules, and/or the shareholders may only want to include certain specific business division(s) in the listing group while some other business division(s) (for example, those that may adversely affect the ability to market the securities or may not be capable of operating independently of its controlling shareholders) may need to be carved-out from the group to be listed. In view of this, it is often the case that certain internal group restructuring transactions will be required to bring the group to a suitable listing structure.
- For certain take-private transactions where companies are listed on US stock exchanges and which have operations in China, these would, typically be effected through some forms of corporate merger at the offshore level. Such corporate mergers could involve the direct or indirect transfer of the equity interest of the PRC companies.
- For strategic take-overs or partial acquisitions of PRC group companies by foreign multinational corporate buyers (for example, multinational business acquisitions), it may be necessary to undertake some form of group restructuring post-acquisition to integrate the two group's operations to achieve cost-savings, improvements in tax and cost efficiencies, and/or maximisation of enterprise value.
The Chinese regulatory rules generally do not restrict/ prohibit PRC companies from conducting internal group restructuring transactions, which could take different forms, such as equity transfers, asset transfers, corporate mergers (including mergers by absorption), or corporate splits/divisions/ spin-offs.
However, such corporate restructuring transactions generally are treated as taxable under PRC tax laws, unless the specific restructuring transaction qualifies for the so-called special tax treatment under the corporate restructuring rules provided for in the China corporate income tax (CIT) law (as discussed below), which would effectively allow any PRC tax liabilities otherwise triggered to be deferred. In some cases, the PRC tax liabilities arising from corporate restructuring could be significant, particularly if it involves the direct/indirect transfer of immovable properties in China, which have generally increased in value over the years.
To mitigate these corporate restructure tax costs, many Chinese companies have sought to obtain relief from special tax treatment under corporate restructure provisions of the CIT Law or to conduct their internal corporate restructuring transactions at cost so that no gain or loss would arise for both accounting and tax purposes. However, the corporate restructure tax rules are somewhat rigid and have been less helpful in providing tax relief to legitimate internal corporate restructuring transactions due to the stringent conditions required for tax deferral relief and the uncertainty surrounding how certain conditions are applied. This situation is exacerbated by the fact that the PRC tax authorities have began to apply transfer pricing adjustments aggressively to internal restructuring transactions. This has made tax costs the major hurdle for the implementation of corporate restructures and prompted calls for the need for a change to make the tax rules more business friendly.
Challenges to obtain corporate restructuring relief
While special tax relief, known as the special tax treatment provides for tax deferred treatment under circular Caishui  No 59 (Circular 59), this tax relief is difficult to obtain for certain corporate restructuring transactions because of these restrictions and issues:
- One of the conditions for tax relief on equity transfer requires the transferee to acquire at least 75% equity interest of the enterprise being transferred – this condition is unnecessarily restrictive as this will make most joint venture interest not eligible for corporate tax relief;
- Another condition for tax relief under Circular 59 is that the purchaser should pay no less than 85% of the total consideration in the form of equity. However, it may sometimes not be commercially feasible for the transferee enterprise to issues its or its subsidiaries' shares to the transferor enterprise as transfer consideration; this could perhaps be due to the commercial consideration that the transferor and transferee enterprises may want to exist as sister companies rather than create a direct shareholding relationship. An example of this would be where a certain business division/asset that needs to be carved out to a separate group and the transferor and transferee enterprises are operating in different business divisions;
- Where a merger takes place between two foreign holding companies, one of which holds a PRC tax resident company's equity interest, it is not clear whether this would qualify for a special tax treatment under Circular 59, as it does not fall squarely into the provisions under a domestic merger and the situations qualifying for special tax treatment referred to under cross-border restructure;
- For domestic corporate mergers, it appears that Circular 59 only provides relief for horizontal mergers but not for vertical mergers based on local interpretations;
- And Circular 59 imposes unduly rigid conditions for tax relief for cross-border group restructuring transactions – where the restructuring involves the transfer of PRC resident enterprises between two non-PRC tax resident enterprises, there is only one permissible type of transaction structure that can qualify for tax deferral relief; that is, the non-PRC tax resident transferor enterprise must transfer its equity interest in a PRC resident enterprise to another non-PRC tax resident transferee enterprise in which it holds a 100% direct interest; and there is no change in the withholding tax (WHT) position on the gains from the alienation of the equity interest in the PRC resident enterprise. In practice, we note that not many restructuring transactions can fall within this specific transaction structure to obtain tax relief; and
- Also in relation to an offshore equity restructure, there is no special relief available for Circular 698 reporting obligations in relation to a corporate restructure, which adds further uncertainty to corporate restructures. Although a draft circular has been prepared to provide for such a relief, it has yet to be issued in final form. Guoshuihan  No 698 (Circular 698), was issued by the SAT on December 10 2009 with retrospective effect from January 1 2008, to require offshore indirect equity transfers of PRC resident enterprises by foreign investors to be reported to the PRC tax authorities where the specified reporting condition is satisfied.
With all of this in mind, we have, in a general meeting with the SAT, asked whether it has any plans to relax the specified restructuring conditions or otherwise expand the types of restructuring transactions (particularly cross-border restructuring transaction) that can enjoy the special tax treatment. However, the SAT indicated that they do not have any plans to relax the rules. Hence, it is likely that the challenges will remain for the above corporate restructuring and no relief would be granted for those corporate restructuring transactions.
Reasonable commercial purposes
Even if the particular restructuring transaction prima facie satisfies all of the specified conditions for enjoying tax deferral relief under Circular 59, in practice, another challenge facing the transaction parties is to convince the PRC tax authorities that the corporate restructuring transaction has "reasonable business purposes" when negotiating with the relevant PRC tax authorities for the grant of the special tax treatment. In this regard, no special tax treatment would be granted by the PRC tax authorities for the corporate restructure transaction, if the transaction does not have reasonable commercial purposes or if the PRC tax authorities consider that the main purpose of carrying out the transaction is to achieve the reduction, elimination or deferral of tax. SAT Announcement  No 4 (Circular 4) seeks to clarify this by setting out these indicators, which, among others, will need to be demonstrated by the transaction parties when seeking the tax relief:
- Potential changes in tax positions of the restructuring parties; and
- Any abnormal economic benefits or potential obligations arising to any restructuring parties which would not have otherwise arisen under ordinary market conditions.
However, in practice, we note that the PRC tax authorities have generally taken a rather restrictive interpretation and have therefore often asserted that a restructuring transaction should not be regarded as having reasonable commercial purposes if the restructuring happens to lead to a reduction in the PRC dividend WHT rate (from the general WHT rate of 10% to the reduced tax treaty relief rate of 5%) after the corporate restructuring for ongoing dividends distributed by the PRC resident enterprise to its offshore shareholder(s). This would typically apply to corporate restructuring transactions where the PRC resident enterprise is transferred from a tax neutral jurisdiction (say, the Cayman Islands or British Virgin Islands) to an offshore holding company located in a jurisdiction which has a favourable tax treaty with China (for example, Hong Kong or Singapore).
In reaching this conclusion, many local tax authorities have simply taken the view that a group restructuring transaction that interposes a tax treaty holding company would be regarded as being primarily driven for the purposes of reducing future dividend WHT, and thus should be considered as lacking reasonable business purposes and cannot enjoy the special tax treatment provided under Circular 59. This appears to contradict the criteria imposed in Circular 59 that only a reduction in capital gains withholding tax would be relevant for denying the special tax relief on corporate restructuring.
It also appears that the PRC tax authorities pays no attention to the many non-tax reasons for carrying out a restructuring transaction, such as to reorganise the sub-group to be held by a regional headquarter (for example, in Hong Kong or Singapore) to better align the management reporting structure or to transfer a target group to a suitably held structure for offshore acquisition by the foreign investors. The reduction in dividend WHT could be considered incidental but should not be the "primary purpose" of the restructure.
In this respect, based on our recent meeting and discussion with the SAT on the issues and uncertainties arising from Circular 59, we understand the SAT is also of the view that the mere fact that the dividend WHT rate would be reduced after a corporate restructuring transaction should not by itself cause the transaction to be considered to be lacking "reasonable business purposes" and thus, should not result in the special tax treatment being denied for the corporate restructuring. That said, the SAT emphasised that in a situation where the PRC resident enterprise has a large amount of undistributed profits pre-restructuring, the restructuring parties would not be entitled to enjoy the special tax treatment unless the new offshore shareholder(s) provide a written representation/undertaking to the PRC tax authorities that they agree to forfeit its/their entitlement to enjoy tax treaty relief (that is, a reduction in dividend WHT) for the undistributed profits pre-restructuring. While this may not be the best solution, this at least provides a middle ground for companies to conduct group restructuring transactions without the need to crystallise built-in tax liabilities at that point that the corporate restructure takes place.
To eliminate inconsistent views taken by local tax authorities, it is hoped that the SAT will issue another supplemental circular to clarify this position. However, at this stage, it is unlikely that it will and taxpayers will have to continue to face the challenge of dealing with local tax authorities who are taking different views from the SAT.
Transfer pricing challenges to corporate restructuring
Apart from the challenge of getting the special tax relief noted above, corporate restructuring transactions are also subject to greater scrutiny by PRC tax authorities from a transfer pricing perspective. Under PRC tax laws, if a corporate restructuring transaction is considered a related-party transaction for PRC transfer pricing purposes, it has to be conducted on an arm's-length basis. Otherwise, the transaction value could be adjusted for tax purposes.
It is evident from recent enforcement cases that the PRC tax authorities will no longer accept group or corporate restructuring transactions to be conducted at cost or net book value (NBV), except where the transaction satisfies the special tax relief conditions under Circular 59 as noted above. The PRC tax authorities have the power to adjust transaction prices where the transaction is conducted between related parties and the transfer consideration is not determined in accordance with the arm's-length principle, resulting in a loss of or reduction in tax revenue for the PRC tax authorities.
In increasing numbers of enforcement cases in recent years the PRC tax authorities have begun to challenge the transaction price of corporate restructuring which is not determined in accordance with the arm's-length principle, for example, where the transaction price is at cost or NBV and the transaction is adjusted based on the fair market value (FMV) for the purposes of calculating the PRC capital gains tax for the transferors.
To enforce the transfer pricing rules, many PRC tax authorities now tend to require a valuation report to be submitted by the transaction parties to substantiate that the consideration represents the arm's-length pricing for equity and asset transfers. Such a valuation report would typically need to be prepared by an independent third-party qualified PRC valuation firm, although the form of valuation report and qualification of the local valuation firm is subject to local variation. A qualified valuation firm refers to a valuation firm which has obtained the Certificate of Asset Valuation Qualification and hence is recognised by the PRC government and tax authorities.
That said, the transfer pricing risk of corporate restructuring needs to be carefully managed, particularly where the corporate restructure takes place close to, or immediately before, an external party's acquisition of the equity stake in the post-restructure group where the valuation gap will need to be clearly explained to avoid any transfer pricing adjustments.
Given the challenges noted above, it is hoped that the SAT will introduce more flexible business friendly and clear guidance on how the reasonable business purpose should be interpreted for the provision of special tax treatment for corporate restructure transactions and that further relief will be brought to existing tax laws to address the challenges facing many legitimate corporate restructuring transactions which otherwise are unable to attain special tax treatment in the PRC.
Yvette Chan of KPMG China also contributed to this article.
John Gu is a partner and tax leader for inbound M&A 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 funds 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.
John has bachelor of business and master of finance degrees. He is also a member of the Institute of Chartered Accountants in Australia and a member of the Hong Kong Institute of Certified Public Accountants.
Lily Kang is a tax partner based in Shanghai. She focuses on assisting multinational corporations and private equity funds with China inbound tax planning and due diligence support for structuring their investments into China. Having worked in KPMG's North America office for more than eight years, Lily also has extensive experience in international tax planning. She has helped many Chinese domestic clients in expanding their operations overseas.
Lily holds a master of taxation degree and is a Washington State licensed certified public accountant.
Tax Partner in Charge of Southern China
Eileen Sun has the advantage of having worked at the Chinese Tax Bureau as well as in international accountancy firms. She is a respected specialist in value added tax, transfer pricing, tax audit and customs practices.
Eileen has been providing China tax consultancy services in Hong Kong and Shenzhen to foreign investors for more than 10 years. Before this, she worked in the UK for a chartered accountancy firm.