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Yongjun Peter Ni
White & Case
China

Yongjun Peter Ni of White & Case discusses the long-awaited new rules on reorganisations

As the Chinese economy, the third largest in the world, further expands, both Chinese and foreign investors are adopting more and more sophisticated deal structures and strategies, such as enterprise reorganisations, to achieve their business goals. In China, the term enterprise reorganisation is defined as a transaction that is beyond the normal operations of an enterprise and results in a material change to the legal or economic structure of the enterprise. The main forms of enterprise reorganisations include:

• Change in legal form (for example, change in name, registration address and form of legal entity);
• Debt restructuring schemes (for example, debt forgiveness and debt-to-equity swap);
• Share acquisitions;
• Asset acquisitions;
• Mergers; and
• Spin-offs.

China used to have separate reorganisation rules for foreign investment enterprises and domestic investment enterprises. The two sets of rules were repealed when the new Enterprise Income Tax Law (EITL) became effective on January 1 2008. The EITL applies to all enterprises in China equally, whether they are foreign owned or domestically owned.

Tax treatment of reorganisations under the EITL

The new EITL and its related implementation regulations contain only general principles on reorganisations. The EITL authorises the Ministry of Finance (MOF) and the State Administration of Taxation (SAT) to come up with detailed rules.

In May 2009, after almost one and a half years since the EITL was enacted in May 2009, the MOF and SAT finally released detailed income tax rules on enterprise reorganisations in the form of a circular, the Circular on Certain Questions regarding the Enterprise Income Tax Treatment of Enterprise Reorganisations (Circular 59). Circular 59 sets out detailed guidance on the income tax treatment of reorganisations and takes retroactive effect from January 1 2008.

Under Circular 59, enterprise reorganisations are subject to either (i) general tax treatment (taxable) or (ii) special tax treatment (non-taxable). Unless a transaction qualifies for special tax treatment, the general treatment applies, that is, the transaction will be taxable.

In general, if a transaction meets certain conditions, no gain or loss is recognised at both the shareholder level and the enterprise level. Any unrecognised gain or loss is reflected in the substituted basis of the equity consideration received by a shareholder or an enterprise and is preserved for recognition in a subsequent taxable disposition.

Although not expressly stated in Circular 59, it is quite clear that the Chinese tax authorities have adopted the notion of "continuity of investment" that is widely recognised in other countries, that is, investors are viewed as preserving their interest in a business enterprise through continuing equity ownership, regardless of the change in corporate form.

Taxable reorganisations

If a transaction does not qualify for special tax treatment, the party that disposes of the assets or liabilities will be subject to enterprise income tax (EIT) on any gain recognised from the transaction. The EIT rate applicable to a Chinese resident enterprise is 25% on both capital gains and ordinary income.

If the seller is a non-resident, unless it has a taxable presence in China and the gain is connected to that taxable presence, in which case the tax rate will be 25%, the applicable rate is 10%. Under the EITL, a foreign company is treated as a nonresident, unless the foreign company is effectively managed in China. If a foreign company's substantial management and control over its operations, staff, accounting and property is exercised in China, it would be treated as a Chinese tax resident.

The general tax treatment applicable to the various forms of reorganizations is discussed below.

Change in legal form

If an enterprise that is a legal person (as opposed to an individual proprietorship or partnership) is converted to an individual proprietorship or partnership, or if an enterprise changes its domicile, such as registration address, from within mainland China to outside mainland China (including Hong Kong, Macau and Taiwan), such a change in legal form shall be treated as a liquidation of the old enterprise, followed by a distribution of its assets to its shareholder(s) and a subsequent contribution of such assets to the new enterprise. The parties shall recognise a gain or loss based on the fair market value of the relevant assets.

However, if it is a simple change in legal form, such as a change of name, a change of registration address within the PRC territory (that is, mainland China, excluding Hong Kong, Taiwan and Macau), or a change in the legal form of the entity such as from an equity joint venture to a cooperative joint venture, the general tax treatment will not apply. The enterprise can simply modify the tax registration and generally all the tax attributes will remain the same.

Debt restructuring schemes

If nonmonetary assets are used to repay debts, the transaction shall be treated as a sale of assets at fair market value, followed by a repayment of debt.

Debt-to-equity swap transactions shall be treated as a repayment of debt, followed by an equity investment.

In both cases, a gain or loss shall be recognised to the extent of the difference between the repayment amount and the debt basis.

Share and asset acquisitions

The seller shall recognise a gain or loss upon the sale of shares or assets. The buyer's tax basis in the acquired shares or assets shall be determined based on their fair market value, that is, on a stepped-up basis. The tax attributes of the target shall generally remain the same in the case of a share acquisition.

Mergers

The basis of the assets and liabilities of the acquirer (that is, the surviving enterprise) after the merger shall be determined based on their fair market value, that is, on a stepped-up basis.

The merger shall be treated as a taxable liquidation for the target enterprise and its shareholders.

In a taxable merger, the losses of the target cannot be carried forward to the acquirer.

Spin-offs

A spin-off enterprise shall recognise a gain or loss based on the fair market value of the assets disposed of. The spun-off enterprise(s) shall also determine the basis in the assets received based on their fair market value.

If the spin-off enterprise continues to exist, the consideration received by its shareholders is treated as a taxable distribution by the spin-off enterprise. If the spin-off enterprise ceases to exist, it shall be treated as being liquidated.

In a taxable spin-off, the losses of the spin-off enterprise cannot be carried forward to the spun-off enterprise(s).

Tax-free reorganisations

If all of these five tests are met, Circular 59 allows enterprises to elect for special tax treatment:

• The "business purpose" test whereby the reorganisation must have reasonable business purposes and the main purpose is not to reduce, avoid or defer tax;
• The "substantially all" test whereby the shares or assets acquired are not less than 75% of the total shares or assets of the target;
• The "equity consideration" test whereby no less than 85% of the total consideration must be in equity form;
• The "continuity of business enterprise" test whereby the substantial operations of the target must not change within 12 consecutive months after the reorganisation; and
• The "continuity of propriety interest" test whereby the main shareholders receiving equity as consideration must not transfer such equity within 12 consecutive months after the reorganisation.

If the special tax treatment applies, then to the extent the reorganisation is paid in equity, no gain or loss shall be recognised and all the assets and liabilities shall have a carry-over basis. A gain or loss shall be recognised for the portion of the reorganisation paid in cash or other property, which is commonly referred to as "boot" in other countries, based on this formula:

• Gains or losses = (Fair market value of the transferred assets – Tax basis in such assets) x (Boot amount ÷ Fair market value of the transferred assets)

The specific tax treatment of each form of reorganisation that qualifies for the special tax treatment is discussed below.

Debt restructuring schemes

If the debt restructuring income accounts for more than 50% of the total taxable income of an enterprise in a tax year, the income can be spread evenly over a five-year period.

As a temporary concession, a debt-to-equity swap does not trigger any gain or loss recognition for the time being. The equity received by the creditor will carry a basis equal to its original basis in the debt.

Share and asset acquisitions

For the shareholders of the target, the basis in the equity received will be determined based on their original basis in the equity or assets sold, that is, on an exchange basis.

The basis of the acquirer in the target shall also be determined based on the target's shareholders' original basis in such equity or assets.

The basis of other assets and liabilities of the target and the acquirer (commonly known as "inside basis") as well as all the tax attributes shall remain the same.

Mergers

The acquirer's basis in the acquired assets and liabilities shall be determined based on the target's original basis in those assets and liabilities, that is, on a carryover basis.

All the tax attributes of the target shall be carried over to the acquirer, except that the carryover of the losses of the target is subject to this limitation:

Limitation = Fair market value of the net assets of the target x Interest rate of the longest term government bond issued by the State as of the end of the year of the merger

The basis of the shareholders of the target in the equity received shall be determined based on their original basis in the target, that is, on an exchange basis.

Spin-offs

The spun-off enterprise's basis in the assets and liabilities received shall be determined based on the spin-off enterprise's original basis in such assets and liabilities, that is, on a carryover basis. The tax attributes attributable to the above assets shall also be carried over to the spun-off enterprise.

The losses of the spin-off enterprise that are allocated to the spun-off enterprise based on the ratio of the spun-off assets to the total assets can be carried over to the spun-off enterprise.

For the shareholders of the spin-off enterprises, the determination of their basis in the equity received (new equity) shall depend on whether they surrender their original equity in the spin-off enterprise (old equity). If the shareholders surrender all or a portion of the old equity, their basis in the new equity shall be determined based on the basis in the surrendered equity, that is, on an exchange basis. Otherwise, the basis in the new equity can be determined in the following way:

• To deem the basis in the new equity to be zero; or
• To reduce the basis in the old equity based on the ratio of the spun-off assets to the total assets and allocate the reduced amount evenly to the new equity.

Cross-border reorganisations

The special tax treatment rules discussed above apply to reorganisations taking place within mainland China. To elect for special tax treatment in cross-border reorganisations, the reorganisation must meet certain other conditions in addition to the five tests discussed above.

Foreign to foreign transfers of equity in a Chinese enterprise

Circular 59 provides that when a foreign enterprise transfers its equity in a Chinese enterprise to a related foreign enterprise, the special tax treatment is available only when these three additional conditions are met:

• The transferor must have a 100% direct ownership in the transferee;
• The transfer must not result in a reduction in the Chinese withholding tax on capital gains from future exit; and
• The transferor undertakes in writing that it will not sell the equity in the transferee within three years after the transfer.

The new rules are much more restrictive than the old ones. Under Circular [1997] 207 which has been repealed, the transfer of a Chinese subsidiary within a 100%- controlled group was much easier because neither the 100% direct ownership requirement nor the capital gains tax neutral requirement was applicable.

Foreign to domestic transfers of equity in a Chinese enterprise

Where a foreign enterprise transfers its equity in a Chinese enterprise to a related enterprise in China (for example, a Chinese holding company), the special tax treatment is available only if the transferor has a 100% direct ownership in the transferee, in addition to meeting the five tests discussed above.

Outbound investments

When a Chinese enterprise makes outbound investments using its assets or equity, the special tax treatment is available only if the Chinese enterprise has a 100% direct ownership in the investee enterprise in addition to meeting the five tests discussed above.

Furthermore, if a gain is recognised from the investment, such a gain can be spread evenly over a 10 year period.

In all other circumstances involving cross-border reorganisations, the special tax treatment is available only upon special approval of the MOF or the SAT.

Special rules on tax incentive carryover

Foreign investment enterprises in China are often entitled to various income tax incentives such as reduced tax rates and tax holidays. Whether and how tax incentives can be carried over is therefore a critical issue. Circular 59 provides for special rules on tax incentive carryovers in the case of a merger or spin-off.

If the merger is an absorption merger, that is, an existing enterprise merges into another existing enterprise with the former being dissolved, then provided that the latter's business operations and conditions for enjoying the tax incentive remain unchanged, the surviving enterprise can continue to enjoy its incentive regardless of the tax treatment of the merger (that is, whether taxable or non-taxable), subject to a cap.

Similarly, in the case of a spin-off, if the spin-off enterprise continues to exist after the spin-off, provided that its business operations and conditions for enjoying the tax incentive remain unchanged, the surviving enterprise can continue to enjoy its incentive regardless of the tax treatment of the spin-off (that is, whether taxable or non-taxable), subject to a cap.

The cap in the case of the absorption merger is equal to the amount of the taxable income of the surviving enterprise in the year before the merger. The cap in the case of spin-offs is equal to the amount of the taxable income of the spin-off enterprise in the year before the spin-off, multiplied by the ratio of its remaining assets after the spin-off to the total assets before the spin-off. If the enterprise incurs a loss in the year before the merger or spin-off, the cap is deemed to be zero.

Step transaction notion

Circular 59 also provides that, under the substance over form principle, a series of formally separate steps taking place within a 12-month period before or after the reorganisation shall be collapsed and treated as if they constituted a single integrated transaction.

Documentation requirements

If an enterprise wishes to elect for special tax treatment, it must file its annual tax return together with relevant supporting documents to the relevant tax authorities once the reorganisation is completed.

The documents should substantiate the enterprise's qualifications for tax-free treatment and failure to file such documents will result in the denial of the special tax treatment.

Long awaited

Circular 59 is a long-awaited circular that provides specific rules on reorganisations in the wake of the enactment of the EITL.

However, Circular 59 does not address all the issues regarding reorganisations. For example, it is unclear whether the carryover limit of the losses of the target is an annual limit or one-time limit in the case of a merger that qualifies for special tax treatment. Furthermore, it is unclear if the losses of the acquirer can be carried over and if so, whether there is any similar limit. Another example of uncertainty is whether the tax incentives of the target can be carried over in the case of merger.

As a result, as Circular 59 is implemented and as the tax authorities gain more and more experience, it is expected that the SAT will issue follow-up circulars to clarify the unaddressed issues as well as other issues arising from its implementation.

Peter Ni (yni@whitecase.com) A version of this article was first published in the September/October 2009 issue of the Asia-Pacific Tax Bulletin.