China: China remains the favoured destination for cross-border M&A

According to a recent KPMG study looking at trends regarding investment in China, in 2013, merger and acquisition (M&A) activity continued to be a significant contributor to FDI in China, representing more than 30% of the total amount ($36 billion) of $117.6 billion FDI in China.

While China remained the favoured destination for foreign direct investments and cross-border M&A activities over the past year, attention should be given by foreign investors to the issues below when undertaking cross-border M&A transactions in China.

It is not uncommon for China cross-border M&A transactions to take place indirectly at the offshore holding company level where an offshore holding company is transferred from the seller to the buyer.

In a series of well-documented enforcement cases involving several well-known private equity investors, public listed companies and others (leading examples being enforcement cases undertaken by the PRC tax authorities in Hangzhou, Shanxi, Jilin, Jiangsu and Heilongjiang), it became clear that the PRC authorities have strengthened enforcement efforts in applying Circular 698 against perceived abuse in offshore structures to avoid the 10% PRC withholding tax (WHT) on gains realised from the indirect transfer of investments in PRC resident enterprises. This has caused what was historically considered a theoretical exposure to become a real exposure for cross-border M&A transactions.

In launching the challenges, it is interesting to note that the PRC tax authorities are increasingly showing efforts at collecting information from public sources (such as listed company annual reports and public announcements in respect of any material changes in equity interests) to pursue claims.

Circular 698 has now become one of the most important issues in cross-border M&A transactions in China, when it comes to offshore indirect disposition and acquisition of Chinese companies.

For offshore indirect transfer transactions, greater concerns have arisen for offshore buyers, because of the potential effect that the tax basis of the acquired equity interest could not be stepped up (a draft supplement circular to Circular 698 states that the basis acquired by the offshore buyer from an indirect transfer of PRC company could be disregarded if the offshore seller did not report and pay its tax pursuant to Circular 698 on its indirect disposal transaction), if the seller does not comply with its reporting obligation under Circular 698 for its indirect disposal of the Chinese equity interest and does not pay the exit tax on the gains realised in the event of a challenge. Increasingly, the sellers have been compelled by the buyers to do the reporting under Circular 698 as a condition precedent to the completion and settlement of the M&A transactions.

To address the above concerns, greater time and effort has been spent by the offshore buyers and offshore sellers on the negotiation of how to handle compliance with Circular 698 reporting and the potential exposures, which, in some cases, have caused a significant delay in the closing of the M&A transactions.

Another challenge often encountered in cross-border M&A transactions in China is whether any PRC tax liabilities arising from corporate mergers and corporate splits or spin-offs under an internal reorganisation could be deferred under the PRC tax laws and regulations.

Under PRC tax laws, corporate restructuring transactions would prima facie be treated as taxable transactions, unless certain specific conditions are met which qualify it for special tax treatment.

However, the rigid rules and stringent conditions imposed for relief have made it difficult for many internal transactions to qualify for the tax-deferred relief (please refer to the article "M&A relief – flickering lights at end of tunnel" in the third edition of the China Looking Ahead publication for the International Tax Review for further discussion in this regard). This situation is exacerbated by the fact that the PRC tax authorities have begun to aggressively apply transfer pricing adjustments to internal cross-border restructuring transactions. This has caused the associated tax costs to become a major hurdle for the implementation of cross-border restructuring transactions.

In China, it is absolutely critical for taxpayers to maintain valid tax invoices to support the tax basis for tax deductions in the event of a property disposal.

In practice, we note that the poor record-keeping of many property companies have resulted in their vendors having to face material purchase pricing adjustments for the property value, because they have not been able to maintain valid PRC tax invoices or any relevant documentation in support of their land acquisition, development and construction costs, demolition expenses and so on to be the tax basis of the assets. In some cases, this might be caused by local practice involving cash transactions and off-record dealings in the construction sector, which took place 10-15 years ago.

A further tax challenge increasingly faced by foreign investors in executing cross-border M&A transactions is the ability to enjoy tax treaty relief on their capital gains derived on the direct disposals of the China companies.

It is evident from recent experience and enforcement cases that the PRC tax authorities are increasingly challenging treaty relief claims. Historically, foreign investors have often structured their direct M&A investments into China using an appropriate tax treaty jurisdiction holding company to mitigate the 10% WHT that would otherwise apply on the realised capital gains under the China domestic law.

By way of example, for shareholdings that are less than 25%, the Hong Kong, Singapore or UK tax treaties with China offer protection on the capital gains WHT (except for land-rich companies). However, over the past three years or so, the PRC tax authorities have implemented several measures to limit the scope of treaty shopping and other perceived treaty abuse practices, and have in practice, adopted the economic substance criteria, set out in Circular 601, in determining whether to approve an application of the tax treaty relief claim on PRC sourced income (including capital gains, despite the substance criteria does not appear to be a requirement for enjoying tax treaty relief under the capital gains article of the tax treaties). This has resulted in tax treaty relief claims being increasingly difficult to be obtained for capital gains derived by foreign investors in undertaking cross border M&A transactions.

Beyond Circular 698, we note there is an additional tax risk arising for offshore investors engaging in indirect equity transfers of PRC resident enterprises.

Specifically, the gain on the sale of an offshore company may be regarded as PRC-sourced, giving the right to the PRC tax authorities to tax that gain on the basis of the offshore company's deemed PRC tax residence under PRC domestic tax laws which would make the gains to be regarded PRC source income. This risk has been highlighted in enforcement cases, the most notable cases being the widely published "Vodafone-sale of China Mobile" case and a recent Circular 698 reporting case in the Heilongjiang province, in which the tax authorities taxed the gains arising to the foreign private equity investor, on the basis that the gains should be treated to be PRC source income because the offshore company being transferred is a PRC tax resident enterprise.

This indicates that the PRC tax authorities might take a different or additional approach to tax gains arising from the indirect disposal of Chinese companies by foreign investors.

In conjunction with this effort, we note that the PRC tax authorities have recently in (January 2014) issued another tax circular (SAT Announcement [2014] No. 9) which enable them to regularise the registered tax resident status of foreign incorporated enterprises controlled by PRC residents, and establish a compliance system to approve and track such offshore incorporated Chinese tax resident companies.

As a result of the above, foreign investors may find themselves increasingly exposed to Chinese tax residence risks, where they make offshore indirect disposals of PRC companies.

Given the developments noted above, foreign investors are well advised to fully assess the tax issues and potential impacts arising from particular transactions in order to navigate the increasingly complex tax landscape and to mitigate the potential exposures in China.

Biography
		John Gu Partner in charge, inbound M&A KPMG China Tel: +86 10 8508 7095 Email: john.gu@kpmg.com John Gu is a partner and tax leader for inbound M&A and private equity for KPMG China. He is based in Beijing and leads the national tax practice serving private equity clients. John focuses on regulatory and tax structuring of inbound M&A transactions and foreign direct investments in the PRC. He has assisted many offshore funds and RMB fund formations in the PRC and has advised on tax issues concerning a wide range of inbound M&A transactions in the PRC in the areas of real estate, infrastructure, sales and distribution, manufacturing, and financial services.

Biography
		Paul Ma Partner KPMG China Tel: +86 10 8508 7076 Email: paul.ma@kpmg.com Paul Ma is an M&A tax partner in KPMG China's Beijing office. His focus areas include advising on tax structuring issues in complex M&A transactions including cross-border and domestic acquisitions and divestments; corporate restructuring; take-private transactions and PIPE [Private Investment Public Entity ] transactions; performing tax due diligence on a wide range of industries including real estate, telecommunications, energy and resources, consumer markets, e-commerce and financial services; advising on onshore and offshore fund structuring and formation and representing institutions' limited partners in general partner due diligence.

Biography
		Christopher Mak Partner KPMG China Tel: +86 21 2212 3409 Email: christopher.mak@kpmg.com Chris Mak has experience in advising multinational clients in the consumer, industrial and manufacturing industries in relation to appropriate corporate holding and funding structures to conduct their proposed business activities in Australia. Since joining the Shanghai office, he has been heavily involved in assisting foreign companies on PRC tax issues arising from their investment into China including proposed global restructuring, company set-ups, due diligence, foreign exchange remittance issues and M&A transactions for the industrial, auto and real estate industries.