Restructuring rules restructured

Under the Rules, the forms of transactions that qualify for restructuring are:

• changes in legal form (such as registered name, address or entity type);
• debt restructuring;
• equity acquisition;
• asset acquisition;
• merger; and
• spin-off (splitting and transferring an enterprise's partial or entire assets (spun-off enterprise) to another existing or new enterprise (spin-off enterprise) whereby shareholders of the spun-off enterprise receive equity or non-equity payment of the spin-off enterprise in return).

(2) Special tax treatments

Enterprises undergoing the above forms of restructuring can choose to adopt special tax treatments providing all five of the following conditions are met:

1. Reasonable business purpose (without the primary intention for tax reduction, exemption or deferring tax payment);

2. Satisfy prescribed asset or equity ratio under acquisition, merger or spin-off:

– at least 75% of the total equity is acquired under an equity acquisition; or

– at least 75% of the total assets are acquired under an asset acquisition;

3. Business continuity (the nature of the original business activities remains unchanged for 12 months following the restructuring);

4. Satisfy prescribed equity payment ratio (equity payment consideration of the transaction must be at least 85%); and

5. Ownership continuity (equity consideration received by the original major shareholders from the transaction must not be transferred within a 12-month period following the restructuring.

Timing of recognition and tax basis on gain/loss

A noteworthy feature of the difference between general and special tax treatments is the timing of recognition on the taxable gains or losses. In summary, general tax treatment involves the immediate recognition of the taxable fair value gains or losses arising from both the equity and/or non-equity payment consideration of the assets or equity transferred. Special tax treatment, on the other hand, allows the deferral on the taxable gains or losses arising solely from the equity payment consideration; the non-equity payment portion, however, shall be recognised immediately and taxed according to the calculation method provided in the Rules as follows:

Gain/loss arising from assets transferred corresponding to the non-equity payment
= Fair value of assets being transferred - Tax basis of assets being transferred x (Non-equity payment / Fair value of assets being transferred)

Unutilised tax losses treatments

In the case of a merger or spin-off, unutilised tax losses would be taxed differently under general and special tax treatments. Notably, unutilised tax losses would lapse under the general tax treatment; the special tax treatment allows the unutilised tax losses to be carried forward based on the following conditions:

(i) Merger:

Limited losses to be utilised
= Fair value of net assets of the enterprise being absorbed x Interest rate with the longest term treasury bonds issued by the State as at the end of the year of the merger

(ii) Spin-off: unutilised tax losses of the enterprise being spun-off may be pro-rated and shared between all spin-off enterprises according to the ratio of spun-off assets to the total value of assets.

Unutilised preferential tax treatments

With regards to the unutilised preferential tax treatments brought forward from a pre-merger or pre-spin-off situation, the Rules allow the merged or spin-off enterprise to continue utilising the remaining tax incentives provided the nature of the restructured enterprise and conditions for enjoying the tax incentives remain unchanged.

(3) Other important features

Cross-border restructuring

Special tax treatments are now made available to cross-border restructuring under the Rules; these are limited to the following specific types of situations and conditions, however:

1. Foreign-to-foreign in which equity interest in a tax-resident enterprise (TRE) is transferred by a non-TRE to another non-TRE, of which it has 100% direct ownership. The transaction does not result in changes in the withholding tax burden on the capital gains arising on the sale of equity interest of the TRE. The non-TRE transferor undertakes not to transfer the equity of the non-TRE transferee within three years after the transfer of the TRE.

2. Foreign-to-domestic, in which a non-TRE transfers the equity of a TRE to another TRE, which it has 100% direct ownership.

3. Outbound transfer, in which a TRE invests its own assets or equity in a non-TRE, which it has 100% direct ownership. Should the TRE elect for the special tax treatment, the tax on gain derived from the transfer of asset or equity can be spread evenly over 10 years instead of being settled immediately.

4. Other circumstances as approved by the MoF and the SAT.

Notwithstanding the above limitations, it is encouraging for enterprises to know that the MoF and the SAT are keeping an open-mind to address and consider any special situations that fall beyond the above scope.

Multiple-step restructuring

Multiple-step restructuring, which has been incorporated into the Rules, allows restructuring with multiple-steps which is undertaken within a 12-month period to be assessed as one single restructuring transaction based on the principle of “substance over form”. This new concept, which is similar to international tax practice, is expected to be well-received by enterprises as it aims to simplify the tax implications for many corporate restructurings that are rather complex and time-consuming.

Documentation for special tax treatment

Enterprises are required to provide written documentation to the in-charge tax authorities for record at the time of filing the annual enterprise income tax returns, in order to substantiate the qualification for special tax treatment. The Rules, however, do not elaborate the kind of documentation and reporting requirements of a non-TRE that underwent cross-border restructuring and wishes to elect for special tax treatment.

Nevertheless, it is anticipated that further clarification and guidance will be released shortly by the SAT or local-level tax bureaus regarding the compliance requirements.

Uncertainties

Although the release of the Rules unravelled and clarified many uncertainties that once hovered around the new Enterprise Income Tax (EIT) Law and its Implementing Regulations, there still remain a number of unclear issues to be addressed, including:

• the definition of “business purpose” under the special tax treatment is not being laid down in the Rules;
• It is uncertain whether there is any exception to the 12-month business continuity period under the special tax treatment if there are valid commercial reasons on the change;
• is there any practicality to the 12-month ownership continuity if the restructuring is for the purpose of an overseas IPO or private placement?
• if the prescribed conditions for special tax treatment are breached, is the capital gain/loss taxable immediately, and if so, at what value – fair value at the time of breach or fair value at the actual restructuring period?

Case-study

The diagram below provides a simple illustration of cross-border restructuring (foreign to foreign) that commonly took place
before 2008 and the possible considerations that may arise in respect of the new Rules:



The TRE Company was originally held by a British Virgin Islands (BVI) Company. With the signing of the full-blown PRC-HK Double Tax Agreement (the Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation on Income (中国内地和香港特别行政区关于对所得避免双重征税的安排) promulgated in 1998) and the enactment of the new EIT law, the group decided to transfer the TRE Co from the BVI Co to the HK Company with the purpose of achieving a lower withholding tax on dividends and interest. The restructuring commenced in 2007 and was completed in February 2008. As the TRE Co was transferred at cost, no tax on capital gain was recognised by virtue of the old regulation – the SAT's Handling Questions Concerning Income Tax on Transfer of Equity by Foreign Investment Enterprises and Foreign Enterprises Circular (国家税务总局关于外商投资企业和外国企业转让股权所得税处理问题的通知) of 1997.

The following considerations arise:

- Is it still workable under the new Rules to transfer the above equity interest where there is indirect ownership within the group instead of 100% direct ownership between transferor and transferee?

- Can the old regulations continue to prevail as transaction was initiated in 2007?

- If not, will tax authorities deem the entire transaction based on the new Rules or subject the transactions relating only to FY2008 under the new Rules?

- Are there any transitional provisions available for enterprises caught under the above time-frame?

- Is entering into a “better treaty provision” or “better legal system of a country” a valid reason to satisfy the reasonable commercial purpose?

These questions are subject to further clarification from the SAT.

Next steps

Notwithstanding the underlying uncertainties of the Rules, the pressing issue at hand is for restructured enterprises that have submitted their 2008 annual EIT return based on the former rules to pro-actively discuss with the tax bureau the need to rectify their tax positions.

Enterprises should also turn their focus on how the underlying restructuring transactions will interact with other taxes in China, especially turnover taxes, in order to have a comprehensive understanding of their China tax exposures.

Danny Po, national M&A tax leader, PricewaterhouseCoopers