Driven by regulatory changes and capital market reforms, foreign investors in China have enjoyed strong gains. However, several difficulties in recent years, such as the COVID-19 pandemic, rising interest rates, and geopolitical tensions, have affected the investment environment and pushed investors to consider an exit strategy.
The Chinese taxes associated with such exits can have a significant impact on post-tax investment returns. Tax implications should be evaluated when choosing a way to divest an investment in China.
There are a few important issues to consider, which include ensuring fair market value prices are set, setting out a reasonable commercial purpose, and cross-border position. Compliance reviews by the local authorities are also a factor to watch in the long term.
A foreign investor may decide to dispose or regroup investment in China, due to business circumstances. This could be done by selling off properties, transferring shares/equities of Chinese enterprises directly or indirectly, divestment, or liquidating and deregistering the operational entities.
When making commercial decisions, different tax considerations should be evaluated depending on the method of divestment.
In case of a direct equity transfer, a foreign investor who directly holds a Chinese enterprise, may sell off its equity in the target company, which is a straightforward exit from a commercial perspective.
The equity transfer will be subject to income tax in China on the transferor’s income (if any) derived from the transaction. Where the transferor is a foreign enterprise, it will be responsible for Chinese enterprise income tax (“EIT”) at 10%, and where the transferor is a foreign individual, he/she will be liable for individual income tax (“IIT”) at 20%, unless the applicable tax treaty provides preferential treatment.
In addition, both the transferor and transferee will pay stamp duty at 0.05% for the equity transfer.
A few considerations are important from the tax perspective:
Sales price For tax assessment, the tax laws in China require the equity sales price to be in line with the fair market value (“FMV”). If the equity is sold at a much lower price than the FMV without reasonable commercial justification, the Chinese tax authorities can adjust it and deem the taxable income based on the FMV of the sold equity. To determine a fair price, Chinese tax authorities may refer to the latest or recent net book value; a fair and appropriate appraisal report; the valuation as of the latest round of financing (if any); and the equity transfer price conducted in a recent period (if any), of the target company.
Deductible investment cost The investment cost deducted when computing the taxable income for the equity transfer is the capital injected by the foreign investor in the target company or the consideration paid by the foreign investor to the former shareholder under an equity acquisition. The Chinese tax authorities will want to review payment certificate or written notes from the bank and assessment of the deductible investment cost. If there has been intra-group restructuring of the transferred equity and special tax treatment (i.e. tax deferral regime) was applied, the deductible investment cost should refer to the original investment cost before such restructuring.
Tax filing procedure The transferee of the equity transfer is the statutory withholding agent of the EIT or IIT payable by the transferor. If the transferee fails to withhold tax in due course, it may find itself subject to an administrative fine, between 50% and 300% of taxes overdue. If the transferee is a Chinese party, the income tax payable should be withheld at the time of making the outbound payment or the due date of consideration payment. Where the transferee is also a foreign party, the transferor may make a voluntary tax filing to the Chinese tax authorities. Regarding the voluntary tax filing, if the transferor is an individual, he/she should file an IIT return within the first 15 days of the month following the month in which the equity is transferred, or the equity transfer agreement takes effect, or consideration is paid; and if the transferor is an enterprise, a voluntary tax filing is encouraged such that there will be no late payment interest due (because the relevant tax rules deem a voluntary tax filing as a timely filing of the EIT).
Application for tax treaty If there is a tax treaty between China and the country where the foreign investor is a tax resident, preferential treatment could be applied to the equity transfer, provided that relevant conditions are met. The foreign investor is allowed to determine the applicability of the treatment by self-assessment when filing taxes. Documents such as financial materials of the target company, transaction papers, tax resident status certificate, should be kept. Chinese tax authorities may conduct a follow-up review to determine whether the transferor is entitled to the treatment. If Chinese tax should be imposed on the equity transfer, the foreign investor may be able to apply for tax credit in its resident country by fulfilling the tax obligation and obtaining tax payment certificates in China.
Cross-border payment Foreign exchange procedures must be followed if the transferee of the equity is a Chinese enterprise or individual and the consideration needs to be paid abroad. If a single installment of an outbound payment equals US$ 50,000 or more, the payer should first file a record of cross-border payment with the Chinese tax authority, and then submit the record filing form and relevant documentation to the bank to apply for cross-border remittance. Another option to exit is the equity transfer through an onshore holding company. A foreign investor, who created a holding company to invest in China, may divest part of the portfolio while still retaining another part, or leave room for future reinvestment in China, by selling off the Chinese entity through the holding company but maintaining ownership of the holding company.
Such transaction structure involves China domestic equity transfer and cross-border dividend distribution.
First: equity transfer by the Chinese holding company The equity transfer in this case is a pure domestic equity transfer, and the Chinese holding company is liable for EIT (usually at 25%) on its income derived therefrom, while both the transferor and the transferee are liable for stamp duty at 0.05%. The Chinese holding company should file the EIT return on a quarterly basis and make the annual EIT filing.
Second: dividend distribution from the Chinese holding company to the foreign investor Upon settlement of the taxes with respect to the profit and subject to Chinese company laws, the onshore holding company can make dividend distribution to its offshore shareholder. Withholding income tax (“WHT”) should be withheld at the time of making dividend payment. The standard WHT rate is 10% if the dividend recipient is a foreign enterprise, and 20% if the dividend recipient is a foreign individual. If there is an applicable tax treaty between China and the country where the shareholder is a tax resident, a preferential tax rate may apply.
In addition, a circular provides tax exemption for dividend distribution from a foreign-invested enterprise to a foreign individual. However, its actual implementation may vary and is subject to confirmation with local tax authorities.
Another option to consider is the indirect equity transfer through Offshore SPV. Foreign investors with global investment commercial arrangements may hold their equities of Chinese subsidiaries through relevant offshore intermediate holding companies (“SPV”), among which Hong Kong, the British Virgin Islands (BVI), and the Cayman Islands are the most common.
Under such structure, the foreign investor may sell off the offshore SPV to indirectly dispose of its Chinese subsidiary. This type of transaction offers advantages in closing and foreign exchange between the parties, as well as convenience for the buyer’s restructuring or listing in the future.
Capital reduction or liquidation of the Chinese enterprise is another way to divest. Apart from selling off equities in a Chinese subsidiary directly or indirectly, a foreign investor may also consider reducing or recouping the capital it contributed to the subsidiary.
If the investor is an enterprise, the assets (including cash) obtained by the investor through the capital reduction or capital recoupment from the Chinese enterprise should be divided into three parts:
The part which equates to the original capital contribution should be recognized as investment recovery, which is non-taxable; the part which equates to the cumulative undistributed profits and cumulative surplus reserve of the invested enterprise computed in accordance with the percentage of reduced paid-up capital shall be recognized as dividend income, which is subject to WHT at 10% (or preferential tax rate); and the remaining part, if any, will be recognized as income derived from equity transfer, which is subject to income tax at 10% (or preferential tax rate under tax treaty).
Where the investor is an individual, if the assets (including cash) he/she obtained from capital reduction or capital recoupment is higher than his/her original investment amount, he/she must pay IIT at 20% (or preferential tax rate) on the income it obtains; if the assets obtained are lower than or equal to his/her original investment amount, he/she shall not be liable to pay IIT.
Chinese tax authorities pay close attention to capital reduction by a foreign investor to decide whether there is an intention to reduce or avoid a tax obligation in China.
Under certain circumstances, the foreign investor may consider closing its subsidiary in China, following liquidation and deregistration procedures.
For income tax purposes, the liquidation enterprise should be deemed as selling off all assets, paying off all debts, fulfilling the filing and payment of EIT for its liquidation income (if any), and finally distributing the remaining assets (if any) to the investor. The investor will be subject to income tax for income received from the liquidation.
The tax authority in charge of the transaction will conduct a compliance review of all tax-related matters, covering a period of the past five years or from the establishment of the company. The company should review accounting books, financial statements, tax returns and bank statements, to prepare for the tax deregistration process.
Foreign investors evaluating exit options should conduct tax due diligence on the Chinese invested enterprises before deciding which route to go. To learn more about our services in China, contact our Head of Business Advisory - Ms. Kristina Koehler-Coluccia at firstname.lastname@example.org.
DISCLAIMER: All information in this article is verified to the best of our ability and is assumed to be correct at time of release; however, Woodburn Accountants & Advisors does not accept responsibility for any losses arising from reliance on the information provided within. The information provided is for general guidance and does not replace specialized advice.