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Tax Treatment of Substantive Capital Reductions

金杜研究院 · 公众号 · · 2024-12-27 17:42

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(This article was originally published by ALM China Law & Practice on 25 November 2024)

Standfirst: Part I of this series introduced the implications of the amended PRC Company Law for Formal Capital Reductions. Part II will focus on the accounting and tax treatments of Substantive Capital Reductions, and analyze the tax risks of shareholders with regard to capital reductions not made at fair market value.

Different from Formal Capital Reductions, Substantive Capital Reductions will lead to a net asset outflow from the company.

As such, the tax treatment of shareholders under the Substantive Capital Reduction route will be more complicated.

The Accounting and Tax Treatments of Substantive Capital Reductions

In the case of Substantive Capital Reductions, shareholders may receive income from the company through the capital reduction, which is subject to corresponding tax implications. This leads to various tax and accounting implications for different types of entities, which differ from those encountered where a Formal Capital Reduction is used.

1.The accounting and tax treatments of the company

According to the relevant rules and regulations, when an enterprise repurchases its own stock on an open market for the purpose of a capital reduction, from an accounting perspective this is only treated as a change in the Owner’s Equity. This means that the difference between the repurchase price and the original capital contribution does not have to be recorded in the profit and loss statement. From a tax perspective, the tax treatment of the difference between the repurchase price and the original capital contribution is consistent with the accounting treatment and no tax adjustment is required. As such, regardless of whether the capital reduction is made at book value, at discounted value or at premium value, there will be no tax implications for the company.

However, it should be noted that if the consideration for a capital reduction paid by the company consists of non-monetary assets, the company must treat them as deemed sales, which may give rise to value-added tax, land value-added tax, and enterprise income tax (" EIT "), etc., depending on the nature of the non-monetary assets.

2.The tax treatment of the shareholders

In the case of Substantive Capital Reductions, the tax treatment varies depending on the types of shareholders.

(1) Companies as Shareholders

The State Taxation Administration, Announcement on Several Issues Concerning the Enterprise Income Tax (Announcement of the State Taxation Administration [2011] No.34, " Announcement [2011] No.34 ") provides that, "when an investing enterprise withdraws or reduces its investment from an invested enterprise, the portion of assets acquired by the investing enterprise equivalent to its initial capital contribution shall be recognized as a recovery of its investment cost; the portion equivalent to the accumulated undistributed profits and accumulated surplus reserves of the invested enterprise calculated by the proportion of the reduced paid-in capital shall be recognized as dividend income; the remaining portion of the assets acquired shall be recognized as income derived from transfer of investment assets."

According to the above provision, for shareholders in the form of a company (i.e. a corporation or similar entity under the Enterprise Income Tax Act), the income obtained from a capital reduction is divided into three portions: a) the first portion is the recovery of the investment cost; b) the second portion is dividend income corresponding to the retained earnings; and c) the third portion is the property transfer income that remains after deducting the investment cost and dividend income.

For domestic shareholders:

Dividend income obtained by a resident enterprise from another resident enterprise is exempt from EIT. Therefore, dividend income that constitutes the second portion of income derived from the capital reduction is exempt from EIT.

On that basis, for domestic shareholders, only the property transfer income needs to be included in the taxable income for EIT purpose.

For non-resident shareholders:

However, the tax implications for shareholders of non-resident enterprises are not the same as for domestic enterprises. Non-resident enterprises are generally subject to withholding EIT at 10% for the dividend income they receive and are not eligible for the EIT exemption. Therefore, for the shareholders of non-resident enterprises, both the second portion of dividend income and the third portion of transfer income are taxable to withholding EIT at the rate of 10%, unless tax treaty benefits are applicable.

Nevertheless, it is also necessary to differentiate the nature of these two types of income. The reason is that, if the tax treaty benefit could be applicable, the applicable conditions of dividend income and property transfer income are different, as the dividend income is governed by the Dividends Article while the property transfer income is governed by the Capital Gains Article of the treaty.

Specifically, with regard to dividends, generally if the non-resident shareholder is the beneficial owner of the dividends and a company which directly holds at least 25% of the capital of the invested company paying the dividends, a preferential tax rate (e.g. 5%) could be applicable. (It should be noted that the conditions and the applicable benefits may vary in different tax treaties, and that the circumstances described here are only an example.)

With regard to the property transfer income governed by the Capital Gains Article, under certain tax treaties, if the non-resident shareholder, as recipient of the capital gain, at any time during a certain period (e.g. 12 months) preceding the transfer, directly and indirectly held less than a certain ratio (e.g. 25%) of the invested company and the main value of the invested company does not come from the immovable assets, the property transfer income may be exempt from the withholding tax in China. (Again, these circumstances are provided by way of example only.)

(2) Individuals as Shareholders

The State Taxation Administration, Announcement on Issues Concerning the Collection of Individual Income Tax on Recoveries by Individuals from Terminations of Investments (Announcement of the State Taxation Administration [2011] No.41, " Announcement [2011] No.41 ") provides that, "where an individual terminates the investment, joint venture, operational cooperation and other activities for various reasons, the funds received from the enterprise, cooperative project, other investors of the same enterprise or the other operational cooperators in the form of equity transfer income, liquidated damages, compensations, indemnities, and other items, are subject to individual income tax and shall be calculated as 'property transfer income'. The formula for calculating the taxable income is: Taxable income = Total amount of recovered funds received as equity transfer income, liquidated damages, compensations, indemnities, and other items – Amount of the original actual contribution (investment amount) and related taxes and fees ."

For resident individual shareholders:

According to the above provision, for shareholders in the form of resident individuals, the income obtained from a capital reduction is divided into only two portions: a) the first portion is still the recovery of the investment cost; and b) the second portion is the portion exceeding the investment cost, which shall be recognized as "property transfer income" and is subject to 20% individual income tax (" IIT "). Unlike EIT, in general, the applicable IIT rate for both dividends and property transfer incomes received by domestic individuals is 20%, so that there is no difference in tax burden if dividends and equity transfer incomes are not distinguished.

For non-resident individual shareholders:

Considering that Announcement [2011] No.41 defines the income received by individuals from capital reductions as "property transfer income", the applicable article of tax treaty is the Capital Gains Article. If a tax treaty benefit provided by the Capital Gains Article under certain tax treaty could be applied, the non-resident individual shareholder may be exempted from IIT in China when the relevant conditions are satisfied.

If the tax treaty benefit cannot be applied, then the non-resident individual is subject to 20% IIT for the property transfer income. However, since the foreign individual shareholder is exempted from IIT on the dividends income derived from the invested enterprise, it might be an optimal choice if the invested enterprise makes profit distribution to the foreign individual shareholders first before making capital reduction if commercially feasible. Under this circumstance, the non-resident individual shareholder should be eligible to an exempted IIT treatment on the portion of dividend income, which should reduce the overall tax burden during the capital reduction.

(3) Partnerships as Shareholders

Compared to situations where the shareholder is a company or an individual, there is a lack of clear legal provisions for the tax treatment of capital reduction for partnerships as shareholders. In addition, the special nature of the partnership as a "flow-through entity" under tax law makes it even more difficult to determine the applicability of tax policies.

For domestic partnership shareholders:

Tax Treatment of Substantive Capital Reductions

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