Research on the Standards of Reasonable Commercial Purposein Indirect Equity Transfers by Non-Resident Enterprises Liu Yujie

Research on the Standards of Reasonable Commercial Purposein Indirect Equity Transfers by Non-Resident Enterprises

Liu Yujie 

With the boom in cross-border investment, indirect equity transfers by non-resident enterprises have become a common way to avoid tax, which evades the corporate tax obligations, andreasonable commercial purpose is the core threshold for tax authorities to regulate suchtransactions. 

Announcement No. 7 published by China’s STA in 2015 is currently one of the primary policy bases for tax authorities' supervision and administration of indirect equity transfers by non-resident enterprises. According to Announcement No. 7, indirect equity transfer refers toatransaction where a non-resident enterprise transfers the equity of an overseas enterprise that directly or indirectly holds China's taxable property, resulting in a substantive outcome that is thesame as or similar to the direct transfer of China's taxable property. 

For such transaction, the key criterion for judging whether it constitutes an indirect property transfer as specified in Announcement No. 7 and whether it is subject to enterprise income tax inChina lies in whether the transfer has a reasonable commercial purpose. If a transfer lacks reasonable commercial purpose and is mainly for tax avoidance, the tax authority can “pierce thecorporate veil” and impose tax based on the substance of the transaction. 

In Announcement No. 7, it establishes safe harbor rules for identifying reasonable commercial purpose, namely the Green Port, Red Port, and Grey Port Rules. 

Green Port Rule means if an overseas equity transaction meets the conditions defined by the twoGreen Port safe harbor rules (Article 5 and Article 6 ), it shall be exempted from the obligationtopay enterprise income tax in China. 

Article 5 stipulates that trading shares of listed companies and applying tax treaty-basedexemption treatment do not constitute the evasion of corporate tax obligations; Article 6specifies that qualified intra-group restructurings can also directly determined to have areasonable commercial purpose. 

Red Port Rule conversely, means that if a transaction triggers the criteria of the Red Port safeharbor in Article 4, it will be directly determined to lack a reasonable commercial purpose andberequired to pay enterprise income tax in China. 

Article 4 stipulates four conditions: (1) equity value: over 75% of the value of the overseas enterprise’s equity is directly or indirectly derived from Chinese taxable property. (2) Assets or

income composition ：over 90% of the overseas enterprise’s assets or income in that year is directly or indirectly derived from China. (3) Economic substance：the overseas enterprise whichdirectly or indirectly hold Chinese subsidiary, despite being registered in their host regions andmeeting statutory organizational forms, perform limited functions and bear minimal risks, failingto prove they have economic substance. (4) Tax burden comparison: the income tax burdenof the indirect transfer transaction overseas is lower than the potential tax burden in China for thedirect transfer of the same Chinese taxable property. 

Grey Port Rule means if a transaction neither meets the Green Port criteria nor triggers the RedPort negative list, it shall be subject to a comprehensive assessment based on the eight relevant factors listed under the Grey Port Rules in Article 3. Indicators include: (1) Whether the mainvalue of the overseas enterprise's equity is directly or indirectly derived from Chinese taxableproperty. (2) Whether its income is mainly derived from China. (3) Whether the actual functions performed and risks borne by the overseas enterprise and its subsidiaries which directly or indirectly hold Chinese taxable property can prove the economic substance of the enterprisestructure. (4) The justification of the whole structure and its business model. 

Although there is a set of safe harbour rules, in real cases there are still many ambiguities. For example, in practice, when calculating the percentage of value and assets under red port rule, adopting a book value or fair value standard can lead to a totally different consequence to thetaxpayers. 

Besides, in normal business operations, overseas enterprises may incur losses and the proportionof their domestic assets may exceed 90%. Even if such situations may indeed have commercial rationality, if tax authorities rigidly and inflexibly apply paragraph three of the Red Port Rule anddetermine that the proportion of domestic assets exceeds 90%, it may lead to unreasonablejudgment results that are also unfavorable to taxpayers. 

Therefore, in deciding whether there is a commercial reasonable, more detailed guidance is needed to clarify those standards. Moreover, the authorities shall focus more on the combinationof the principle of taxation legality and the principle of substantive taxation, avoiding rigidly interpreting the law and regulations, achieving fairness in individual cases.