An interesting indirect transfer case was recently reported in Tax Planning, one of the official journals of the SAT. In the Shenyang case, a Cayman seller (company F) transferred a Mauritius subsidiary (company C) to a BVI buyer (company P) on 30 June 2008. Company C held 26.3% of the listed shares of a Shenyang retail company, Listco, listed on the Shenzhen Stock Exchange. Company C, after being acquired by Company P, sold some of the shares of Listco in 2010.
During an investigation against Listco on dividend withholding tax, the Shenyang State Tax Bureau (SSTB) discovered the 2008 indirect transfer and started a Notice 698 investigation.
Company F argued that Notice 698 should not apply because the indirect transfer had reasonable commercial purpose and company C did not abuse the corporate form. Specifically, company F argued that: (1) company C was established in a jurisdiction with a well established legal system that protects group investments; (2) company C had functions that included collecting information and analysing investment projects; and (3) company C assumed the risks in holding Listco’s restricted shares for 30 months before the indirect transfer.
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According to the report, the SSTB had difficulties in collecting evidence from publicly available information to rebut company F’s arguments. However, the bureau discovered from the transactional documents that the transfer price of company C was determined by using the average price of Listco’s listed shares during the 30-day period before closing. The SSTB decided to ignore the questions on reasonable commercial purpose and abusive form under Notice 698. Instead, it applied the “substance over form” principle to see through the indirect transfer and applied paragraph 3 of article 3 of the Enterprise Income Tax Law, which provides that a non-resident enterprise that does not have a place or establishment in China should pay tax on China-sourced income. In other words, the SSTB concluded that, in substance, the income derived from the transfer of company C was China-sourced income because the transfer price was determined by the value of Listco, which was located in China.
This case has certain similarities to the Shenzhen non-resident individual indirect transfer case discussed in the June/July 2012 issue of our China Tax Monthly. In the Shenzhen case, a Hong Kong resident transferred a Hong Kong company in an offshore share deal. The Hong Kong company’s only asset was a Shenzhen warehousing company. The SAT concluded that the subject of the transfer under the share purchase agreement (SPA) included assets of both the Hong Kong company and the Shenzhen company, and therefore income derived from the transfer of the Shenzhen company’s assets located in China should be considered PRC-sourced income and taxable in China.
However, the SSTB was much more aggressive in the Shenyang case than the SAT was in the Shenzhen Case. In the Shenzhen case, the SAT levied tax based on the argument that the SPA in the transaction showed that the subject of the offshore transfer included assets located in China. The SAT did not need to apply the general anti-avoidance rules to re-characterise the transaction. In the Shenyang case, on the other hand, the subject of the transfer is clearly company C, a Mauritian company, under the transactional documents. Because the transfer price was determined by the value of Listco, the SSTB applied the substance-over-form principle to re-characterise the transaction as a direct transfer of the shares of Listco. Without the re-characterisation, the SSTB could not reach the conclusion that the income derived from the transfer of company C was China-sourced income.
The fundamental question under the general anti-avoidance rules is whether a transaction has reasonable commercial purpose. The substance-over-form principle is only a method under the general anti-avoidance rules to re-characterise a transaction. Notice 698 also clearly provides that China’s tax authorities can apply the substance-over-form principle to re-characterise an indirect transfer as a direct transfer and levy tax when the indirect transfer does not have reasonable commercial purpose and abuses the corporate form. Nevertheless, the SSTB somehow concluded that it could skip the step of determining whether a transaction has reasonable commercial purpose and directly apply the substance-over-form principle to re-characterise the transaction.
The Shenyang case made some positive progress on the tax basis issue. Because Notice 698 does not provide clear guidance on how to determine the tax basis, a risk of double taxation exists in a series of indirect and direct transfers. In the Shenyang case, in determining the tax basis of the subsequent sale of the Listco shares by company C after company P acquired company C from company F, the SSTB recognised the purchase price of company C paid by company P to company F as the tax basis of the Listco shares in the subsequent sale by company C. This approach effectively avoided double taxation in a series of direct and indirect transfers. Hopefully, this approach can be adopted by other localities and codified by the SAT in supplementary rules to Notice 698.
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Business Law Digest is compiled with the assistance of Baker & McKenzie. Readers should not act on this information without seeking professional legal advice. You can contact Baker & McKenzie by e-mail at: Zhang Danian (Shanghai) danian.zhang@bakermckenzie.com
