Pursuant to the "Circular on Issues Concerning Treatment of Corporate Income Tax in Enterprise Restructuring Business" (Cai Shui [2009] No. 59, hereinafter "Circular 59"), the corporate income tax treatment for equity transfers can be categorized into two approaches: general tax treatment ("GTT") and special tax treatment ("STT").
Under GTT, transferor enterprises should recognize taxable income arising from equity transfer immediately, triggering the corresponding tax liability. By contrast, STT constitutes a tax deferral arrangement for qualified group restructuring, under which the transferor enterprises do not recognize immediately the income attributable to the equity payment portion, and taxation is deferred until subsequent equity transfer in the future. The core purpose of this arrangement is to prevent enterprises from incurring immediate tax liabilities when carrying out an internal group restructuring. This article uses case studies to illustrate the differences between the two tax treatment approaches and clarifies the relevant conditions for applying STT.
I. Case Example
Overseas Company A holds 100% of the equity in PRC resident Company M, with a tax basis of 80 million RMB. Company A transfers all its equity in Company M to another offshore Company B, over which it has 100% direct control. 90% of the consideration consists of equity payment (fair value of 90 million RMB), and 10% is in cash (10 million RMB), with a total fair value of 100 million RMB. Company A is a non-resident enterprise subject to a 10% tax rate.
GTT: Immediate Recognition of Income from the Transfer of Equity
According to Article 4 of Circular 59,
Income from the equity transfer = proceeds from the equity transfer – tax basis of the equity acquired; Tax payable = income from the equity transfer × applicable tax rate. Therefore, for Company A,
Income from equity transfer = 100 million – 80 million = 20 million RMB
Tax payable = 20 million × 10% = 2 million RMB.
Company A should recognize the income and pay withholding tax of 2 million RMB. Company B's tax basis for the equity in Company M is determined at the fair value of 100 million RMB.
STT: Deferral of Income from the Equity Payment Portion
Pursuant to Article 6 of Circular 59, if Company A meets the conditions for STT, the income corresponding to the equity payment portion (90%, or 90 million RMB) shall not be recognized for the time being, and no tax is due on this portion of the income. However, for the non-equity consideration portion—in this case, the cash payment (10%, or 10 million RMB)—the corresponding income still need to be recognized:
Income from the non-equity payment = (100 million – 80 million) × (10 million ÷ 100 million) = 2 million RMB
Tax payable on the non-equity portion = 2 million × 10% = 200,000 RMB.
Company A should recognize the income and pay withholding tax of 200,000 RMB. Company B's tax basis for the equity in Company M acquired is 100 million × 10% + 80 million × 90% = 82 million RMB, while the tax basis for the portion of equity in Company M acquired through equity payment remains unchanged at 80 million × 90% = 72 million RMB.
II. Conditions for Applying STT in the Four Scenarios
According to Articles 5 and 7 of Circular 59, the conditions for electing special treatment differ across the following four scenarios:
(I) Five Basic Conditions Met Simultaneously in All Scenarios
1. Reasonable Business Purpose: The enterprise restructuring serves a reasonable commercial purpose and is not primarily motivated by tax reduction, exemption, or deferral.
2. Equity Threshold: The acquired equity should constitute at least 50% of the total equity of the acquired enterprise.
3. Business Continuity: The original substantive business operations relating to the restructured assets shall not be changed within the 12 consecutive months following the enterprise restructuring.
4. Equity Payment Ratio: The amount of equity paid as consideration in the restructuring transaction should be no less than 85% of the total transaction consideration.
5. Shareholder lock-up period: The principal shareholders who receive equity as consideration in the enterprise restructuring shall not transfer the equity acquired within the 12 consecutive months following the restructuring.
(II) Additional Conditions for Cross-Border Transfers
Pursuant to Article 7 of Circular 59, cross-border equity transfers involving non-resident enterprises should, in addition to the five basic conditions listed above, also meet extra specific requirements:
Scenario②: A non-resident transfers its equity in a resident enterprise to another non-resident enterprise over which it holds 100% direct control (downstream parent to subsidiary transfer), and such transfer does not result in a change in withholding tax liability. The transferor should provide a written commitment to the competent tax authority that it shall not transfer its equity in the transferee non-resident enterprise within 3 years (including 3 years).
Scenario③: A non-resident enterprise transfers its equity in a resident enterprise to another resident enterprise over which it has 100% direct control.
Scenario④: A resident enterprise invests its assets or equity in a non-resident enterprise over which it has 100% direct control. If the enterprise elects STT for the income from the transfer of such assets or equity, that income may be evenly allocated to the taxable income over a period of 10 fiscal years.
STT is not automatic and should be reported or filed with the tax authorities by the enterprises. If the required procedures are not followed in accordance with regulations, STT will not be available. Enterprises are strongly advised to thoroughly assess the eligibility criteria during the design phase of the restructuring plan to mitigate the risk of unexpected tax liabilities.
At PHC Advisory, we have advised on numerous group restructurings involving multinational groups and their PRC subsidiaries. A thorough understanding of the STT available for qualifying restructuring transactions can deliver material tax savings upon implementation of a restructuring and defer actual tax payment to a future point when the restructured equity is subsequently disposed of. Multinational groups can therefore significantly improve their cash flow position by properly evaluating and applying such preferential tax rules.
At PHC Advisory, we can offer you full support on matters regarding doing business in China, or any other issues your business may face. If you would like to know more about policies relevant to your business in Italy or Asia, please contact us at info@phcadvisory.com.
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The content of this article is provided for informational purposes only, financial advice must be tailored to the specific circumstances on a case-by-case basis, and the contents of this article do not legally bind PHC Advisory with the reader in any way.
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