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Insight Center: Publications

Tax in the Middle Kingdom

Author: Steven D. Bortnick

2/06/2009
This article first appeared in PEI Manager, February 2009. Copying without permission from PEI Manager is unlawful. It is reprinted here with permission.

Private equity investors – and many other international investors – have turned their attention to the People’s Republic of China (PRC) in recent years. As long ago as the first half of 2005 more than 35 international private equity funds had raised PRC-focused capital, and important international private equity investors are likely to continue to focus on opportunities in the PRC.

This article identifies selected points affecting international private equity investments in the PRC, focusing on tax efficiency at the investors’ level and at the portfolio company level. While the focus here is on PRC taxation, such considerations must be addressed – as for any international private equity investments - for both the portfolio company’s country and investors’ countries.

Initially it should be noted that both tax and non-tax rules affecting foreign private equity investments in the PRC continue to evolve. For example, a new Enterprise Income Tax Law came into effect on 1 January 2008. However, established foreign invested enterprises that have been issued a business license before 16 March 2007 may continue to enjoy the tax incentives available under the PRC’s old tax law (subject to graduated increases by 2012). Clearly many details under the new law remain yet unclear.

Thus, the points below are based in part on prior PRC investment structuring from abroad and in part on new broad statutory provisions. (Citations for a number of the points below may be found in the lengthier article referred to in the box above.) Reliance upon the points raised in this article should be preceded by confirmation of evolving PRC and other rules and by consultation with professional advisers appropriately authorized to provide PRC and other relevant tax advice.

Tax Efficiency at the Investor Level

Under US rules taxing tax-exempt investors on unrelated business taxable income, a US tax-exempt investor will be taxed on income from a debt financed investment – thus any debt incurred to finance a private equity investment should be incurred at the level of a corporation below the tax-exempt investor or below a partnership in which it invests. In the case of a PRC private equity investment, this suggests that debt financing should be incurred (1) at the level of the PRC corporation holding the investment or (2) at the level of a non-PRC corporation which in turn makes the PRC investment.

In the first case, PRC legal and/or tax limitations on debt-to-equity ratios of PRC enterprises must be examined as the same evolve from time to time. Historically foreign invested enterprises have been restricted to borrowing from foreign owners one to three times the amount of their equity investment and the new income tax law, as discussed further below, limits the deductibility of interest by PRC enterprises.

In the second case, interest expense accrued or paid by a non- PRC corporation used to hold the PRC investment may well not be deductible for PRC income tax purposes from the taxable income of the PRC enterprise in which the investment has been made.

The new PRC income tax law also provides that so-called tax resident enterprises of which actual management or control is located in the PRC – not just those organized in the PRC – may be subject to PRC corporate income tax on their worldwide income, rather than only on PRC source income. Thus, any foreign enterprise organized to hold private equity investments in the PRC should have its effective management – including substantial and overall management and control over business operations, personnel, finance, accounting and properties – outside the PRC in order to avoid such worldwide income taxation.

The new income tax law provides a withholding tax rate on the gross amount of dividends, interest, rents, royalties and other investment earnings paid to non-resident enterprises – such as foreign owners of PRC private equity investments – at the rate of 20 percent. Implementing regulations currently reduce this rate to 10 percent.

This is as low as withholding tax rates under most PRC income tax treaties with other countries. However, a few such treaties reduce PRC withholding taxes even further to, e.g., 5 percent on certain dividends. Moreover, any such regulatory concession for non-treaty investors clearly is subject to amendment at any time. Accordingly, attention should be paid to structuring through PRC income tax treaty jurisdictions such as Mauritius or other countries with favorable PRC treaties, subject to avoiding PRC management which may cause a treaty country company to be treated as a PRC tax resident, unless the treaty overrides such PRC treatment.

However, even under such a structure, the new income tax law empowers PRC tax authorities to make reasonable adjustments where an enterprise implements an arrangement with no reasonable commercial purpose other than to reduce its taxable income or profit. Furthermore, many PRC income tax treaties have a broad limitation-of-benefits clause under which the PRC can deny treaty benefits to a treaty resident which is not majority owned by other residents of the treaty country or which pays a majority of its income to nonresidents of the treaty country, unless it is publicly traded in the treaty country.

Alternatively, using a Hong Kong company to own a PRC portfolio company may permit payment of dividends subject to PRC withholding taxes of only 5 percent on dividends and 7 percent on interest. Hong Kong in turn generally does not impose withholding tax on most company distributions to foreign owners and also has negotiated a very limited number of its own income tax treaties, including a treaty pending finalization with Luxembourg.

Establishment of a PRC investment fund may be permitted in certain local jurisdictions of the PRC. However, such a fund may be subject to a maximum PRC income tax rate of 35 percent, which does not seem particularly favorable compared to the PRC rates applicable to distributions to foreign funds as discussed above. Moreover, as noted further below in connection with taxation of PRC portfolio companies, management fees even between unrelated enterprises generally are non-deductible in the PRC, which may limit the deductibility of investment adviser fees paid by a PRC fund. In addition, PRC tax treatment of carried interests of investment advisers in a fund, in lieu of or additional to their basic annual management fees, seems currently unclear – so any such arrangement likely should be structured in a non-PRC enterprise.

Tax Efficiency at the Portfolio Company

The new PRC Enterprise Income Tax Law referred to above has replaced the former separate income tax laws applicable to domestic invested enterprises and to foreign invested enterprises. Under the latter law, foreign invested enterprises meeting legal requirements also obtained numerous tax concessions and preferences not permitted to domestic invested enterprise. For acquisition structuring purposes, it should be noted that, if the PRC portfolio company has been a foreign invested enterprise which previously received such benefits, those benefits may need to be paid back if it ceases business within 10 years after their commencement.

Now a flat tax rate of 25 percent is uniformly applied to the taxable income of resident enterprises, except for small or low profit enterprises meeting certain requirements that benefit from a 20 percent tax rate and high-technology enterprises supported by the state which enjoy a 15 percent tax rate.

Calculating taxable income:

Management fees paid between enterprises are now non-deductible – presumably including hotel management company fees, holding company management assistance, and others.

Interest charged between units of the same enterprise is non-deductible. This does not apply to interest charged between related parties controlled by the same owners, except as noted further below. However, interest on a loan from a non-financial institution – such as a controlling shareholder or foreign or domestic affiliate – to a non-financial enterprise is deductible only at the amount that would have been charged by a financial institution making the same loan.

Deduction of interest on loans from related parties – or guaranteed or collateralized by related parties – is prohibited where the loan exceeds stipulated standards, and no carry forward of deduction to future years is provided. A circular to the new income tax law, released in fall of 2008, sets the prescribed debt/equity ratio at 2:1 for a non-financial enterprise’s related party debt.

Rents and royalties between operational units of the same enterprise (but not between related parties controlled by the same owners) are also non-deductible.

Depreciation of capital assets is limited to the straight-line method (unless, under certain circumstances, an enterprise may utilize an accelerated method) and excludes an estimated residual value which must be determined by the user at the beginning of use. Depreciation periods range from 20 years for buildings and structures to three years for electronic equipment.

Intangibles such as patents, trademarks and copyrights are to be amortized over not less than 10 years.

An important asset that cannot be amortized is goodwill arising from an acquisition, which may only be deducted when the entire enterprise is transferred or liquidated.

Additional deductions and tax preferences are available for enterprises engaged in encouraged activities – currently high technology, service centers, public infrastructure projects, environmental protection projects and others.

The PRC’s previous extensive transfer pricing regime, requiring arm’s length charges between related parties controlled by the same owners, continues under the new income tax law. Appropriate methods for pricing goods and services between related enterprises include the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, the profit split method and others. Any transfer pricing adjustment will now bear interest at a specified rate, currently 5 percent above the interest rate published by the People’s Bank of China. However, advance pricing approvals remain available.

Steven D. Bortnick

John Forry is a principal with the accounting and tax advisory firm of Eisner based in New York and a professor of international finance at several US and European graduate schools. Steven Bortnick is a partner with the law firm of Pepper Hamilton based in New York and Princeton. For further information on the topic, see the authors’ forthcoming article, “Structuring International Private Equity Investments in the People’s Republic of China”, scheduled for publication in early 2009 in The Banking Law Journal.

The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.