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backCHINAtalk June, 2012

Recent China Tax Developments Affecting Private Equity Investment

There has been talk in the market that draft tax rules may unify the tax treatment of partnerships nationwide and seek to impose tax on unrealized gains of partners in Chinese partnerships. The State Administration of Taxation has publicly stated in early May that the rules on partnership taxation will not provide for the taxation of unrealized gains.

In a recently reported Circular 698 case involving the sale of a Hong Kong company owning 56 percent of a Chinese company, the Chinese tax authorities asked the Hong Kong purchaser to withhold the BVI seller's Chinese capital gains tax liability from its purchase price payment.

Implications for Private Equity investors

• The draft tax rules, if implemented, may change the Chinese tax position of private equity investors investing in China as partners in Chinese partnerships. In particular, local tax incentives may not survive.

• Foreign purchasers in direct or indirect equity transfers may be approached by the Chinese tax authorities to withhold Chinese tax payable by the foreign sellers from the purchase price.

What the developments are

The draft tax rules on the taxation of partners in Chinese partnerships have been provided to various government authorities and interested parties for comment. The draft rules are not publicly available. According to the news reports:

• The rules will elaborate on the taxation of general and limited partners (e.g. timing and computation) following the present principle that tax on partnership income is imposed at the partner level but not the partnership level, i.e. that a partnership is a pass-through for tax purposes.

• The rules will unify the tax treatment of partnerships nationwide. Present local incentives for private equity or venture capital investment may not survive.

• There were rumors that the rules may tax unrealized capital gains on equity investments held by a partnership, e.g. upon an IPO of the underlying investee company. A senior State Administration of Taxation official has publicly clarified in early May that the draft rules do not seek to tax unrealized capital gains.

Separately, it has recently been reported that the Jincheng State Tax Bureau in Shanxi Province asked a Hong Kong purchaser of shares in another Hong Kong company to withhold Chinese income tax on the capital gain of the BVI seller in the transaction. As the Hong Kong company that was the target in the transaction held a 56% interest in a Jincheng company, the transaction triggered China's tax rules on indirect share transfers under Circular 698. The tax bureau approached the Hong Kong purchaser to arrange the withholding from the unpaid part of the consideration after it was unable to agree with the BVI seller on the tax computation. Thereafter, the BVI seller agreed to pay Chinese tax according to the tax bureau's computation.

Following this case precedent, a foreign purchaser in direct or indirect equity transfers of Chinese resident companies may be approached by the Chinese tax authorities to withhold the Chinese income tax payable by the foreign seller, particularly where prior tax collection from foreign sellers is unsuccessful. The legal basis for imposing a withholding obligation on a foreign purchaser in these situations remains a point of uncertainty under the current tax laws and regulations.

Actions to consider

• Be on the watch for release of new partnership tax rules which may affect the China tax position of your investments in Chinese partnerships.

• When acquiring investments with underlying Chinese companies from foreign sellers, ensure that the sellers fully comply with their tax filing and payment obligations under China's indirect share transfer rules in order to avoid the Chinese tax authorities looking to you to withhold Chinese tax from payment of the purchase price.

• When selling investments with underlying Chinese companies to foreign purchasers, be prepared that the Chinese tax authorities may seek to force you to accept their tax assessments by asking the purchasers to withhold.

Conclusion

Further rules will be released on the taxation of partners in a Chinese partnership, although the content and release date are as yet unknown. The designation of foreign purchasers as withholding agents in direct or indirect share transfers of Chinese companies from foreign sellers may become a reality.

Source: Baker & McKenzie - GAI

For more information or to contact Baker & McKenzie, please click here.

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