By Ding Fa “David” LIU
Jun He Law Offices

With the new Enterprise Income Tax Law (new EIT law) taking effect on January 1 2008, the tax treatment of mergers, divisions and reorganizations of foreign investment enterprises (FIEs) are now in limbo. Technically, with the repeal of the Foreign Investment Enterprise and Foreign Enterprise Income Tax Law (old EIT law), all circulars issued under the old EIT law would automatically cease to be effective. However, based on past experience, the PRC tax authorities tend to follow the old circulars even though the old circulars would technically cease to be effective with implementation of the new tax law.

This article analyzes the tax treatment of mergers, divisions and reorganizations of FIEs under Circular [1997] No. 71 and Circular [1997] No. 207 (Old Circulars) which were issued under the old EIT law. It also looks at the uncertainty of the tax treatment of mergers, divisions and reorganizations of FIEs under the new EIT law.

Tax Treatment of Mergers and Divisions under Old Circulars Tax Treatment at the Company level Pursuant to Circular 71, the assets, liabilities and owner’s equity after a merger or a division should be recorded at their historical cost in the hands of premerger/ division enterprise. Irrespective of the accounting treatment, the assets, liabilities and owner’s equity shall, for tax purposes, be recorded at the historical cost in the book of accounts of the postmerger/ division companies.

Tax treatment of Shareholders The shareholders would not be subject to tax in respect of the merger or division, nor would they get a step-up basis for their equity in the merged company or companies resulting from the division.

Tax Treatment of Reorganizations under the Old Circulars

Tax Treatment at the Company level FIEs involved in a reorganization shall not adjust the book value of their assets, liabilities and owner’s equity according to the appraisal conducted for purposes of completing the reorganization. If, after the reorganization, an FIE has adjusted the book value of its assets, liabilities and owner’s equity according to accounting rules, the FIE would be required to make re-adjustments to eliminate additional amount of depreciation or amortization resulting from the adjustment made pursuant to the accounting rules.

Tax treatment of Shareholders

Under Circular 71, as a general rule FIEs and foreign enterprises (i.e., non-resident enterprises under the new EIT law) are required to calculate and withhold/pay EIT on capital gains realized from transfer of equity or shares of investee companies. However, under Circular 207, a foreign enterprise or China holding company (the Transferor) may transfer its equity interest in a Chinese company free of enterprise income tax to an affiliate, which the Transferor directly or indirectly holds 100% of the shares, or which, together with the Transferor, is wholly owned by the same person, if (A) the equity transfer is made at the historical cost thereby no taxable gains have been realized, and (B) the reorganization of the group of companies is undertaken for the rationalization of the group’s operations.

Uncertainty under New EIT Law

The new EIT law is silent on the tax treatment of mergers, divisions and reorganizations. Article 75 of the implementation regulations of the new EIT law attempts to clarify this issue by stipulating that unless otherwise mentioned by the public finance and tax authorities under the State Council, i.e., the Ministry of Finance (MOF) and the State Administration of Taxation (“SAT”), income or loss shall be realized upon transfer of assets as part of a restructuring, and the tax basis for such assets must be re-determined based on the transaction price. At the time of this article going to press, neither MOF nor the SAT has issued a circular (New Circular) dealing with the tax treatment of mergers, divisions and reorganizations.

This creates uncertainty as to how the intra company group mergers, divisions and reorganizations would be treated under the new EIT law. The uncertainty is acerbated by the general arm’s length principle in Article 41 of the new EIT law, which grants to the tax authorities broad discretion to adjust the income and losses where the associated parties failed to conduct transactions under the arm’s length principle thereby reducing the taxable income of one of the parties to the transaction.

Concluding Remarks

Under the old EIT law and Old Circular, mergers, divisions and reorganizations could be carried out free from EIT if certain specified conditions are met. However, it remains to be seen whether the EIT neutral mergers, divisions and reorganizations, an EIT neutral reorganization involving transfer of equity interest in an FIE to an overseas holding company in particular, would continue to be available under the new EIT law; and if they will be available, what conditions must be met in order to achieve an EIT neutral merger, division or reorganization.

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