(Promulgated by the State Administration of Taxation on April 28, 1997)
In accordance with the relevant provisions of the Income Tax Law of the People's Republic of China for Foreign Investment Enterprises and Foreign Enterprises (hereinafter referred to as the Tax Law) and its Implementing Rules, tax issues concerning confirmation of the continuity of business activities, asset valuation, preferential taxation, the carry-over of losses, etc., which arise when foreign investment enterprises (hereinafter referred to as enterprises) reorganize the format of their business operations through a merger, division, rearrangement of share rights or transfer of assets, etc. Will be treated as follows:
I. Tax Treatment in Mergers
A "merger" refers to a situation where two or more enterprises merge to become one enterprise in accordance with the provisions of relevant laws and regulations. A merger where all the parties to the merger dissolve themselves and jointly establish a new enterprise is called a merger by new establishment (or a dissolution merger). A merger where one party continues to exist while the other parties to the merger dissolve themselves and are then incorporated into the existing party is called a merger by absorption (or a continuation merger). Regardless of which merger method is adopted, these enterprises will not need to undergo liquidation procedures. Unless shareholders (investors) to the pre-merger enterprise ask to withdraw their shares, they will continue to be shareholders to the post-merger enterprise. The claims and debts of a pre-merger enterprise will be passed on to the post-merger enterprise after relevant legal procedures have been carried out.
The business activities of an enterprise before and after a merger will be regarded as continuous business activities for taxation purposes. A post-merger enterprise which is still regarded as a foreign investment enterprise in accordance with the provisions of relevant laws will treat its taxation matters in accordance with the following provisions:
(1) Treatment of Asset Valuation
Valuation of the various assets, debts and shareholders' interests of a post-merger enterprise. The original book value must not be adjusted in accordance with the value derived from the valuations carried out by the enterprises to facilitate the merger. Any post-merger enterprise which adjusts the book value of its assets in accordance with the valuation amount during profit and loss accounting and bases its depreciation or amortization calculations on this amount must carry out adjustments in accordance with one of the following methods when it calculates its yearly taxable income:
(1) Yearly adjustments based on actual amounts. The amount of the current cost and expense which were actually over-calculated or under-calculated by depreciation, amortization, etc. in each tax year due to changing the value of assets, adjustments must be made to the cost and expense items listed in the annual tax declaration. A corresponding increase or decrease must also be made to the current taxable income amount.
(2) Comprehensive adjustment. The amount of the asset value alteration, regardless of the asset type and based on an average ten-year period, will be adjusted in the cost and expense items listed in the annual tax declaration. A corresponding increase or decrease will be made to the taxable income amount for each tax year,
An enterprise must apply to its competent tax authority to have its selection of one of above adjustment methods approved when making its annual tax declaration. An enterprise must also attach all relevant calculation materials to its competent tax authority for examination and approval.
(II) Treatment of Fixed Term Preferential Tax Exemption or Reduction
If the production or business operation of a post-merger enterprise comply with the Tax Law provisions on entitlement to a fixed term preferential tax exemption or reduction, the post-merger enterprise will carry on this pre-merger preferential taxation. The specific treatment of tax issues will be conducted in accordance with the following methods:
(1) If the period for the fixed-term tax exemption or reduction in which all the pre-merger enterprises were entitled has already expired, the post-merger enterprise will not continue to be entitled to this preferential taxation.
(2) If the period for the fixed-term tax exemption or reduction in which all the pre-merger enterprises were entitled has not expired and the remaining periods are equal, the post-merger enterprise will continue to be entitled to the preferential taxation until the expiry of this period.
(3) If there is not an equal remaining period for the fixed-term tax exemption or reduction in which all the pre-merger enterprises were entitled, or if any of the parties to the merger was ineligible for a fixed-term tax exemption or reduction, the post-merger enterprise must separately calculate appropriate taxable income amounts in accordance with the provisions of Item (V) of this Section. With respect to the taxable income from the corresponding business for which the remaining periods for tax exemption or reduction are not equal, the preferential treatment will separately continue to be enjoined until the period expires; with respect to the taxable income from the business to which the preferential taxation is not applicable, the preferential treatment will not be enjoined.
(III) Treatment of Reduced Tax Rates
Based on actual production and operational circumstances and in accordance with the relevant provisions of the Tax Law, its Detailed Implementing Rules and other relevant provisions, a post-merger enterprise and its various business establishments must determine whether they are eligible for reduced tax rates based on regional or industry factors. The enterprise must then separately calculate appropriate taxable income amounts in accordance with the provisions of Item (V) of this Section.
(IV) Treatment of Losses from a Previous Period
A post-merger enterprise may use its income from subsequent years to recover any operating losses of the various pre-merger enterprises which are still outstanding. These losses must be recovered within the remainder of the loss recovery period stipulated in Article 11 of the Tax Law. If the post-merger enterprise has business establishments in regions where different tax rates are applicable, it must separately calculate the appropriate income mounts in accordance with the provisions of Item (V) of this Section. The operating losses of a pre-merger enterprise as referred to above must be recovered from income subject to the same tax treatment as this pre-merger enterprise. Specific cases will be handled in accordance with the methods stated in paragraph 2 of Article 91 of the Implementing Rules of the Tax Law.
(V) Division and Calculation of Taxable Income Amounts
Where a post-merger enterprise is involved in operations to which different tax rates are applicable or is the result of a merger of enterprises which have different amounts of time remaining under fixed-term tax exemption or reduction, this post-merger enterprise, as stipulated in the previous paragraph, must divide its taxable income in order to suit different applicable tax treatments. This must be handled in accordance with the provisions of Articles 91, 92 and 93 of the Implementing Rules of the Tax Law. The division and calculation of its taxable income amounts must be handled in accordance with the following methods:
(1) If, after a merger, the pre-merger enterprises continue to separately form corresponding business establishments which carry on their pre-merger production and business operations, and if the post-merger enterprise is able to establish separate account books which can accurately and fairly calculate the taxable income amounts of its various business establishments, then the post-merger enterprise may adopt the factual basis method of accounting to separately calculate the taxable income amounts of its various business establishments.
(2) If, after a merger, the pre-merger enterprises do not separately form corresponding business establishments or, if they do separately form corresponding business establishments but the competent tax authority decides that the post-merger enterprise would be unable to accurately and fairly calculate the taxable income amounts of its various business establishments, the post-merger enterprise must divide and calculate its total taxable income for that year by applying one ratio or an average ration of several ratios, such as annual sales income ration, cost and expenditure ration, assets ration, employee number and wage amount ration, of its various business establishments adopting different tax treatment or various types of businesses. If the above-mentioned ratios involve amounts for items in post-merger years which are not easy to determine, the above-mentioned ratios may be determined in accordance with the relevant amounts for these items in the last full tax year before the merger or another appropriate period.
II. Tax Treatment of Division
A division refers to a situation where one enterprise divides to become two or more enterprises in accordance with the provisions of relevant laws and regulations. A division where the original enterprise is dissolved and all the parties to the division separately establish new enterprises is called a division by new operations (or a division through a dissolution); and a division where the original enterprise continues to exist and one part of it divides to establish one new enterprise or a number of new enterprises is called a derivative division (or a continuation division).
Regardless of which division method is adopted, these enterprises will not need to undergo liquidation procedures. Shareholders (investors) in a pre-division enterprise may decide to continue to be shareholders as a whole or part in the various post-division enterprises. The claims and debts of a pre-division enterprise will be passed on to the post-division enterprise in accordance with the provisions of relevant laws, its taxation matters will be handled in accordance with the following provisions:
(I) Treatment of Asset Valuation
Valuation of the assets, debts and shareholder's interests of the various enterprises after a division must be based on the book costs recorded by the pre-division enterprises. The original book value must not be adjusted in accordance with the values derived from the valuation carried out by the enterprise to facilitate the division. Any post-division enterprise which adjusts the book value of its assets in accordance with the valuation amount and bases its depreciation or amortization calculation on this amount during profit and loss accounting must carry out adjustments in accordance with the methods stipulated in Item (1) "Treatment of Asset Valuation" of Section I on enterprise mergers of these Provisions when it calculate its yearly taxable income.
(II) Treatment of Preferential Taxation
The various post-division enterprises must separately ascertain whether they are entitled to reduced tax rates and whether they are able to continue to receive fixed term preferential tax exemption or reduction to which their pre-division enterprise was entitled. This will be based on their production and operational circumstances in accordance with the Tax Law, its Implementing Rules and relevant provisions.
(1) The entitlement of post-division enterprises whose production and business operations comply with the Tax Law provisions on entitlement to preferential taxation granted to a pre-division enterprise has already expired, the post-division enterprise will not have renewed entitlement for this preferential taxation. Where the production or business operations of a pre-division enterprise were not entitled to preferential taxation, but the post-division enterprise alters these operations to those which are entitled to preferential taxation the post-division enterprise may be entitled to preferential taxation for the balance of the period to be calculated from the year that the pre-division enterprise first made a profit.
(2) Where the production or business operation of a post-division enterprise fails to comply with provisions of the Tax Law on entitlement to preferential taxation, the enterprise will not be entitled to or continue to be entitled to preferential taxation.
(III) Treatment of Losses from a Previous Period
In accordance with the provisions of the division agreement, the various post-division enterprises will share responsibility for any operation losses of the pre-division enterprises which are still outstanding. These various post-division enterprises may use their income from subsequent years to recover the losses within the remainder of the loss recovery period stipulated by the provisions of Article 11 of the Tax Law.
III. Tax Treatment of the Rearrangement of Share Rights
The rearrangement of share rights refers to a change occurring to the shareholders (investors) to an enterprise or the monetary amount or ratio of shares held by these shareholders. Specific cases include: 1) the transfer of share rights, this being when a shareholder to an enterprise transfer all or part of the share rights or shares it holds to another party; 2) capital addition and share expansion, this being when an enterprise raises funds through the public sale of its shares and the issue of shares. In this case new shareholders can invest in shares or existing shareholders can increase their investment by expanding their share rights, thereby increasing the enterprise's capital. The rearrangement of an enterprise's share rights is an act of investment or trading by its shareholders. It may be regarded as a rearrangement of the structure of the enterprise's share rights, but will not affect the enterprise's continuity. Enterprises in this situation will not need to undergo liquidation procedures. The claim and debt position of an enterprise will remain in effect after the rearrangement of its share rights.
The issues arising from the rearrangement of share rights will be handled in accordance with the following provisions:
(I)Treatment of Earnings from the Transfer of Share Rights
Foreign investment enterprises and foreign enterprises must calculate and pay income tax or withhold and pay income tax on earnings from the transfer of share rights or shares in enterprises which they own in accordance with the provisions of the Tax Law, its Implementing Rules and other relevant provisions. Losses from transfer of share rights or shares by an enterprise within the Chinese territory may be deducted from its taxable income amount for that period.
Earnings or losses from the transfer of share rights refer to the balance amount when the transfer price is deducted from the cost price of the share rights.
The transfer price of share rights refers to the amount received by the transferor of the share rights, including cash, nom-monetary assets, rights and interests or other forms of payment. If the enterprise in which the shares are held has undistributed profits, various funds established with after-tax allocations or other shareholder's retained earnings, the share rights transferor, at the same time as it transfers the share rights, will also transfer the sum of this shareholder's retained earning rights (to be limited to the actual amount belonging to the share rights transferor as allotted in the book value of the enterprise in which the shares are held). The amount regarded as the investment earnings of this transferor of share rights will not be included as the investment earnings of this transferor of share rights will not be included in the transfer price of the share rights.
The cost price of share rights refers to the amount that the shareholder (investor) actually paid to the enterprise when it invested in the shares or the amount of the transfer price of the share rights when purchasing these share rights.
(II) Treatment of the Premium on a Share Issue
The premium gained by an enterprise issuing shares when the issue price exceeds the face value of the shares will be regarded as the shareholder's interests. It will not be regarded as business profit subject to income tax. When an enterprise is undergoing liquidation, this premium will not be included in taxable income at liquidation.
(III) Limits on entitlement to Tax Refunds on Reinvestment when Profits (Dividends) Is Used to Buy Shares
Preferential provisions of the Tax Law which permit the partial refund of taxes already paid on reinvested amounts will not apply in a case where a foreign investor uses profits (dividends) from an enterprise to buy shares (including share allotments) in this enterprise or to buy shares in another enterprise.
(IV) Treatment of Tax Issues in Relation to an Enterprise Whose Share Rights Are Rearranged
The business activities of an enterprise before and after the rearrangement of its share rights will be arranged as continuous business activities for taxation purposes. After the rearrangement of its share rights, an enterprise which is still regarded as a foreign investment enterprise in accordance with the provisions of relevant laws or to which taxation laws and regulations continue to apply will handle its taxation matters as follows:
(1) An enterprise must not adjust the book value of its various assets, debts and shareholder' interest in accordance with the values derived from the valuations carried out by the enterprise to facilitate the rearrangement of its share rights. Any amount and bases its depreciation or amortization calculations on this amount during profit and loss accounting must carry out adjustments in accordance with the methods stipulated in Item (1) "Treatment of Asset Valuation" of Section I on enterprise mergers of these Regulations when it calculates its yearly taxable income.
(2) The various items of preferential taxation to which an enterprise is entitled in accordance with the Tax Law, its Implementing Rules and other relevant provisions will not alter as the result of a share right rearrangement. After the rearrangement of its share rights, an enterprise will continue to enjoy any existing preferential treatment until the expiry of the term of validity of the preferential taxation. The enterprise will not, however, have renewed entitlement to this preferential taxation.
(3) Any operating losses incurred by an enterprise before the rearrangement of its share rights which remain outstanding after the rearrangement may be recovered with income from subsequent years. This must be done within the remainder of the loss recovery period stipulated by the provisions of Article 11 of the Tax Law.
IV. Tax Treatment of the Transfer of Assets
The transfer of assets refers to an enterprise transfers its all or part of assets or receives all or parts of the assets of another enterprise (including goodwill, business operations and liquidated assets). The transfer and receipt of assets will not affect the continuity of the transferor and transferee enterprises.
Tax issues arising from the transfer of assets will be handled in accordance with the following provisions:
(I) Treatment of Earnings from the Transfer of Assets
An enterprise's earnings or losses from the transfer of assets must be included in its taxable income amount for that period in accordance with the provisions of the Tax Law, its Implementing Rules and other relevant provisions. The enterprise will then calculate and pay income tax on this amount.
(II) Treatment of the Valuation of Assigned Assets
The various assets transferred to a transferee may be listed in the transferor's account of assets in accordance with the actual transfer price of each item. If the categories of the assigned assets are numerous and diverse or if it is difficult to separately calculate the transfer price of each item when goodwill or business operations are valued together with various other items, the assets may be listed in the transferee's account of assets in accordance with the transferor's net book value of the items. The difference between the actual total transfer price and the net book value of these assets may be regarded as the transfer price of the goodwill or business operations and may be listed separately as intangible assets of the transferee. Average amortization must be carried out over a minimum period of ten years from the date of the asset transfer. If the balance of the life of the enterprise after the asset transfer is less than ten years, average amortization will be carried out over the remainder of the enterprise's life.
(III) Treatment of Preferential Taxation
Where the transferor and transferee of assets do not alter their production and business operations after the asset transfer, they may continue to be entitled to their original preferential taxation. In the case of a fixed term preferential tax exemption or reduction, an asset transfer will not permit the enterprise to calculate the term of the preferential taxation again.
If either the transferor or transferee of the assets does alter its production or business operations after an asset transfer so that original operations that were entitled to preferential taxation become operations that are ineligible, it will not continue to be entitled to this preferential taxation after the asset transfer. If the original operations that were not entitled to preferential taxation for the balance of the period to be calculated from the year that this enterprise first made profits.
(IV) Treatment of Losses from a Previous Period
Any operation losses an asset transferor or transferee which occur either before or after the asset transfer may be recovered by this party from its respective income in subsequent years. This must be done within the loss recovery period stipulated by the provisions of Article 11 of the Tax Law. Regardless of whether an enterprise transfers al or part of its assets and operations, the enterprise's operation losses must not be brought forward mutually between the transferor and transferee.
V. After a merger, division or rearrangement of an enterprise's share rights, the provisions of income tax laws and regulations on foreign investment enterprises will no longer apply to the enterprise if the ratio stipulated by laws on foreign investment enterprise.
This provision will apply unless otherwise stipulated in relevant tax laws, regulations or rules. Instead, the enterprise must handle its taxation matters in accordance with the income tax laws and regulations which apply to enterprises with domestic investment. At the same time, entitlement to the fixed term tax exemption or reduction which the enterprise received before the reorganization in accordance with the provisions of Article 8 of the Tax Law will be handled in accordance with the following circumstances:
(I) Regardless of the length of the operational life of the pre-reorganizational enterprise, the provisions of Article 8 of the Tax Law on the repayment of taxes previously exempted or reduced will not apply in cases where the share rights held by foreign investors to a pre-reorganizational enterprise were not relinquished in the reorganizational activities and are already incorporated in or assigned into the post-merger or post-division enterprise or are retained in the enterprise after the rearrangement of its share rights.
(II) In cases where the share rights held by foreign investors to a pre-reorganizational enterprise were relinquished in the enterprise's reorganizational activities or were transferred to domestic investors, when the actual operational life of the enterprise before the reorganizational is less than the period stipulated for entitlement for fixed term preferencial tax exemptions or reductions, enterprise income tax payments which were previously exempted or reduced must be repaid in accordance with the provisions of Article 8 of the Tax Law.
VI. Foreign enterprises which establish organizations or premises within the territory of China to engage in production or business operations may handle taxation issues concerning these organizations or premises in China with reference to the provisions of these Provisions if they are involved in reorganizational activities, such as merger, division, rearrangement of share rights or the transfer of assets.
VII. These Provisions shall take effect as of 1997.
Where the tax treatment of issues in previous years differs from these Provisions, tax authorities must carry out revisions in accordance with these Provisions from 1997. Where results of tax procedures implemented before 1997 shall, in principle, also be revised in accordance with these Provisions.
This translation, together with any explanatory material, is provided courtesy of Lehman Tax & Accounting.
