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As foreign investors continue to seek out investment opportunities in China, there is a need for greater awareness of the implications of recent tax law developments, particularly with respect to the economic substance of and business purpose for using offshore holding structures. These developments are contained in the circulars Guoshuihan 601 and Guoshuihan 698.

These circulars were introduced by the State Administration of Taxation to regulate and tax certain transactions or arrangements which had previously enjoyed tax treaty relief or were otherwise not subject to PRC tax, particularly where offshore holding structures are used. Both circulars were issued in 2009, although Circular 698 has retrospective application as from 1 January 2008.

Both circulars are relevant in the wider context of the application of China¡¯s general anti-avoidance rules (GAAR), which were first introduced in January 2008 as part of the new corporate income tax law. The GAAR rules operate widely and give the tax authorities significant discretion in challenging transactions that are not undertaken with reasonable business purposes (i.e. where the taxpayer is primarily entering into the transaction to gain a tax benefit).

The circulars are also relevant to tax treaty relief procedures for foreign investors. Circular 601 has a significant impact on foreign companies that are investing in or earning passive income (dividend, interest and royalties) from China and where treaty relief is sought.

In the case of Circular 698, foreign investors need to be mindful of the reporting requirements and the potential tax liabilities arising from an indirect disposal of PRC companies at the offshore level.

Commercial substance

Circular 601 aims to prevent the abuse of tax treaty benefits. In essence, it only grants treaty benefits to entities that are regarded as the beneficial owner of China-sourced income. Offshore entities need to demonstrate that they have sufficient commercial substance, such as actual operations being undertaken and the employment of personnel in the tax treaty jurisdiction. They cannot be a mere corporate shell or a conduit entity.

In the context of Circular 698, the particular scenario that the tax authority is trying to scrutinize and challenge is the use by foreign investors of offshore holding structures for investing into China. Prior to Circular 698, investors could exit from an investment in the PRC at the offshore level through a sale of the offshore holding companies which ultimately hold the PRC resident company. Gains from an offshore disposal of this type traditionally do not require PRC regulatory or foreign exchange approval, and are generally considered to be outside the PRC tax net to the extent that neither the transferor nor the entity being transferred are PRC tax residents.

Circular 698 changes this. Firstly, foreign investors are required to disclose to the PRC tax authorities reportable transactions which involve an offshore disposal of a company that is subject to tax at an effective rate of less than 12.5% (or if the jurisdiction does not tax offshore income). Secondly, where the GAAR apply to the offshore disposal, the transactions would be subject to adjustment by the PRC tax authorities and treated as a taxable disposal of the underlying PRC company.

Circular 698 imposes a requirement on the seller to report to the PRC tax authorities. The obligation to settle any tax arising as a result of Circular 698 also lies with the seller. Practically, Circular 698 appears to have had some early success. A number of high-profile cases have been reported and negotiated with the PRC tax authorities, and PRC taxes have been imposed and collected.

Active role

For Chinese legal counsel with cross-border responsibilities, it will be worthwhile to consider the impact of Circulars 601 and 698 when designing or implementing offshore holding structures, corporate restructuring options or exit strategies.

In a situation where a legal counsel is advising a company acting as a buyer in an offshore transaction, and the counter-party has potential Circular 698 reporting obligations, it is advisable that the buyer does not merely assume a passive role in the transaction. It should ascertain the seller¡¯s position with respect to Circular 698 and make sure that the reporting obligation is properly discharged. It is also advisable for the buyer to build in some protective measures for itself when making the acquisition, either in the form of a tax indemnity, escrow account or insurance coverage to cater for the contingent Circular 698 liability.

For Circular 601 purposes, when a PRC company remits income from China to the overseas recipient, it will be required to withhold the requisite PRC taxes. Nevertheless, where the offshore recipient is resident in a jurisdiction which has a favourable tax treaty with the PRC, the prevailing PRC rules require the overseas recipient to lodge an application to the PRC tax authorities if it wishes to enjoy the treaty benefits or relief accorded under the applicable tax treaty. In practice, the Chinese payer may be asked to assist with this application. Due to its withholding obligation, it is expected that the Chinese payer would have a significant role in assisting the overseas recipient to make the application and provide the necessary evidence to the tax authorities.

When a PRC company seeks to list overseas via an IPO, the potential implications of Circular 698 should also be considered. The listing vehicle is likely to be an offshore company. Due consideration should thus be given to whether indirect disposal of PRC resident companies would be taken to have been effected and potential reporting obligations thereby to have arisen under Circular 698.

In short, in the case of overseas listings, M&A, introduction of new investors, share swaps and other transactions that involve changes in the direct or indirect ownership over a PRC investee company, the potential implications of Circular 698 should be considered carefully and mitigating actions taken.