New corporate income tax policy in corporate restructuring

Llinks Law Offices
David Yu and Clare Lu
[email protected]; [email protected]

The corporate income tax (CIT) treatment for corporate restructuring has become a hot topic ever since the income tax regimes for domestic enterprises (DE) and foreign-invested enterprises (FIE) were combined since January 1 2008. The Notice Regarding Several Questions about Corporate Income Tax Treatments for Corporate Restructuring (Cai Shui [2009] No. 59, Circular 59), issued by the Ministry of Finance (MOF) and State Administration of Taxation (SAT) on April 30 2009 and effective since January 1 2008, replaced the previous income tax regimes for DEs and FIEs.

Together with the new CIT law and its detailed implementation rules, Circular 59 became the guiding regulation for corporate restructuring. At the same time, Circular 59 stipulates that general tax treatment or special tax treatment will be applied separately in corporate restructuring depending on the circumstances.

In substance, the special tax treatment should be considered a deferral of tax payment obligation until the disposal of relevant assets (equity). Therefore, the policy of special tax treatment is a preferential treatment characterised as a reduction of current cash flow by deferring CIT payment rather than a general tax reduction or exemption. However, in practice, there are uncertainties and difficulties in Circular 59's implementation.

In response to the high demand for operating instructions for Circular 59, the Administration Measures of Corporate Income Tax for Corporate Restructuring (SAT Notice [2010] No. 4, Notice 4) was issued by SAT on July 26 2010 and became retroactively effective on January 1 2010. As a complementary circular, Notice 4 further clarifies the income tax treatment for corporate restructuring, as well as provides more relevant detailed operating instructions.

Subsidiary or parent?

Circular 59 defines 'equity payment' as a payment by the transferee, who buys or exchanges assets that consist of the shares of the transferee itself or its controlled enterprise during corporate restructuring. Notice 4 further clarifies that a 'controlled enterprise' refers to an enterprise whose shares are directly held by the enterprise in question. This means that it is a subsidiary of the enterprise in question rather than the parent.

Payment with the subsidiary's shares usually qualifies as a non-cash-based assets exchange. Notice 4 includes one type of equity payment, which expands the range of restructuring categories which enjoy special tax treatment (when other criteria are also met). However, there is no clear definition as to how many shares (e.g. percentage of shares) of a company held by a transferee is needed for a company to be regarded as a subsidiary of the transferee.

'Reasonable commercial purpose' specified

Circular 59 stipulates that one of the criteria an enterprise must meet enjoy special tax treatment during restructuring is that “such corporate restructuring shall have reasonable commercial purpose, without the purpose of releasing, exempting, or delaying tax payment”. Notice 4 specifies the exact scope of “reasonable commercial purpose”, which provides clearer guidance for approval tax authorities when an enterprise submits application documents for special tax treatment.

Therefore, the enterprise should try to keep documents and information accurate and consistent. Not only will this convenience tax authorities in reviewing the application documents and obtaining the enterprise's detailed information, but the enterprise may also ensure that it obtains the special tax treatment.

However, the strict requirements on special tax treatment may be in conflict with the operational objectives of the transferor. Although some details are still pending for further clarification from SAT, these requirements might be inconsistent with the transferor's operational objectives. As such, the transferor is left with little choice but to forego the election of special tax treatment.

Is loss quota on 'one-off' or 'annual' basis?

Notice 4 states that the limit of the amount of losses of the enterprise being merged that may be utilised by the merged enterprise, as stipulated in Circular 59, is determined on an annual basis within the remaining carry-forward period. This statement clearly signifies the amount of losses is on a one-off basis. However, when applying special tax treatment, the transferor cannot effectively utilise the losses carried forward.

In general tax treatment, the transferor shall instantly recognise gain from the asset (equity) transfer in excess of the original acquisition cost calculated at fair value. If there is tax-deductible operating loss, the transferor can use gains from the transfer to offset the loss. However, if special tax treatment is elected (to the extent that the prescribed conditions are met), tax-deductible operating losses cannot be effectively utilised to offset the transferor's gain from the asset (equity) transfer.

Therefore, the transferor should consider whether to exploit the special tax treatment depending on actual circumstances.

Relevant government department cooperation crucial

Circular 59 emphasises that, in equity acquisitions, asset acquisitions, mergers and spin-offs, special tax treatment is available where 85% or more of the total consideration is paid in the form of equity. Notice 4 does not contain any inconsistent provision regarding this under Circular 59. However, in practice, how such equity consideration is registered is at the sole discretion of the local administration for industry and commerce, which might possibly interpret the equity payment otherwise.