Meaning
Regulatory guidance issued by the state administration of taxation governs the reporting and taxation of indirect transfers of chinese taxable assets by non resident enterprises through offshore intermediaries. This circular 7 establishes the principle that if an indirect transfer of assets lacks a reasonable commercial purpose and aims to avoid chinese enterprise income tax, the transaction should be recharacterized as a direct transfer. The scope of this rule includes equity in a chinese resident enterprise, assets of a chinese establishment and real estate located within china.
Tax authorities examine the entire chain of offshore entities to determine if the intermediate company has any economic substance or if it exists solely to facilitate the transfer of ownership. If the transaction is deemed taxable, the transferor is liable for enterprise income tax on the gains realized from the sale. The regulation applies regardless of where the transaction takes place or the jurisdiction of the participating entities.
Substance Assessment
Evaluation of the commercial rationale behind a multi layered corporate structure is the primary tool used by tax officials to identify potential tax avoidance. Under circular 7, the authorities look for evidence that the offshore holding company performs significant functions, holds tangible assets or employs a sufficient number of personnel to justify its existence. If the company is a mere shell with no active business operations, the tax office may disregard its role in the transaction.
This assessment considers the duration of the holding period and the history of the group’s corporate structure. A transfer that occurs shortly after the creation of an offshore entity is more likely to be scrutinized than one involving a long established subsidiary with its own independent revenue streams. The burden of proof often falls on the taxpayer to demonstrate that the structure was not created for the primary purpose of reducing tax liabilities.
Reporting Obligation
Voluntary disclosure of an indirect transfer allows the parties involved to manage their tax risks and avoid the penalties associated with non compliance. Although circular 7 does not mandate reporting, it provides a safe harbor for those who choose to notify the tax authorities within thirty days of signing the transfer agreement. This notification involves submitting the share transfer contract, the organizational chart of the group and a written explanation of the commercial purpose of the deal.
If the authorities later determine that the transaction is taxable, the parties who reported the deal may benefit from a reduction in interest charges on the unpaid tax. Failure to report can lead to the imposition of significant penalties on both the transferor and the transferee, especially if the transferee fails to withhold the tax due. Most multinational corporations now include tax indemnity clauses in their sale and purchase agreements to address the potential liabilities arising from these rules.
Tax Liability
Calculation of the tax due depends on the fair market value of the chinese assets being transferred and the cost basis of the offshore shares. When circular 7 is applied, the gain is calculated as the difference between the sales price and the original investment cost, adjusted for any capital injections or distributions. The standard tax rate for such gains is ten percent, which is the same rate applied to direct transfers of equity by non resident enterprises.
Payment of the tax is usually handled through a withholding mechanism where the buyer deducts the amount from the purchase price and remits it to the chinese tax bureau. If the buyer fails to withhold, the seller must report and pay the tax directly. The enforcement of these rules has become more stringent as tax authorities increase their cooperation with international counterparts to track cross border mergers and acquisitions.
Tax settlements reached under this regulation are final and provide the parties with legal certainty for their future operations in china.
