specifically targeting offshore transactions involving the indirect transfer of shares in resident Chinese companies. A typical offshore structure consists of a parent company, owning the shares of an intermediary special purpose vehicle (SPV), which directly holds the shares of the Chinese resident entity (CRE). Both the parent company and the SPV are usually non-resident entities.
This structure provides a tax benefit to the parent company. Since the implementation of Circular 698 the transfer of shares in a Chinese resident entity held by an intermediate SPV (an indirect transfer), can be a taxable event. This indirect transfer is the target of the Circular. However, if a reasonable business purpose for the SPV can be established, no tax liability is incurred in respect of the indirect transfer. Circular 698 actually does not define what a reasonable business purpose is, though Article 120 of the Enterprise Income Tax law defines what reasonable commercial purpose is not: he expression ot have a reasonable business purpose as used in Article 47 of the EIT Law means that the main purpose is to reduce, exempt or defer the payment of taxes. It is suggested that a transaction or business activity that is entered into to further a commercial objective for the company or its shareholders may be a reasonable commercial purpose.
Circular 698 and Treaties Interestingly, Article 58 of the EIT "In the case of inconsistency with the EIT and any treaty between China and foreign governments, the provisions of the treaty will prevail . . . Enter the China/Seychelles Double Taxation Agreement . . . which explicitly prevents China from taxing capital gains of companies resident in the Seychelles" states that in the case of inconsistency with the EIT and any treaty between China and foreign governments, the provisions of the treaty will prevail. The presumption, therefore, is that Circular 698 is subject to the terms of any relevant income tax treaty. Enter the China/Seychelles Double Taxation Agreement (C/S Treaty). Article 13 of the C/S treaty explicitly prevents China from taxing capital gains of companies resident in the Seychelles, where the holding is less than 25%, except where such income represents gains from the alienation of a permanent establishment (defined as a fixed place of business through which the business of an enterprise is wholly or partly carried on).
Accordingly, unless it can be established that the CRE is a permanent establishment of the SPV, for holdings of less than 25% no taxable event could arise from the direct transfer of shares. Further, Article 5(7) of the C/S Treaty says: he fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other. ?Therefore, it is unlikely that the CRE would get caught by the permanent establishment clause.
Thus one could effectively bypass the provisions of Circular 698 by creating a Seychelles offshore structure with ParentCo (the defacto controlling entity) being a Seychelles IBC, foundation or purpose trust holding the shares of a Seychelles special purpose vehicle (it would have to be a Seychelles Company Special Licence Company (CSL) in order to access the provisions of the Treaty), holding the shares of the Chinese resident entity. It is important to bear in mind that there is no tax under Circular 698 where a reasonable business purpose for the existence of the offshore SPV can be provided. So any structures created should be established with that in mind. However, it appears, for the time being, that the C/S Treaty trumps the Circular in the event of any inconsistency with the EIT. The provisions of the Circular will pose a challenge for the traditional structures for investing in China, and existing structures will require review, forcing the creative energies of corporate and trust service providers to continually evolve.
