Disposals of Investments in China

　　This article discusses the PRC tax consequences for a foreign investor onthe disposal of its interest in a foreigninvestedenterprise (FIE) (i.e. a whollyforeign-owned enterprise， an equity jointventure or a legal person cooperativejoint venture) or a foreign-invested partnership(FIP). A representative office (RO)cannot be transferred to a third party ora related party； if a foreign investor doesnot intend to maintain its RO， it mustclose the RO. Since foreign investorsfrequently hold their interests in an FIEthrough an offshore holding company，we focus on the PRC tax implicationsof direct transfers of FIEs/FIPs， as wellas indirect transfers of such entitiesthrough the transfer of the offshorecompany. In both situations， the contentwill be limited to foreign investors thatare corporate entities.

　　Direct transfer of equity interestin an FIE

　　Capital gains derived by a foreign parentcompany from the transfer of its interestin an FIE are considered PRC-sourceincome and subject to a 10-percent PRCwithholding tax， provided the parentcompany does not have a permanent establishment(PE) in China， or if the parentcompany does have a PE， the income isnot effectively connected with the PE.

　　Capital gains are calculated as theconsideration paid for the equity transfer，less the cost of the equity interest.The consideration paid for the equitytransfer is the total amount receivedby the transferor， including cash andnon-monetary assets. The cost of theequity interest is the original amountpaid by the transferor to the FIE as acapital contribution， or， if the transferoracquired its interest in the FIE in a priortransfer， the amount paid by the currenttransferor to the previous transferor asthe consideration.

　　An exemption from the withholdingtax on capital gains may be available incertain cases.

　　Direct transfer of interest in an FIP

　　As mentioned in our last article， an FIPis a relatively new business vehicle availableto foreign investors， and the taxrules governing partnerships in Chinaare not yet fully developed. Thus， thetax treatment of gains or losses derivedfrom the transfer of a foreign investor’sinterest in an FIP is not covered in thecurrent PRC tax laws and regulations. Asforeign investors start to use FIPs morefrequently， the issue will need to beaddressed.

　　Indirect transfer of equity interestin an FIE

　　Gains derived from the transfer of anoffshore holding company by a foreigninvestor are non-PRC source incomeand， thus， should not be subject to PRCwithholding tax， unless China’s generalanti-avoidance rule (GAAR) applies. TheGAAR was introduced into the EnterpriseIncome Tax Law in 2008， when thenew law took effect， and in 2009， theState Administration of Taxation (SAT)issued guidance on the application ofthe GAAR in Circular 698.

　　According to Circular 698， if theactual tax burden in the jurisdiction ofan offshore intermediary holding companybeing transferred is less than 12.5percent， or if the jurisdiction in whichthe offshore intermediary holding companyis resident grants an income taxexemption for foreign-source income，the nonresident investor will be subjectto documentation requirements. Usingthe “substance-over-form” principle， theChinese tax authorities can disregardthe existence of an offshore intermediaryholding company if it lacks businessobjectives and was established for thepurpose of avoiding taxes. Once the offshoreholding company is disregarded，the transaction will be re-characterizedas a transfer of the underlying PRC companyand， thus， the gains derived fromthe transaction will become PRC-sourceincome subject to PRC withholding tax.While Circular 698 creates some legalquestions as to whether the ChineseGovernment has the right to tax foreigncompanies and/or require them tosubmit information that may or may notbe relevant to Chinese enterprises， in anumber of cases， the PRC tax authoritieshave taxed foreign companies ontheir gains from indirect transfers. Thus，foreign investors， including strategicinvestors and private equity funds， nowhave greater administrative and complianceburdens when using offshore companiesas vehicles to invest in China.

　　The SAT is drafting supplementalrules on indirect transfers， which likelywill contain two major improvements： (i)the threshold for triggering the documentationrequirement will be raisedso that fewer foreign companies will becaught by the indirect transfer rules；and (ii) a safe harbor will be provided forqualified intra-group reorganizations，which will exempt such reorganizationsfrom PRC capital gains and requireless documentation. These rules areexpected to be issued in 2014.