The persistent gap
October 13, 2010 | BY
clpstaff &clp articles &The new supplemental enterprise reorganisation tax measures fail to open any new doors for cross-border reorganisations to qualify for special tax treatment. In addition, they still require fine-tuning with numerous details lacking
Enterprise reorganisations are central to the growth of business activities. As soon as an enterprise is formed, it could become engaged in reorganisation for various legitimate reasons. Nevertheless, multiple factors would affect whether and how to structure enterprise reorganisations. Among them, tax remains a key consideration. Enterprise reorganisations will generally be subject to tax unless they are specifically exempt. Taxable enterprise reorganisations could potentially lead to exceedingly high tax bills and force business executives to think twice before making a move. Obviously, there should be a balance on tax and economic considerations with respect to enterprise reorganisations. To encourage enterprise reorganisations, the leading economies generally lay out the mandatory conditions for tax-free treatment. To be more precise, it does not really mean a tax-free escape, but a tax deferral until a future recognition event.
China has been very slow in playing a catch-up in this area. On April 30 2009, the Ministry of Finance (Mof) and the State Administration of Taxation (SAT) jointly issued Caishui [2009] No. 59 (Circular 59) to set out the guidelines on the income tax treatment of enterprise reorganisations. Hailed as a step forward, Circular 59 has proved to have limited practical value for many reasons since its adoption. One reason is that Circular 59 lacks specifics with respect to the key terms and the implementation requirements. Both taxpayers and tax officers are struggling with difficulties in properly applying Circular 59. It has long been expected that the SAT would come up with further clarifications just to make it work.
On July 26 2010, the SAT released the Measures for the Administration of Enterprise Income Tax in Connection with Enterprise Re-organisation (企业重组业务企业所得税管理办法), SAT Announcement [2010] No. 4 (Announcement 4), to provide the supplemental rules on the application of Circular 59. Announcement 4 does not deviate from Circular 59 on the basic distinction between taxable reorganisations subject to a general tax treatment and tax-free reorganisations eligible for a special tax treatment. To be eligible for a special tax treatment, a reorganisation continues to have to meet with the five general tests: 1) reasonable business purpose; 2) transfer of substantially all shares or assets; 3) equity consideration; 4) continuity of business enterprise; and 5) continuity of proprietary interest. Instead, Announcement 4 primarily focuses on the filing requirements and the clarification of various key terms with respect to enterprise reorganisations.
Filing requirements
Enterprise reorganisations could take various forms, including change in legal form, debt restructuring, stock acquisition, asset acquisition, merger, and spinoff. The filing requirements vary with the form of enterprise reorganisation. Regardless of how a reorganisation is classified, all the parties involved must uniformly adopt the same tax treatment, either the general tax treatment or the special tax treatment. Both taxable reorganisations and tax-free reorganisations have to be filed with the Chinese tax authorities.
In the case of a taxable reorganisation, the following documents must be filed:
| Reorganisation Form
| Filing Documents for Taxable
|
| Change in legal form
| Tax return; Regulatory approval documents; Tax basis of all assets and asset evaluation reports; Credit and debt statements; and other documents required by the Chinese tax authorities
|
| Debt restructuring
| Debt payoff contracts and non-cash asset evaluation reports, in the case of a debt discharge through non-cash assets; or equity conversion contracts, in the case of a debt-to-equity conversion deal
|
| Stock or asset acquisition
| Acquisition contracts; and stock and asset evaluation reports
|
| Merger or spinoff
| Tax return; Regulatory approval documents; Tax basis of all assets and asset evaluation reports; Debt statements; and other documents required by the Chinese tax authorities
|
In the case of a tax-free reorganisation, enterprises involved are required to file with the in-charge tax authorities for record filing purposes. The filing must be able to prove that the reorganisation meets the mandatory conditions of the special tax treatment. Otherwise, enterprises cannot enjoy the tax deferral and would be subject to a general tax treatment. In addition, if desirable, enterprises involved in a tax-free reorganisation can, after the reorganisation is completed, apply for a confirmation on the election of the special tax treatment to ensure certainty. In this circumstance, the lead party of any reorganisation will submit an application to the in-charge tax authorities on behalf of all parties. The lead party is defined as follows:
| Reorganisation Form
| Lead Party in Tax-Free Reorganisations
|
| Debt restructuring
| Debtor
|
| Stock or asset acquisition
| Seller
|
| Merger
| The surviving enterprise, or the enterprise with greater assets pre-merger
|
| Spinoff
| The surviving enterprise, or the spun-off enterprise
|
The application will ultimately be reported to the provincial tax authorities for review. In principle, the provincial tax authorities are supposed to render a confirmation decision before the settlement of enterprise income tax for the current year. This type of confirmation decision is different from an advance ruling in the taxation system of the United States, which is regarding the tax treatment of a proposed transaction.
Announcement 4 highlights one particular condition required of tax-free reorganisations, a reasonable business purpose. Under Section 18 of Announcement 4, enterprises should seek to prove the reasonable business purpose with the following information:
1. The reorganisation form, background, time, operating model before and after the reorganisation, and relevant business norm;
2. The form and substance of the transaction from the legal and commercial perspectives;
3. The tax and financial impacts on the parties;
4. Whether the reorganisation will give rise to abnormal economic benefits or potential obligations to any of the reorganisation parties that would not arise based on normal market economy principles; and
5. The involvement of non-resident enterprises.
The filing obligations do not end with the completion of the reorganisation. If an enterprise no longer meets the conditions of the special tax treatment within the prescribed post-reorganisation period as required, it needs to notify other parties within 30 days upon the changes. Then, the lead party is required to inform the in-charge tax authorities within 30 days after receiving the initial notice. If the special tax treatment is reversed, the parties involved will have to make necessary adjustments on their respective income tax liabilities.
Clarification of key terms on enterprise reorganisations
Reorganisation date: The reorganisation date is relevant to both the continuity of the business enterprise test and the continuity of the proprietary interest test. The continuity of the business enterprise test requires the substantial operation of the target to remain unchanged within 12 consecutive months after the reorganisation, whereas the continuity of the proprietary interest test prohibits the main shareholders from disposing of their received equity considerations within 12 consecutive months after the reorganisation. Announcement 4 clarifies that both restrictive periods start with the reorganisation date. The term of the “main shareholders” refers to the shareholders holding at least a 20% equity interest in the seller or the target prior to the reorganisation. The reorganisation date is defined as follows:
| Reorganisation Form
| Reorganisation Date
|
| Debt restructuring
| The effective date of the debt restructuring contract or agreement
|
| Stock acquisition
| The date on which the equity transfer agreement is effective and the formalities of the transfer are completed
|
| Asset acquisition
| The date on which the asset transfer agreement is effective and the actual transfer of possession is completed
|
| Merger
| The date on which the acquirer becomes the owner of the target's assets and changes its own business registration
|
| Spinoff
| The date on which the spinoff enterprise becomes the owner of the spun-off enterprise's assets and changes its own business registration
|
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