China: Case study – indirect share transfer

Chinese entities are often indirectly transferred in M&A cases. Such an indirect share transfer of a Chinese company could also trigger capital gains taxation issues in China. The Chinese tax authority would assess local taxes if the indirect share transfer has commercial reasonableness or is arranged for the reason of tax benefit shopping.

The indirect share transfer without a reasonable commercial purpose can be re-characterised as a direct share transfer and taxed in China. We illustrate here an indirect share transfer case which has triggered the capital gains tax in China.

In 2022, a German company purchased 100% of the shares in a Hong Kong company (company A). Company B, the Chinese subsidiary wholly owned by company A, was indirectly transferred in the acquisition. Neither the buyer nor the seller paid the corresponding withholding tax for the share deal to the Chinese tax authorities.

Whether the share transfer had the reasonable business purpose became the most controversial point between the tax authorities and the seller. The tax authorities deemed that this share transfer did not have a reasonable business purpose by considering the following facts:

• The main equity value of company A (around 85%) was derived from company B.
• Company A’s long-term equity investment in company B accounted for more than 90% of its total assets.
• Company A was only a shell company to hold the shares in company B. Company A did not conduct any active business in Hong Kong. There was no recruitment of employees, office, operating expense or income of any kind in Hong Kong.
• The share transfer was nominally a transfer of equity interests in company A, but in essence, it was carried out to transfer the equity interests in company B.
   

Finally, based on the tax notice issued by the tax authority, 10% withholding tax was imposed on the capital gain derived from the share deal. The German buyer was also punished because it failed to withhold the corresponding taxes arising from the deal.

When an overseas acquisition results in a transfer of a Chinese entity indirectly, the deal parties are advised to check whether there are any tax implications in China and assess the deal on the following factors:

1. If the overseas enterprise has economic substance.
2. If the main value of the equity of the overseas enterprise is from taxable assets in China.
3. If the overseas enterprise’s income is mainly from China.
4. Existence of shareholders, business model and the relevant organisation.
5. Taxation in the country of the overseas enterprise on the deal.
6. Exchangeability between the indirect transfer of the Chinese enterprise and direct transfer.
7. Applicability of related tax treaties or arrangement applicable for the indirect transfer.

Furthermore, relevant parties (the seller, the buyer and the Chinese entity) of the transaction of indirect share transfer could report to the tax authorities beforehand as a good practice standard to eliminate the tax uncertainty in the share deal.

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