Case Study: Income Tax Issues for a Foreign Investor Transferring Equity in a Chinese Company
By David Gao
Brief description of the case:
Company A is a company incorporated and operated in Portugal. In 2013, A established a wholly foreign-owned enterprise, Company B, in China with registered capital of RMB 1 million. In 2022, A intends to transfer all the equity of Company B to Company C, another foreign enterprise. The transfer price is EUR 250,000 (approximately RMB 1.8 million at the exchange rate at that time), which exceeds the net value of the equity.
Question:
During the equity transfer process, a tax issue arises: Should Portuguese Company A pay corporate income tax to the Chinese tax authorities on the portion of the transfer income that exceeds the net value of the equity?
Legal Analysis:
According to the Corporate Income Tax Law of the People's Republic of China (hereinafter referred to as (“Corporate Income Tax Law”) and related tax regulations, China classifies enterprises into resident and non-resident entities based on their registration and actual place of management. In this case, Company A, as a foreign company, has no establishment in China. Therefore, the income from the equity transfer falls under the non-resident category, and China requires non-resident enterprises without establishments in China to pay corporate income tax on income earned in China.
Pursuant to Article 4(2) of the Enterprise Income Tax Law, the applicable tax rate for the income derived by a non-resident enterprise from the income specified in Article 3(3) of the Law is 20%, while pursuant to Article 27 of the Law, the income derived by a non-resident enterprise from the income specified in Article 3(3) of the Law could be exempted or reduced from taxation. Article 91 of the Regulations for the Implementation of the Enterprise Income Tax Law of the People's Republic of China further provides that non-resident enterprises earning the income specified in Article 27(5) of the Enterprise Income Tax Law shall be subject to enterprise income tax at a reduced rate of 10%. Therefore, the effective tax rate applicable to the income earned by a non-resident enterprise pursuant to Article 3(3) of the Enterprise Income Tax Law is 10%.
In this case, if based solely on the provisions of the Enterprise Income Tax Law and other relevant domestic laws, Portuguese Company A should pay income tax to the PRC tax authorities at a rate of 10% on the portion of the remittance income exceeding the net value of the equity.
However, Article 58 of the Enterprise Income Tax Law stipulates that where an agreement or treaty on taxation concluded between the Government of the People's Republic of China and a foreign government has provisions different from those of this Law, it shall be dealt with in accordance with the provisions of the agreement or treaty. Article 91 of the Law of the People's Republic of China on Administration of Tax Collection also provides that if a treaty or agreement on taxation concluded between the People's Republic of China and a foreign country has provisions different from those of this Law, it shall be handled in accordance with the provisions of the treaty or agreement.
The above provisions establish the principle of giving precedence to the application of treaties.
After legal research, we find that a tax treaty was signed between the Chinese and Portuguese governments on April 21, 1998, titled "Agreement Between The Government Of The People’s Republic Of China And The Government Of The Portuguese Republic For The Avoidance Of Double Taxation And The Prevention Of Fiscal Evasion With Respect To Taxes On Income," which is currently in effect.
Article 13 of this agreement outlines principles for taxing property income as follows:
1. Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other Contracting State.
2. Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise) or of such fixed base, may be taxed in that other State.
3. Gains of an enterprise of a Contracting State from the alienation of ships or aircraft operated in international traffic or movable property pertaining to the operation of such ships or aircraft shall be taxable only in that Contracting State.
4. Gains from the alienation of shares of the capital stock of a company the property of which consists principally of immovable property situated in a Contracting State may be taxed in that Contracting State.
5. Gains from the alienation of any property other than that referred to in paragraphs 1 to 4, shall be taxable only in the Contracting State of which the alienator is a resident.
On the basis of the above provisions, in the present case, by applying the exclusion rule, we can determine that the income from the transfer of the equity held by the Portuguese company A in the Chinese company B does not fall within the circumstances described in Article 13, paragraphs 1 to 3, of the Agreement. It has been verified that there is no immovable property in the name of Company B, so that it does not fall under the circumstances described in Article 13, paragraph 4 of the Agreement. Therefore, in this case, the fact that Portuguese Company A transferred its capital gain from Chinese Company B falls within the scope of paragraph 5 of Article 13 of the Agreement. According to the provisions of this paragraph, Portuguese Company A should only be taxed in Portugal, so the Chinese tax authorities cannot tax the equity transfer income.
Conclusion:
Following legal research and consultation with the relevant Chinese tax authorities, it has been confirmed that Portuguese Company A is only liable to pay tax in Portugal on the income generated by the share transfer and that the Chinese tax authorities will not impose any tax on this transaction.
