TAX NEWS - June 2010

China Tax: Tax laws

1. Reply on the Pre-tax Deduction Issues in Relation to the Interest Occurred Due to the Overdue Paid-in Capital    

(State Administration of Taxation, Guoshuihan [2009] No.312)

This Reply clarifies that the interest of external loans of an enterprise may not be deducted from the enterprise's income tax in the event that certain investor of the enterprise fails to make its capital contribution within the stipulated period. The non-deductible amount should be equal to the interest accrued from the difference between the registered capital and the paid-in capital.

The non-deductible interest shall be calculated as follows:

The non-deductible interest for each calculation period = the interest occurred during the calculation period × the overdue amount of the paid-in capital ÷ the debt amount of this period.

In the above computing formula, each calculation period refers to the period in a year during which the account paid-in capital and the outstanding debt remain unchanged; the total non-deductible amount shall be the aggregate amount of the non-deductible interest under each period during the year.

KW Comments: The rationale of the non-deductibility of interest expense arising from the investors' borrowing to make capital contribution is that when an enterprise makes capital contribution with borrowed money, especially when the payment is not made within the agreed time limit, the relevant interest expense is not reasonable expense, therefore, should be borne by the investors themselves. The "stipulated period" means the subscription period for capital contributions as stipulated in the articles of associations of limited liability companies or companies limited by shares (which should not conflict with the laws and regulations).

The investors who do not inject capital in accordance with the stipulated period include the investors at the establishment stage of the company and the investors at the capital increase stage. Under the second scenario, if the capital is to be increased by installment, and the investors do not inject the capital within the agreed-upon period, the circular Guoshuihan [2009] No.312 should also be applicable.


2. The Administrative Measures on Non-residents Enjoying Tax Treaty Treatment (Trial)

(State Administration of Taxation, Guoshuifa [2009] No.124)

The Measures set forth that non-residents (including enterprises and individuals) shall follow the approval or filing procedures as set forth in the Measures in order to enjoy the tax treaty treatment. Those who fail to undergo the approval or filing procedures are not entitled to enjoy the relevant treatment. For the treatment on dividends, interest, royalties and capital gains, the non-residents should submit the application to the competent tax authorities for approval; while for the treatment on permanent establishment and business profit, dependent and independent services rendered by individuals, as well as other favorable treatment provided by the tax treaty, the tax payers or withholding agents should complete the relevant filing with the local tax authorities before tax liabilities arise or during declaration period.

The non-residents which were entitled to enjoy tax treaty treatment but did not enjoy it and hence overpaid tax may apply to the competent tax authority for approval of such treatment within 3 years after the date of settlement of the overpaid tax; overdue application will not be accepted. Tax payers or withholding agents who have enjoyed or implemented such treatment should keep the relevant certificates and materials no less than 10 years.

KW Comments: These measures set out that non-residents which apply for tax treaty treatment should complete filing or approval formalities, and clarify the documents to be submitted as well as the retention period.

Both non-resident tax payers and withholding agents should pay special attention to these Measures; otherwise, it is possible that the tax treaty treatment may not be enjoyed.


3. New Tax Rules on M&A released

(Notice on Several Issues regarding Enterprise Income Tax Treatment in relation to Enterprise Restructuring, Caishui [2009] No.59), announced on April 30, 2009, and effective from January 1, 2008)

Restructuring includes change of legal form, debt restructuring, share acquisition, asset acquisition, merger, and split-up. The Notice divided the restructuring into general restructuring and special restructuring. For general restructuring, the profit or loss should be recognized according to the fair market value of the relevant assets or shares when they are transferred, while special restructuring is entitled to the tax deferment incentives.

To satisfy special restructuring, the following requirements should be met:

(a) There is a reasonable commercial purpose(s) for restructuring.Tax deduction, exemption, or deferral cannot be the main purpose of the restructuring;

(b) The acquired, merged or split portion of assets or shares reach certain percentage of the total amount of assets or shares (not less than 75% of the total assets or shares of the enterprise initiating restructuring);

(c) The enterprise does not change its substantial business activities within 12 consecutive months after restructuring;

(d) The consideration must be paid in shares in compliance with the provisions of the Notice (not less than 85% of the total payment); and,

(e) The original shareholder who receives share consideration must not transfer those shares within 12 consecutive months after the restructuring.

For offshore restructuring, in addition to those requirements set forth above, one of the following conditions must be satisfied for special restructuring purpose:

(a) When a non-resident enterprise transfers shares of its resident enterprise to its 100%-owned non-resident subsidiary, it does not change the withholding tax burden therefrom.The said transferor shall state in writing that it will not transfer the shares of the transferee it owns within 3 years;

(b) A non-resident enterprise transfers its shares of a resident enterprise to another resident enterprise which is 100%-owned by the non-resident enterprise;

(c) A resident enterprise invests its 100% directly owned non-resident enterprise with its owned assets or shares; or

(d) Other situations provided by the Ministry of Finance or State Administration of Taxation.

KW Comments: The implementation of the Notice resolves the confusion of the enterprise income tax rules regarding merger and acquisition after the new Enterprise Income Tax Law and its Detailed Implementation Rules enacted since January 1, 2008. According to the Notice, general restructuring should recognize and be responsible for enterprise income tax, while special restructuring may enjoy tax-deferred payment.In addition, the transferring at cost method within a group was denied by the Notice. Most importantly, the Notice stipulates that the calculation of tax basis must be of fair market value of shares or assets.Essentially, this stops the past practice of a transferor deducting the retained earnings from share consideration.


4. Tax Rules on Liquidation released

(Notice on Several Issues regarding Enterprise Income Tax in relation to Enterprise Liquidation, Caishui [2009] No. 60, announced on April 30, 2009, and effective from January 1 2008)

The enterprise liquidation income tax treatment is the treatment of the liquidation income, liquidation income tax, and dividends distribution when an enterprise suspends its business operations, disposes its assets or distributes the remaining assets to its owners.When computing liquidation income, the realizable property or transaction value of the total assets of the enterprise is subtracted by the tax basis, liquidation fees, relevant taxes and fees, plus the profit from debt settlement.The amount of remaining assets distributed to shareholders equal to the undistributed profits and surplus reserves should be recognized as dividends; the difference between remaining assets and dividends or investment cost would constitute either capital gains or loss of the investment.

KW Comments: A company may undergo liquidation because of the expiration of a business term, the dissolution decision from the shareholder's meeting, the revocation of the business license, etc. Along with Circular No. 59, other liquidation income tax treatment situations for an enterprise and its shareholders arise: (1) when an enterprise either changes from a legal entity to a non-legal entity such as a sole proprietorship or partnership enterprise, or removes its the registered address to outside of China, such as Hong Kong, Macau and Taiwan; (2) when required by law in a merged enterprise during general restructuring; (3) when a split enterprise seizes operation during general restructuring.

In this Circular, it is worth noting that dividends and capital gains make up a shareholder's income tax.While in this Circular, the retained earnings of capital gains are tax-deductible, the same earnings are not tax-deductible in Circular No. 59.