A Simple Research about the Internal Logic behind China’s Special Tax Treatment for Cross-Border Corporate Restructurings/Yu Bingqing

A Simple Research about the Internal Logic behind China’s Special Tax Treatment for Cross-Border Corporate Restructurings

/Yu Bingqing

This report focuses on analyzing the internal logic behind the special tax treatment for cross-border corporate restructurings in Circular [2009] 59, which ranges from relaxed to strict control as it moves from purely foreign, to semi-foreign, to purely domestic restructurings, based on "tax sovereignty risk." The report also compares key points with EU regulations.

1. The objective of Circular [2009] 59: Distinguishing

The core goal of Circular [2009] 59 is to distinguish between a "genuine sale" (which is to be taxed normally) and an "internal restructuring" (which can be tax-deferred), the aim of which is to achieve tax neutrality. 

To compare, we have learned that the objective of TMD is to foster a unified market by removing tax obstacles which hinder cross-border corporate restructuring in EU.

The objective is crucial because it determines the framework and the rationale of the following classifications and conditions.

2. The framework of Circular [2009] 59: Two Modes

Circular [2009] 59 divides tax treatment of corporate restructurings into two categories: the general treatment and the special treatment, which this report sees as the "default mode” and the "preferred mode”. The former is immediate taxation, and the latter is deferred taxation, by allowing the transferee to inherit the book value of the transferor as the tax base. 

In comparison, the deferral treatment granted by TMD, on the contrary, is the default mode, which is align with objective of TMD. But there are some excluded scenarios:

(i) the main purpose is tax avoidance;

(ii) interruption of effective connection of a PE(“branch requirement”);

(iii) when immovable property involved;

(iv) purely domestic situations.

However, in common, both regimes allow taxpayers to opt for immediate taxation.

3. Five cumulative conditions for switching from “Default Mode” to “Preferred Mode” in Article 5 of Circular [2009] 59:

1. reasonable business purpose and must not be primarily aimed at reducing, deferring, or exempting tax payments; 

2. the proportion of assets or equity being acquired, merged, or spun off must be no less than 75%; 

3. continuity of business activities within 12 months after the reorganization;

4. the equity portion of the consideration must be no less than 85%; 

5. non-transfer of the equity received by major shareholders within 12 months after the reorganization. 

4. The key additional conditions cross-border corporate restructurings: 

Although Article 7 of Circular [2009] 59 formulates four types of cross-border corporate restructurings with corresponding conditions, this report categorizes into 3 levels:

The first and strictest level, under paragraph 1 of article 7, involves a non-resident company transferring equity of a resident company to another non-resident. It requires 100% direct control, no change to future withholding tax obligations, and a three-year lock-up commitment.

The second level, in paragraph 2 and 3 of article 7, where a resident enterprise invests to a non-resident or a non-resident transfers its equity in a resident enterprise to another resident. These two scenarios merely requires 100% direct control. The leniency is justified because foreign assets or tax base are injected inbound.

The last level, which is the most lenient, in paragraph 4: technically it is a catch-all provision for relevant authorities to handle special cases not covered, but practically the risk and intensity are determined on a case-by-case basis, which I see as flexibility.)

In conclusion, Article 5 of circular 59 is like a safe harbor with 5 cumulative conditions, to provide certainty. And Article 7 serves as a “watchdog” to prevent cross-border abuse. The four categories, or this report defines as 3 levels, arranged from the strictest to the most lenient, according to their level of “tax sovereignty risk” expressively form a clear hierarchy. Compared with the TMD, one of the 3 directives based on the EU’s pooled sovereignty, Circular 59 is not just a preferential regime but a systematic and indicative firewall.