A Chinese merger & acquisition case with an eye-catching title has recently been reported on WeChat – “Tax Office Analysed Enterprise Group Packaged Transfer – ChangChun State Tax Bureau Solved the Difficult BEPS Question Posed by Packaged Share Transfer Using Tax Haven”. The Article stated that the source is from the ChangChun State Tax Bureau. The taxpayer was assessed additional Corporate Income Tax (“CIT”) of RMB 2.22million plus interest of RMB 310,000. Although not many details were provided in the Article, there are a few takeaway points that may be helpful to the readers.
Summary of the Article
In February 2010, the Chinese Party, a ChangChun Company, formed a 50/50 Sino-Foreign Equity Joint Venture (“JV”) in ChangChun with a Hong Kong Company (“HKCo”) for the manufacture and sale of electronic products and parts of motor vehicles and other products. The shareholding structure is as follows:
In January 2014, HKCo signed a Sale and Purchase Agreement (“SPA”) with a US company (“USCo”) to transfer its shares in the JV and other assets and shareholdings in companies related to motor vehicle electronic business to the USCo. The disposal was packaged deal involving shareholdings in 20 companies. The USCo replaced HKCo as the 50% shareholder of the JV, as below:
There was only one SPA covering the packaged transfer (including the 20 companies). As this was a direct transfer of a Mainland entity, ChangChun tax bureau had the taxing right on the gains derived by HKCo on the JV share transfer. CIT filing was made on the JV share transfer on the basis of No-Gain-No-Loss.
The share transfer was subject to Circular GuoShuiHan (2009) 698, which stated that when the foreign investor (actual controlling party) transfers shareholdings in companies located both inside and outside of China, the companies in China shall provide the SPA of the packaged transfer and the SPA for the transfer of each Chinese company to the in-charge tax bureau. If no separate SPA is available, the companies in China shall provide detailed information about each company being transferred, in order to precisely segregate the consideration of the transfer of each company involved. If it is not possible to precisely segregate the consideration, the in-charge tax bureau may adopt the reasonable method to adjust the transfer price.
The ChangChun tax bureau investigated the case and issued the “Notice on Tax Matters” to the JV requesting various information including: shareholding structure chart of the JV pre- and post-transfer, a report on the deal, method in determining the consideration, the SPA, separate SPAs for the individual companies, detailed information of each company included in the transfer, a chart showing the allocation of the consideration to each company transferred, the balance sheets, profit and loss accounts and cash flow statements of the JV for the previous 5 years, the medium-long term budget plan of the JV prepared in the year immediately before the share transfer, and an explanation of the commercial reasons for the packaged share transfer by the foreign investor.
Through consolidating and analysing the information provided and conducting interviews, the tax investigation team found the following facts: (1) HKCo and USCo were unrelated parties, the deal was conducted at arm’s length, and there were commercial reasons for the packaged share transfer; (2) before the deal, the financial position, operating results and cash flow of the JV were satisfactory, there were no special circumstances that would prevent the JV from continued operation, and the future prospect was positive, such that there was a risk that the No-Gain-No-Loss filing position adopted by the JV would understate the value of the company and thus posed a tax risk; (3) as there were no separate SPAs for the companies being transferred and no detailed information on the other 19 companies were provided, it was not possible to determine the value of the JV through an allocation of the deal transfer price; (4) the packaged transfer had in effect created the situation where gains from the transfer of individual companies would not be realised in the jurisdictions where they were located, and with the gains booked by the HKCo in Hong Kong, resulted in the actual utilisation of the benefits of a tax haven.
Additional Tax Assessment
After detailed investigation and rounds of negotiations, as HKCo did not provide separate SPAs or detailed information of the companies transferred, it was agreed that the consideration for the transfer of the JV shall be adjusted based on a reasonable methodology. The taxpayer and the tax bureau agreed to perform a valuation on the JV. The Market Approach was rejected on the basis that there was no sufficient market data available, and since the JV was at a stage of healthy development, the Cost Approach (Asset-based Approach) was considered inappropriate. The two sides agreed to adopt the Income Approach. The JV was accordingly valued at RMB 161,169,400, and the gain on 100% share transfer would be RMB44,361,244. The 50% share being transferred would result in a gain of RMB22,180,622元, and the additional CIT of RMB 2.22 million plus interest of RMB310,000 were assessed.
In this particular case, the Mainland tax office has all the rights to assess income tax on gains derived from the transfer of the JV alone (although the background facts have not mentioned, it seems likely that the other 19 companies sold were not Mainland entities). To determine the standalone value of the JV, the Income Approach is generally adopted and is widely applied in China in similar situations. The discount rate and other assumptions would have a significant impact on the tax liability, and the discussion with tax office could drag on. Depending on the stage of discussion, taxpayers may need to consider the interest costs, if applicable, against the benefits of standing firm on their negotiation position.
Package sale is very common and there are good reasons for the acquirer to buy the lot. There could be various contractual relationships with external as well as internal parties established, banking covenants, employees, licences, regulatory concerns etc. If there are companies that the buyer does not want to acquire, those companies would be carved out. The transaction value must, therefore, reflect the combined value of the Group acquired from the Buyer’s perspective. There may not even be a deal if the acquirer is only allowed to buy one particular company of the target group.
The question, therefore, is how to factor-in the group value into the pricing of the entity that is subject to tax on share transfer (the JV in this case). The JV was not sold on a standalone basis. One could argue that the assessment of income tax on the sale of JV based on a standalone sale model is not reflecting the arm’s situation. Notwithstanding, as the Seller did not provide information on the 19 companies sold to the Mainland tax office, it is not unreasonable for the tax office to ignore the 19 companies and assess tax on the JV disposal based on the stand-alone valuation of the JV as in this case. The fact that the Seller filed the tax return on the JV disposal on a No-Gain-No-Loss basis probably reflected that the other 19 companies might not be performing well, and some might even be loss-making.
The tax on disposal is payable by the Seller. It is therefore very important for the Seller to correctly assess the tax impact of the transaction before the deal is closed. Filing the tax return of the JV disposal in this case on the basis of No-Gain-No-Loss would be a somewhat aggressive position to take if the JV is making a profit. If the Seller genuinely believed that the tax office would accept the filing position, he was probably ill-advised, which cost him RMB 310,000 of interests.
Some helpful tips can be drawn from this case.
Seller – In a merger & acquisition deal, the Seller is often the party responsible for reporting for tax in jurisdictions where the transaction would be taxable. The Seller should, therefore, consult with tax advisors to understand the obligations, exposure, and formulate a strategy to manage the tax filing obligations and position. In the JV case above, other than preparing for the worse case scenario, the advisor should be creative in coming up with arguments of why the deemed disposal price of the JV is less than what the tax office would like to assess.
For example, these days the tax offices around the world are keen on reviewing the value-chain of the group and split up the taxable profits accordingly. Would it be possible to perform a similar analysis on the target group and allocate the deal price to each company (or jurisdiction) according to their value contribution, and put the numbers down onto SPA? Maybe a non-Mainland entity of the group holds intellectual property rights and thus a larger portion of the value should be allocated to it, and thereby reducing the taxable profits of the JV? Thinking-out-of-the-box is just the starting point, establishing convincing arguments and provide solid supporting including contracts and analysis are the keys to success. Obviously, the taxpayer has to be careful in whether such analysis would create issues for the past, present, and future tax filings in different parts of the world.
Buyer – The Buyer would also have a vested interest in how much tax the Seller is to pay even after the deal is closed. Why? The deemed disposal value assessed by the tax office could become the stepped-up cost-base of the company acquired. In the future disposal of the same company, the Buyer would deduct the stepped-up cost-base of RMB 80,584,700 (50% of RMB161,169,400). In theory, the more tax the Buyer pays now, the less tax that the Seller would pay in the future.
In the case of an indirect disposal involving Mainland entities, the Buyer may even have a withholding obligation on the tax that they Seller may need to pay under Public Notice 2015 No.7. The two sides must agree on action to be taken for completing the tax filing obligations. For indirect transfer case, even though the Buyer has no plan of disposal of the acquired companies in the foreseeable future, he should closely follow up with the Seller and obtain copies of the relevant tax filing records as soon as possible for two purposes: (1) be sure that the tax withholding obligation is no longer applicable; and (2) substantiate the cost-base of the Mainland company acquired.
Finally, it is interesting to note that the Article mentioned that “the packaged share deal transferred the gains to a tax haven, and avoided the reporting of tax at the location of the group entities”. According to the Article, Hong Kong is a tax haven, which is something that almost no Hong Kong taxpayer would agree. It reflects that some misunderstanding still exists between Hong Kong and the Mainland. Such misunderstanding would increase the challenges that Hong Kong taxpayers face when they negotiate with the Mainland tax authorities in a situation similar to this JV case. Also, in this particular case, as it is a Hong Kong company directly disposing of the equity in a Mainland enterprise, it is difficult to understand why there are BEPS concerns as mentioned in the Article. Given the mindset of the Mainland tax office as demonstrated in the Article, taxpayers should be prepared to fight the uphill battle in any tax negotiation.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 28 May 2018: https://manageyourtax.com/HKEJ Forum 11)
Ref: The Article (in Chinese only):