Foreign Income & Taxpayers
Since first opening the door to the outside world a little over 30 years ago, the government of the People’s Republic of China has exhibited a general policy that encourages foreign investments. However, doing business in China remains challenging for many U.S. taxpayers, as China’s business regulations and culture vastly differ from those of the United States. When a U.S. company wants to reorganize a worldwide structure that includes Chinese entities, tax issues should be carefully considered to avoid any unforeseen Chinese tax liability. The example below demonstrates how Chinese tax issues could derail a “perfectly” planned reorganization for U.S. income tax purposes.
Example: The existing structure is as follows: A U.S. holding company ( USCo 1 ), a C corporation, is the direct sole shareholder of two U.S. companies ( USCo 2 and USCo 3 ), which are also C corporations. The three U.S. corporations file a consolidated U.S. corporation income tax return to report their combined federal income tax liability. USCo 2 is also the sole owner of a wholly foreign owned enterprise ( WFOE ) in China. Because WFOE is treated as a foreign corporation by default, the consolidated U.S. corporate income tax return filed by the U.S. corporations includes a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, to report WFO E ’s activities. Exhibit 1 illustrates the existing structure.
For business reasons, management would like to reorganize the structure by having USCo 2 transfer all of its equity interest in WFOE to USCo 3 without any consideration. After this reorganization, USCo 3 will become the sole shareholder of WFOE. Because there is no plan to dispose of any of WFOE’s shares, for U.S. income tax purposes, WFOE is still owned by the consolidated group that comprises USCo 1, USCo 2, and USCo 3. The post-reorganization structure is shown in Exhibit 2.
This proposed reorganization is not a taxable transaction for U.S. income tax purposes because all of the parties involved in the transaction are within a consolidated group. For U.S. income tax purposes, the transaction is interpreted as USCo 2 making an in-kind dividend to USCo 1 by initially transferring the equity interest in WFOE to USCo 1, followed by a subsequent transfer of the equity interest in WFOE to USCo 3 as an equity contribution. Because all of the U.S. entities are within a consolidated group, such intercompany transactions are ignored. Therefore, this is a tax-free reorganization in the U.S.
However, because WFOE ’s immediate parent company has changed, this reorganization would be considered a taxable transaction for Chinese capital gain tax purposes. Reorganizations in China are currently governed by Ministry of Finance and State Administration of Taxation Caishui [2009] No. 59 (Circular 59), which identifies two types of reorganization:
-
“General reorganization,” under which capital gain should be recognized by the transferor of an ownership interest in a company at the time of transfer; or
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“Special reorganization,” which is a tax-free transaction for stock equity transfers.
Furthermore, Circular 59 identifies two scenarios that qualify as “special reorganizations” when reorganizations involve foreign parent companies:
Scenario 1:
The
transfer of the equity interest in a Chinese tax
resident company (TRC) from a foreign company
(Foreign Parent) to another foreign company
(Foreign Sub), which is a wholly owned subsidiary
of the foreign parent, assuming other requirements
identified by Circular 59 are also met. (See Exhibit 3.)
Scenario 2:
A
foreign parent transfers the equity interest in a
TRC (TRC Sub) to another wholly owned TRC (TRC
Parent). (See Exhibit 4.)
Both scenarios require the transfer of the Chinese subsidiary to a new parent company that is a wholly owned subsidiary of the original parent company. Any reorganization that falls outside of these parameters will not likely be approved by the Chinese taxing authority as a tax-free “special reorganization.”
Applying Circular 59 to the above example, because USCo 2, the original parent company of WFOE, is not the sole shareholder of USCo 3, which is the new parent company of WFOE, the transfer of the ownership interest of WFOE from USCo 2 to USCo 3 does not match either of the two scenarios listed in Circular 59. As Circular 59 is silent on the Chinese State Administration of Taxation’s view on the above group restructuring arrangement, it will most likely be considered a taxable “general reorganization” by most of the local Chinese tax agents. Since the Chinese taxing authority would usually only review the immediate parent companies rather than the ultimate ownership under Guoshuihan [2009] 698 (Circular 698), the fact that USCo 2 and USCo 3 are owned by a common parent company, USCo 1, would not usually affect this determination.
As a result, USCo 2 would need to recognize Chinese capital gain tax on the difference between the fair market value (FMV) of WFOE and its basis in WFOE (Circular 59). The FMV of WFOE should be based on the valuation report issued by a Chinese-certified CPA. If WFOE ’s FMV is substantially higher than its basis, a large amount of Chinese capital gain tax (at a 10% rate) could make this reorganization a costly transaction, forcing company management to consider other alternatives, such as making USCo 3 a wholly owned subsidiary of USCo 2 before transferring WFOE to USCo 3 . Thus, prior to finalizing a reorganization involving Chinese subsidiaries, companies should carefully consider the potential ramifications of Chinese tax laws.
EditorNotes
Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.
For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or mindy.cozewith@mcgladrey.com.
Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.
