Tax Treatment of Capital Reductions: Part II Substantive Capital Reductions

In Part I of this series, Daisy Duan, Yingjie Yang and Cuishi Li of King & Wood Mallesons introduced the implications of the amended PRC Company Law for Formal Capital Reductions. In Part II, the authors focus on the accounting and tax treatments of Substantive Capital Reductions, and analyze the tax risks of shareholders with regard to capital reductions not made at fair market value.

Summary

  • Different from Formal Capital Reductions, Substantive Capital Reductions will lead to a net asset outflow from the company
  • As such, the tax treatment of shareholders under the Substantive Capital Reduction route will be more complicated


I.     The Accounting and Tax Treatments of Substantive Capital Reductions
In the case of Substantive Capital Reductions, shareholders may receive income from the company through the capital reduction, which is subject to corresponding tax implications. This leads to various tax and accounting implications for different types of entities, which differ from those encountered where a Formal Capital Reduction is used.

According to the relevant rules and regulations, when an enterprise repurchases its own stock on an open market for the purpose of a capital reduction, from an accounting perspective this is only treated as a change in the Owner’s Equity
1.    The accounting and tax treatments of the company
According to the relevant rules and regulations, when an enterprise repurchases its own stock on an open market for the purpose of a capital reduction, from an accounting perspective this is only treated as a change in the Owner’s Equity. This means that the difference between the repurchase price and the original capital contribution does not have to be recorded in the profit and loss statement. From a tax perspective, the tax treatment of the difference between the repurchase price and the original capital contribution is consistent with the accounting treatment and no tax adjustment is required. As such, regardless of whether the capital reduction is made at book value, at discounted value or at premium value, there will be no tax implications for the company.

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