By China Briefing
Hong Kong and China entered into a Double Taxation Arrangement (DTA) in 2006. The treaty’s purpose is to avoid double taxation, reduce tax evasion, improve ties between both jurisdictions by reinforcing their respective tax laws, encourage competition, and promote investment. A fourth protocol was signed on April 1, 2015, which amended four key aspects of the DTA, including a tax exemption for capital gains derived by foreign investors that sell shares of a China-based company. Companies should be aware of these changes and how to calculate the capital gain tax of restricted shares when applying for a capital gains tax exemption. Below, we construct a case study to explain the capital gain tax calculation and its impact on companies.
The Test Case: Capital Gain tax calculation through Selling Restricted Shares
Company A, a global venture capital holding company, had a subsidiary incorporated in Hong Kong, while Company B was a private Chinese company that decided to become a listed company. Before Company B became listed, Company A purchased restricted shares of Company B. Company A planned to sell their shareholdings after a 12-month restricted stock trade period. Subsequently, Company A transferred RMB 20 million from Company B, which accounted for 32 percent of Company B’s total shares. Company B then launched a share reform scheme to increase registered capital to meet the China Securities Regulatory Commission’s requirements. The registered capital of Company B was RMB 70 million, and needed to increase to RMB 100 million. The remaining RMB 30 million was comprised of the following:
- Contributed surplus: 13 million
- Legal earned surplus reserve: 7 million
- Undistributed profit: 10 million
Due to the change of registered capital, the percentage of company A’s share decreased to 30 percent. This raises the question: how are the differing components of the remaining RMB 30 million taxed?
Definitions and axioms
To answer the above question it is necessary to understand the definition of a few technical terms:
- Registered capital: Capital approved by government authorities and invested by shareholders.
- Contributed surplus: Amount of money that a company earns from sources other than its profits. For example, when a company issues and sells shares at a price greater than their face value, the contributed surplus figure helps investors and the company distinguish between non-operational and operational income.
- Earned surplus reserve: Earnings not paid out as dividends, but instead reinvested in the core business or used to pay off debt.
- Undistributed profit: Profit that has not been distributed as dividends to stockholders.
- Capital Gain = Selling Price – Cost of Investment.
- Value-added portion: Total proceeds after subtracting the deductible cost of investment.
- Capital contribution: The registered capital increase converted from net assets.
The cost of investment refers to the consideration Company A originally paid to acquire Company B’s shares. Therefore, the RMB 20 million which was transferred from Company B will be treated as the cost of investment in capital gains tax computation.
Given the PRC Corporate Income Tax (CIT) Law and its implementation rule, as well as Notice No. 698, the equity shares that were converted from capital surplus cannot be regarded as the cost of investment in capital gain tax computation. However, when the registered capital was converted from legal earned surplus reserve and undistributed profit, it was split into two taxable events: the profit declared as a dividend and the dividends re-injected into Company B. Therefore, the conversion of surplus reserve and undistributed profit can be regarded as the capital contribution and constitute the deductible cost of investment in capital gain tax computation.
Furthermore, during Company B’s share reform, Company B also converted undistributed profit into the capital reserves. Chinese tax authorities imposed a 10 percent withholding dividend tax during the conversion. This capital reserve is therefore regarded as the capital contribution and a portion of the cost of investment.
A new circular for disposal shares
According to a section of Circular 53, which became effective September 2016, any transactions taking place before September 1, 2016 should be subject to a six percent VAT rate on the actual value-added portion. Furthermore, Clause 10 states: “Taxable events which occurred prior to this date but have not been dealt with shall be handled pursuant to this provision of this circular.” Tax authorities stated that the legislation has a retrospective effect, meaning Company A should pay withholding VAT for stock selling.
Circular 36, the fundamental regulation on taxation expansion of the VAT reform, clarifies the scope of taxpayers and the scope of taxable activities. The following is a summary of the points relevant to this case from the circular:
- Article 1: States that VAT taxpayers include all entities and individuals.
- Article 6: Clarifies that overseas entities who conduct taxable activities within China must pay VAT through its withholding agent.
- Article 12: Clarifies that taxable activities within China refer to any purchaser of services that is located in China.
- Article 13: States that activities which are not subject to VAT must be performed outside of China.
It is crucial to define the cost of investment in order to calculate capital gain. However, the capital conversion during the share reform seen in this case study is a unique situation, and current tax regulation does not expand on capital contribution. It is advisable to consult relevant tax authorities to obtain proper guidance on this issue.
About the Author
Since its establishment in 1992, Dezan Shira & Associates has been guiding foreign clients through Asia’s complex regulatory environment and assisting them with all aspects of legal, accounting, tax, internal control, HR, payroll and audit matters. As a full-service consultancy with operational offices across China, Hong Kong, India and emerging ASEAN, we are your reliable partner for business expansion in this region and beyond.