A new milestone for taxation on Indirect Asset Transfer by Non-Resident Enterprises — a review of the past and present of bulletin 7

After several rounds of revisions and consultations in the past few years, the State Administration of Taxation (“SAT”) has recently promulgated the Bulletin on Several Issues concerning the Enterprise Income Tax (“EIT”) on Indirect Asset Transfer by Non-Resident Enterprises (“Bulletin 7”)[1]. Tax matters occurred but have not been settled before 3 February 2015, the date of implementation of Bulletin 7, shall be governed by Bulletin 7. Meanwhile, the relevant provisions of Guo Shui Han [2009] No. 698 (“Circular 698”)[2] and SAT Bulletin [2011] No. 24 (“Bulletin 24”)[3] concerning indirect equity transfers shall be revoked accordingly.

In accordance with Bulletin 7, indirect transfer of China taxable assets conducted by non-resident enterprises through arrangements that do not have reasonable commercial purposes, which results in avoidance of EIT, shall be deemed as direct transfer of China taxable assets and thus subject to tax in China. As an upgrade to Circular 698, Bulletin 7 shall have profound impacts on the tax costs, investment structuring and exit plan of foreign enterprises making investments into China and of domestic enterprises setting up “red-chip” structures for overseas listings.

In this article, we will review the past and present of Bulletin 7 in order to enable our readers to have a better understanding about the China tax implications of indirect transfer of China taxable assets (including equity interest) by non-resident enterprises.

The Past of Bulletin 7

Pursuant to Paragraph 3, Article 3 of the PRC Enterprise Income Tax Law (“EIT Law”), non-resident enterprises that have no establishments or places in China, or have establishments or places in China but the income derived by the enterprises has no actual connection with such establishments or places, shall be subject to EIT on the income sourced in China. Further, Paragraph 3, Article 7 of the Detailed Implementation Rules of the EIT Law provides that the source of income derived from transfer of equity investments shall be determined on the basis of the location of the enterprises being transferred.

In light of the above regulations, when a non-resident enterprise (“Company A”) transfers its equity interest in another non-resident enterprise (“Company B”), as Company B is located outside China and the income derived by Company A from the equity transfer is therefore sourced outside China, Company A shall not be subject to EIT in China.

However, Circular 698 (which was promulgated on 10 December 2009 with retrospective effect from 1 January 2008) and Article 6 of Bulletin 24 provided further guidance on the transfer of China equity interest by non-resident enterprises and caused significant change and impact on the foregoing principles. Circular 698 raised that where a non-resident enterprise indirectly transfers the equity interest in a Chinese resident enterprise through such arrangement as abuse of organizational structure and without reasonable commercial purposes, the tax authority may re-characterize such equity transfer in accordance with its economic substance, denying the existence of the intermediate holding company, and deem the non-resident enterprise to be directly transferring the equity interest in the Chinese resident enterprise and levy EIT (generally at 10%) on the capital gain derived by the non-resident enterprise.

Take the above-mentioned Company A and Company B as an example, assuming that Company B holds the shares of a Chinese enterprise (“Company C”), when Company A transfers its shares in Company B, if it is established that the transfer is lack of reasonable commercial purposes and Company B has no substantive business operations, the PRC tax authority may disregard Company B and therefore deem Company A to be directly transferring the shares of Company C, which is a Chinese resident enterprise. Then, Company A shall be subject to EIT on the capital gain derived from the share transfer. The structure of the transaction is illustrated as follows:

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Circular 698 was an important step marched forward by the PRC tax authority in the field of anti-tax avoidance. Since it involved division of the authority to levy taxes and cross-border tax jurisdiction, Circular 698 had drawn widespread attention and aroused controversy internationally since its promulgation. For indirect equity transfers, where the intermediate holding companies are usually incorporated in tax havens, no taxes would be levied in these jurisdictions; however, since the transferors may be taxed in their home countries, the tax levied by the PRC tax authority pursuant to Circular 698 on non-resident enterprises may lead to double taxation. As some developed countries do not admit the principle applied for the taxation on indirect equity transfers and double tax treaties could not be applied for the avoidance of such double taxation, this situation may cause extra tax burden on taxpayers.

Since the issuance of Circular 698, there have been more than 20 published cases, among which the highest amount of EIT levied was close to RMB500 million. Nevertheless, as Circular 698 only provided general guidance and principles and was lack of detailed implementation rules, in practice, there might be cases where the transferors of certain indirect equity transfer transactions had filed reporting to the tax authority under Circular 698, but the tax authority did not take any further action and the final official assessment was still pending.

The Present of Bulletin 7

Undoubtedly, Bulletin 7 is originated from Circular 698. It sets out clear guidance on such aspects as the application of general anti-avoidance rules (“GAAR”) to indirect asset transfers, the factors involved in determining the reasonable commercial purposes, the relevant tax obligation and legal liabilities, etc., which will, to a large extent, provide more certainty for both compliance by taxpayers and administration by the tax authority.

Compared with Circular 698, Bulletin 7 made changes in the following major aspects:

1. Expanding applicable scope

Circular 698, while focusing on indirect equity transfers, limited the reporting obligations to those transactions where the effective tax rate of the host country (region) of the offshore holding company that is being transferred is lower than 12.5% or if the host country (region) of the offshore holding company does not levy tax on the offshore income of its residents[4].

The applicable scope of Bulletin 7 is expanded from indirect transfer of equities to indirect transfer of China taxable assets. “Indirect transfer of China taxable assets” refers to those transactions where a non-resident enterprise transfers the equity or other similar interest of an offshore company (excluding overseas-registered Chinese resident enterprises[5]) which directly or indirectly holds China taxable assets, resulting in the same or a similar effect as that of direct transfer of China taxable assets, including the change in shareholders of offshore enterprises caused by restructuring of non-resident enterprises.

“China taxable assets”, as a newly-raised concept, refers to those assets which are held directly by non-resident enterprises and the income derived from the transfer of which shall be subject to EIT in China pursuant to the applicable tax laws, including the assets owned by the establishments or places of non-resident enterprises in China, immovable properties located in China and equity investments in Chinese resident enterprises. Such a concept is raised in line with the basic principle established by Bulletin 7 for the tax treatment of indirect transfer of China taxable assets, i.e. re-characterize an indirect transfer of China taxable assets to a direct transfer, and the China tax treatments of both scenarios should be same or similar.

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2. Adopting different applicable tax rates

Under Circular 698, if the intermediate holding company were disregarded, the offshore transferor would be generally subject to EIT at 10% on its income derived from the equity transfer.

Pursuant to Article 2 of Bulletin 7, depending on the specific situation, the tax treatment of the income derived by a transferor from transferring the equity of an offshore enterprise that is attributable to China taxable assets, should be handled in the following order:

The income attributable to the assets owned by the establishment or place set up in China by a non-resident enterprise or its subsidiaries which directly or indirectly hold China taxable assets, shall be regarded as the income connected with such establishment or place and be subject to EIT at 25%;
The income attributable to immovable properties[6] located in China, shall be regarded as the income derived from the transfer of immovable properties in China and be subject to EIT at 10%;
The income attributable to equity investment in a Chinese resident enterprise shall be regarded as the income derived from the transfer of equity investment assets in China and normally be subject to EIT at 10%.
It should be noted that if the value of the equity of an offshore enterprise being transferred is attributable to both China taxable assets and non-China taxable assets, the income derived from the transfer should be divided between the two types of assets based on reasonable methods, and only the portion attributable to China taxable assets shall be subject to EIT in accordance with Bulletin 7.

With reference to the interpretation rendered by the SAT for Bulletin 7, assuming that a Cayman Islands (“Cayman”) company holds China taxable assets as well as non-China taxable assets and its shareholder (a non-resident enterprise) obtains 100 from disposal of the equity in the Cayman company, if 80 is attributable to China taxable assets, then the non-resident enterprise shall be subject to EIT on the basis of 80; if 120 is attributable to China taxable assets while -20 is attributable to non-China taxable assets, the non-resident enterprise shall be subject to EIT on the basis of 120.

Nevertheless, Bulletin 7 does not specify the “reasonable methods” to be applied for the segregation of income between those attributable to China taxable assets and those attributable to non-Chinese taxable assets. In this regard, we expect the PRC tax authority to provide further guidance through published cases in the future (for example, dividing the income derived from equity transfer between China taxable assets and non-China taxable assets by taking into account such factors as capital contribution, net asset value, operating income, etc.)

3. Differentiating treatment for “Grey Harbor”, “Green Harbor” and “Red Harbor”

While Circular 698 only imposed reporting obligation on transactions where the intermediate offshore holding company being transferred is located in a tax-free or low-tax country (region), Bulletin 7 sets out three scenarios, i.e. “Grey Harbor”, “Green Harbor” and “Red Harbor” under different criteria:

3.1. “Grey Harbor” (Assessment of “Reasonable Commercial Purposes”)

Pursuant to Article 3 of Bulletin 7, in order to determine the existence of reasonable commercial purposes, all the arrangements relating to an indirect transfer of China taxable assets should be taken into account and the following factors should be analyzed in conjunction with the facts and circumstances on a comprehensive basis:

Whether the main value of the offshore enterprise’s equity is directly or indirectly attributable to China taxable assets;
Whether the assets of the offshore enterprise are mainly comprised of, directly or indirectly, the investment in China or whether the income derived by the offshore enterprise is mainly sourced, directly or indirectly, from China;
Whether the functions performed and the risks assumed by the offshore enterprise and its subsidiaries that directly or indirectly hold China taxable assets are able to prove that there is economic substance for the group structure;
The duration of the shareholders of the offshore enterprise, its business model and the relevant organization structure;
The status of the income tax payable offshore in respect of the indirect transfer of China taxable assets;
Whether the indirect investment or the indirect transfer of China taxable assets by the equity transferor can be substituted by a direct investment or a direct transfer of China taxable assets;
The applicability of double tax treaty or arrangement for the indirect transfer of China taxable assets;
Other relevant factors.
Although the concept of “reasonable commercial purposes” was firstly raised in the GAAR of the EIT Law[7], no detailed rules were further provided as to what constitutes “reasonable commercial purposes”. Therefore, in the context of Circular 698, the PRC tax authority usually assessed the “economic substance” of an intermediate offshore holding company by taking into account, on a comprehensive basis, of such factors as the number of employees, office space, other assets and liabilities, etc. In comparison, Bulletin 7 for the first time explicitly raises a set of criteria for the assessment of “reasonable commercial purposes”, mainly from the following three aspects:

Whether the value of the equity, assets or income of the offshore enterprise are mainly derived from sources within China or attributable to China taxable assets [i.e. factors (1) and (2) above];
Whether the functions performed and risks assumed by the offshore enterprise can prove its economic substance [i.e. factor (3) above]; and
Whether the indirect transfer is adopted for tax avoidance purposes [i.e. factors (4) to (7) above].
Based on these criteria, certain factors or conditions may be conducive to demonstrate the reasonable commercial purposes of an indirect transfer transaction involving China taxable assets, for example, the indirect transfer transaction is conducted after the investment structure has been established for a long time, the income tax payable offshore is higher than the potential EIT liability for the indirect transfer, there are legal barriers for the transferor to directly invest and hold China taxable assets, or the indirect transfer of China taxable assets may be applicable to double tax treaty or arrangement, etc.

In summary, it should be emphasized that in order to assess whether an indirect transfer arrangement of China taxable assets has “reasonable commercial purposes”, all the specific factors of the transaction, including those explicitly specified and the other relevant factors that are not explicitly specified, should be taken into account and analyzed comprehensively based on the principle of “substance-over-form”. Under no circumstances should a positive or negative conclusion be reached by relying on one of the factors or certain factors.

3.2. “Green Harbor” (or “Safe Harbor”)

For an indirect transfer of China taxable assets by a non-resident enterprise, if one of the following conditions can be satisfied, it shall fall within the scope of “Safe Harbor” and thus not be subject to EIT in China:

(1) A non-resident enterprise buys and sells the shares of one same overseas listed company in a public stock exchange.

As to this provision, it should be noted that the buying and selling transactions should take place in a public stock exchange and the target of the transactions should be the shares of one same listed company. As such, this condition would not be fulfilled if (i) the shares of the company sold by the transferor in a public stock exchange were bought before the company was listed or acquired through a non-public market after the company was listed; or (ii) the shares of the company were purchased by the transferor in a public stock exchange but sold in a non-public market.

(2) If the non-resident enterprise directly held and transferred China taxable assets, the income derived thereof would be exempt from EIT under the applicable double tax treaty or arrangement.

Under certain double tax treaties or arrangements, where a non-resident enterprise directly holds less than 25% shares of a Chinese resident enterprise (whose assets are not mainly comprised of immovable properties), China shall not be allowed to levy tax on the income derived from the transfer of such shares.

Based on our understanding, the logic behind this principle is that if a non-resident enterprise can be exempt from tax when it directly holds and transfers China taxable assets, it could prove to a certain extent that the investment structure and indirect transfer were not established or arranged for the avoidance of China tax, and thus the non-resident enterprise should not be subject to EIT for such indirect transfer.

(3) Qualified intra-group restructuring

An intra-group restructuring that satisfies all of the following conditions shall be regarded as having reasonable commercial purposes and exempt from tax in China:

– Shareholding percentage: the transferor holds or is held by the transferee or both parties are mutually held by another party, directly or indirectly[8], for over 80% of the shares; if over 50% (exclusive) of the value of the equity of an offshore enterprise is, directly or indirectly, attributable to immovable properties in China, the above-mentioned 80% shareholding requirement shall be increased to 100%.

– No reduction in tax burden: the EIT burden of a future indirect transfer transaction that would be occurred after the existing indirect transfer shall not be reduced as compared with that of the same or a similar transaction occurred in the absence of the existing indirect transfer.

The purpose of this provision is to prevent the abuse of double tax treaty or arrangement by non-resident enterprises. Take the aforesaid Company A, Company B and Company C as an example, assuming that Company A, through Company B, indirectly holds 20% shares of Company C and Company A transfers the shares of Company B to Company D, which is a non-resident enterprise, and Company D then transfers the shares of Company B to Company E, which is also a non-resident enterprise, if the EIT burden of this latter share transfer is not reduced as compared with that of the transaction where Company A directly transfers the shares of Company B to Company E, it would fulfil the condition set out by this provision.

However, as illustrated below, assuming that Company A is a Cayman company and Company D is a Hong Kong company, since (i) there is no double tax treaty between Cayman Islands and China, and (ii) under the double tax arrangement between mainland China and the Hong Kong SAR, if the Hong Kong company holds less than 25% of the shares of a Chinese resident enterprise (with its main assets not consisting of immovable properties), no EIT shall be levied on Company D for transferring such shares. Hence, if Company D subsequently transfers the shares of Company B, the PRC tax authority shall be restricted from levying EIT on the indirect transfer as Company B holds less than 25% of the shares of Company C. In this context, the EIT burden of the indirect transfer described above may be reduced as compared with that of the transaction where Company A transfers the shares of Company B and therefore could not fulfill the condition specified by this provision.

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– Form of consideration: the transferee shall pay all the consideration in the shares of its own or the shares of an enterprise that it has a control relationship (excluding the shares of public listed companies).

In our understanding, the main reason to exclude the shares of public listed companies from the qualified consideration is that the government currently encourages intra-group share restructurings (i.e. non-cash transactions) with reasonable commercial purposes, while the shares of public listed companies are highly liquid and can be easily obtained and converted into cash and are therefore excluded from the qualified form of consideration.

Having said the above, it should be noted that even if an intra-group reorganization could not meet all the above conditions, it does not necessarily mean that the transaction shall be regarded as one without reasonable commercial purposes. In this case, the reasonable commercial purposes of the transaction should still be tested and assessed based on Article 3 of Bulletin 7 (i.e. “Grey Harbor” rules).

3.3. “Red Harbor” (or “Dangerous Harbor”)

An indirect transfer of China taxable assets fulfilling all of the following conditions shall be automatically assessed as having no reasonable commercial purposes and thus subject to tax in China (unless it could fall into the scope of “Green Harbor” as elaborated above).

More than 75% of the value of the offshore enterprise’s equity is derived, directly or indirectly, from China taxable assets;
At any time during the one-year period preceding the indirect transfer of China taxable assets, more than 90% of the offshore enterprise’s total assets (exclusive of cash) are directly or indirectly comprised of investments in China; or within the one-year period preceding the indirect transfer of China taxable assets, more than 90% of the offshore enterprise’s income is directly or indirectly derived from China;
Although the offshore enterprise and its subsidiaries which directly or indirectly hold China taxable assets are registered in their host countries (or regions) to fulfill the legal organization requirements, they only perform limited functions and assume limited risks, which are not sufficient to prove their economic substance;
The foreign income tax payable under the indirect transfer of China taxable assets is less than the potential China tax that would be levied under the direct transfer of China taxable assets.
Pursuant to the above rules, for an indirect transfer of China taxable assets, if (i) the value, total assets and income of the intermediate offshore holding company being transferred are mainly derived from or comprised of China taxable assets, (ii) the functions performed and risks assumed by the company are limited (i.e. lack of economic substance), and (iii) the foreign tax payable under the indirect transfer is less than the potential EIT that would be levied in China under a direct transfer, then the transaction shall be considered as one without reasonable commercial purposes (but with the main purpose for the avoidance of EIT), which would be re-characterized by the PRC tax authority and subject to EIT.

4. Specifying payer as withholding agent

In accordance with Article 37 of the EIT Law, tax payable levied on the income obtained by a non-resident enterprise shall be withheld at source, with the payer as the withholding agent. However, Article 37 does not specify whether the payer is a Chinese resident enterprise or a non-resident enterprise. In this regard, Article 15 of Guo Shui Fa [2009] No.3[9] further provides that where both parties to an equity transfer transaction are non-resident enterprises and the transaction is carried out outside China, the non-resident enterprise receiving the transfer income or its agent shall be required to declare tax with the tax authority in charge of the Chinese resident enterprise whose equity is being transferred. This circular also does not require the non-resident enterprise making the payment to be liable for the obligation to withhold tax.

Bulletin 7 explicitly provides that if EIT is to be imposed on an indirect transfer of China taxable assets, the tax withholding agent shall be the entity or individual that has direct payment obligation to the equity transferor. If the withholding agent fails to withhold or not fully withhold the tax, the transferor shall declare the tax with the competent tax authority within 7 days from the date when the tax obligation arises[10]. Where the withholding agent fails to withhold tax and the transferor fails to declare such tax, the tax authority may impose a penalty based on the applicable tax administration regulations (i.e. the withholding agent shall be subject to a penalty ranging from 50% to three times of the amount of unpaid or underpaid tax); however, the penalty imposed on the withholding agent may be mitigated or waived on the condition that it has submitted the required materials within 30 days upon signing the relevant equity transfer contract or agreement.

In our view, for an indirect transfer of China taxable assets, where both the buyer and the seller are non-resident enterprises and the transaction is conducted outside China, if it can be concluded that the transaction shall be subject to EIT based on the relevant regulations, the buyer should firstly consider fulfilling its tax withholding obligation as per the rules mentioned above, although as a non-resident enterprise it may face practical difficulties in such aspects as tax registration (either temporary registration or registration as a tax withholding agent) and foreign exchange control and therefore need to communicate with relevant local government authorities on how to fulfill its tax withholding obligation; however, if the buyer and the seller could not reach a consensus as to whether EIT shall arise from the indirect transfer of China taxable assets, it is advisable for the buyer to voluntarily report the transaction to the competent tax authority by submitting the required materials within the specified time limit in order to alleviate or waive the potential administrative penalties for not fulfilling the tax withholding obligation.

Given that Bulletin 7 has explicitly specified the tax withholding agent, it can be perceived from the above analysis that although in practice such a requirement may cause potential dispute or controversy between the seller and the buyer of an indirect transfer of China taxable assets, from the perspective of tax administration and collection, it will definitely enhance the capability of the PRC tax authority to acquire the relevant transaction information in a timely manner and protect its interest for the levying of taxes.

5. Changing mandatory reporting to voluntary reporting

Circular 698 provided that for indirect transfer of equity, if the actual tax rate of the host country of the offshore holding company (which holds the shares of the Chinese resident enterprise) that is being transferred is lower than 12.5% or if the host country (region) does not levy tax on the offshore income of its residents, the transferor should report the transaction to the tax authority in charge of the (indirectly) transferred Chinese resident enterprise within 30 days upon signing the equity transfer contract. However, Circular 698 did not stipulate the legal liability that would be assumed by the transferor should it fail to fulfill the reporting obligation.

Bulletin 7 abolishes the above mandatory reporting obligation by adopting a principle that encourages voluntary reporting and further expands the scope of reporting parties to the buyer and the seller of an indirect transfer of China taxable assets as well as the Chinese resident enterprise involved in the transaction. In case of voluntary reporting, the required materials are relatively easy to obtain or prepare, including the equity transfer contract, equity investment structure, financial statements of the offshore enterprise and its offshore subsidiaries for the last two fiscal years and a statement elaborating on the reasonable commercial purposes of the transaction.

Pursuant to Article 13 of Bulletin 7, where the transferor does not declare tax and the withholding agent fails to withhold such tax, the tax authority, in addition to pursuing the unpaid tax, shall impose an interest on the transferor at the benchmark interest rate[11] plus 5%. In order to encourage voluntary reporting, Article 13 also prescribes that the 5% punitive interest may be waived if the transferor has submitted the required materials to the tax authority within 30 days upon signing the relevant equity transfer contract. Furthermore, as discussed above, if a withholding agent fails to fulfill its tax withholding obligation, its liability may be mitigated or waived if it has submitted the required materials within the specified time limit.

Meanwhile, in accordance with Article 10 of Bulletin 7, if the tax authority has detected that an indirect transfer of China taxable assets may be subject to EIT, it shall require the parties to the transaction, their advisors as well as the Chinese resident enterprise involved in the transaction to submit detailed materials[12].

Even though Bulletin 7 adopts a voluntary reporting principle, expanding the scope of reporting parties and encouraging the transferor and the withholding agent to report voluntarily, we are of the view that as compared with Circular 698, these measures would in fact cause the PRC tax authority to be more active in the tax administration on indirect transfer of China taxable assets and enable it to exert more effective and comprehensive control on the reporting of such transactions.

6. Application of GAAR

Article 11 of Bulletin 7 provides that the tax authority shall follow the relevant regulations concerning GAAR when processing the investigation into an indirect transfer of assets.

As specified by the Administrative Measures for General Anti-Avoidance Rules (Trial)[13], effective from 1 February 2015, tax avoidance schemes adopted by enterprises for obtaining tax benefits but without reasonable commercial purposes shall be subject to special tax adjustments. A “tax avoidance scheme” has the following characteristics:

The sole or main purpose is to obtain tax benefits;
The tax benefits are obtained by using an arrangement where it complies with the tax law in form but is not consistent with its economic substance.
Meanwhile, special tax adjustments made by the tax authority shall be based on similar arrangements that have reasonable commercial purposes and economic substance and follow the principle of “substance-over-form”. The adjustment method includes re-characterizing a part or the whole of the transactions of an arrangement.

Obviously, Bulletin 7 is in fact a specific application of GAAR. In practice, the arrangements adopted by non-resident enterprises for indirect transfer of China taxable assets without reasonable commercial purposes usually possess the features of tax avoidance schemes, i.e. lack of economic substance and for the purpose of tax avoidance.

The implementation of the Administrative Measures for General Anti-Avoidance Rules (Trial) and Bulletin 7, from both procedure and substance perspectives, shall render solid legal basis to the PRC tax authority for the investigations in respect of indirect transfer of China taxable assets and further strengthen its capability for anti-tax avoidance.

KWM Observation

In the past few years, among the global combat against base erosion and profit shifting (“BEPS”), China has intensified its efforts in anti-tax avoidance and issued a series of rules and regulations to target tax-avoidance arrangements adopted by multinational companies, such as transfer pricing, thin capitalization, cost sharing, controlled foreign company, abuse of tax treaties, etc. Meanwhile, the Administrative Measures for General Anti-Avoidance Rules (Trial) explicitly specifies the application scope, criteria and administrative procedure of GAAR, while Bulletin 7 is considered as a specific application of GAAR in the area of indirect transfer of China taxable assets.
In line with the principles established in GAAR and with reference to the spirit and legislative intent of Circular 698, Bulletin 7 clarifies the income tax treatment and administrative procedures for the indirect transfer of China taxable assets by non-resident enterprises. Inevitably, Bulletin 7 will have a profound impact on the tax cost of offshore enterprises (including the red-chip structure adopted by Chinese enterprises or individuals) as well as the design of investment structure, structuring of transactions and selection of exit plans.

Qualified intra-group reorganizations may gain benefit from the “Safe Harbor” rules specified in Bulletin 7. Considering the facts and circumstances, the relevant enterprises should assess the tax implications of their restructuring plans, and if commercially feasible, make adjustments accordingly so as to meet the requirements set out in the “Safe Harbor” rules. Furthermore, Circular Caishui [2009] No. 109[14], which was issued at the end of 2014, provides favorable special tax treatments for intra-group reorganizations by resident enterprises[15]. Enterprises that have cross-border reorganization plans should take both Bulletin 7 and Circular Caishui [2009] No. 109 into account in order to evaluate their tax positions and optimize the restructuring schemes.
The “Red Harbor” rules may pose significant negative impact directly on enterprises that are lack of reasonable commercial purposes. However, in the absence of clear guidance rules, certain provisions, e.g. “offshore enterprise and its subsidiaries which hold directly or indirectly China taxable assets…perform limited functions and assume limited risks which are not sufficient to prove their economic substance” may be difficult to implement in practice and hence cause disputes between the tax authority and enterprises. The relevant enterprises should pay special attention to this rule and evaluate their functions and risks in combination with the features of their industries in order to mitigate such tax risks.
From another perspective, for a transaction that falls into the scope of “Red Harbor”, the transferor should assess the tax cost beforehand in order to properly adjust the transaction price, structure the transaction and envisage the exit plan.

Bulletin 7 emphasizes that the economic substance of an offshore enterprise and its offshore subsidiaries should be assessed on the basis of function and risk analysis. For an enterprise that plans to indirectly transfer its China taxable assets, we would suggest to assess the connection between the equity of the offshore enterprise being transferred and the functions performed and risks assumed by such an enterprise, analyze the economic importance of the enterprise in its group structure, and if feasible, enhance its economic substance, from such perspectives as equity structure, personnel, assets, income and financial information, etc.
As for the transactions falling within the scope of “Grey Harbor”, the reasonable commercial purposes should be assessed comprehensively based on the eight specified factors. As illuminated by the published cases under Circular 698, most of the disregarded offshore intermediate holding companies are shell companies with “no assets, no liabilities and no personnel”. In comparison, Bulletin 7 requires to assess whether the actual functions performed and risks assumed by an offshore enterprise and its subsidiaries can match the economic substance of the group structure. Therefore, even an offshore enterprise being transferred may have personnel, assets, liabilities and income, if the value, asset or income of the enterprise are mainly attributable to China taxable assets or do not match the functions and risks of the enterprise, the transferor may still face a negative result from the test of economic substance.

As stipulated by Bulletin 7, besides parties to an indirect transfer transaction as well as the Chinese resident enterprise involved, the tax authority may require the transaction advisors to submit the relevant materials. A similar requirement was firstly raised in the Administrative Measures for General Anti-Avoidance Rules (Trial), under which the tax authority may require the entities or individuals that render planning and structuring advice to enterprises to provide materials and other supportive evidence during the general anti-avoidance investigations. Given that it is reiterated in Bulletin 7, the parties to an indirect transfer transaction and their transaction advisors should be mindful of this requirement.

Although Bulletin 7 provides some certainty for compliance by taxpayers and law enforcement by the tax authority, there are still areas or issues that remain unclear and need to be addressed by the SAT or negotiated by enterprises with the competent tax authority. For example, what are the reasonable methods when allocating income to China taxable assets? What is the scope of the enterprises that have a control relationship with the offshore enterprise being transferred as specified by the “Safe Harbor” rules (whether a parent company, a subsidiary or both are included in the scope)? How to define “main assets” and “main source” when assessing the reasonable commercial purposes? How to quantify the value of an offshore enterprise, the value of China taxable assets or total assets (by book value or by assessed value)? How to determine the reasonableness of the duration of offshore shareholders and organization structure?
The issuance of Bulletin 7 epitomizes that China has been escalating its efforts in establishing an anti-avoidance system and administering the taxation on non-resident enterprises. As compared with Circular 698, Bulletin 7 is more complex: the applicable scope of indirect transfer is expanded, the tax treatment is varied (by differentiating “Green Harbor”, “Red Harbor” and “Grey Harbor”), the parties to an indirect transfer transaction face more options (voluntary reporting to avoid or mitigate penalty vs. non-reporting), the assessment of reasonable commercial purposes may be subjective and uncertain, etc. All this require the parties to an indirect transfer transaction to comprehensively assess the transaction costs and risks and get fully prepared in such respects as investment structuring, M&A transaction arrangement, documentation, transaction pricing, indemnification mechanism, etc. Where necessary, professional advice from tax lawyers and tax advisors should be sought in due course.