Tax Issues in Acquisition of Equity Interest in Domestic Enterprises

Prior to issuance of the Circular, the SAT had issued several regulations covering tax issues in mergers between enterprises. The two most important ones are: (i) Income Tax Treatment of Reorganization of Foreign Investment Enterprises such as Mergers, Splits, Reorganization of Equity and Asset Transfer Tentative Provisions (effective April 28 1997); and (ii) Several Questions Concerning Income Tax when Enterprises are Reorganized (effective June 24 1998), which together with the Income Tax Questions Relevant to Enterprise Merger and Division Circular (effective June 21 2000) sets out tax policies on mergers, divisions and other restructurings between domestic enterprises. The new Circular is the first that deals specifically and solely with tax issues over the equity interests that foreign investors take in domestic enterprises.

Application of FIE-related Tax Laws and Regulations

The Circular provides that if foreign investors acquire 25% or more of the equity interest in a domestic enterprise and restructure the enterprise into an FIE, then the Restructured FIE shall pay the applicable taxes pursuant to the FIE-related tax laws and regulations. The Circular remains silent on a scenario where foreign investors acquire less than 25% equity interest in a domestic enterprise. This question is answered by the Enterprise Tax Treatment Issues Concerning Foreign-invested Enterprises in which the Proportion of Foreign Investor Contribution is less than 25% Circular (promulgated by the SAT on April 18 2003 and effective the same date), in which it is stipulated that the applicable tax system and tax registration in respect of an FIE with a foreign equity interest that is less than 25% shall be the same as that applicable to domestic enterprises, unless otherwise stipulated by the State Council.

Business Operation Period

The Circular sets out that if Restructured FIEs satisfy the conditions under the PRC Foreign Investment Enterprise and Foreign Enterprise Income Tax Law (the FIE Income Tax Law) and its implementing rules, Restructured FIEs shall be entitled to the various tax preferential treatments.

As we know, production-oriented FIEs with business operation periods of 10 years or more enjoy certain preferential tax treatments under FIE-related tax laws and regulations. Unlike newly established FIEs, Restructured FIEs have already commenced business operations before restructuring. For the purpose of the FIE-related tax laws and regulations, the Circular provides that the business operation period of a Restructured FIE shall commence from the date of the issuance of a business licence for the Restructured FIE, and shall end on the expiry date as stated in the business licence.

Pre-acquisition Losses

Pursuant to Article 11 of the FIE Income Tax Law, operational losses incurred by an FIE may be made up by income in the following tax year; if the following tax year's income is insufficient, then the balance may be made up by income gained two years hence, and so on, over a period not exceeding five years. In consideration of this provision, the Circular acknowledges that if the cumulative losses incurred by a Restructured FIE have not been made up before being restructured into an FIE, the Restructured FIE may continue to make up such losses over the remaining years in the period not exceeding five years provided under the FIE Income Tax Law.

First Profit-making Year

As mentioned above, production-oriented Restructured FIEs with operation periods of 10 years or more shall be entitled to preferential tax treatments under the FIE-related tax laws and regulations. This includes (but is not limited to) exemption from income tax for the first two years and 50% reduction of income tax for the following three years, starting from the first profit-making year. Based on the Circular, if a Restructured FIE makes profits in the year that it is being restructured into an FIE, and remains profitable after having made up the losses incurred before its restructuring, the said year shall be the first profit-making year of the Restructured FIE. If the actual business operation period of the first profit-making year is less than six months, the Restructured FIE shall have the option to choose the following year as the starting year of the period in which it is entitled to tax exemptions and preferential treatments.¹

Endnote

1 See Article 77 of the FIE Income Tax Law Implementing Rules, issued in 1991.