Tax matters in the course of Chinese outbound investment

For Chinese enterprises commencing to invest offshore, Chinese lawyers face a historical opportunity to provide complementary services, but are also struggling with the difficulties of how to provide legal opinions in connection with those outbound investments under a non-uniform Chinese legal environment.

To date, Chinese lawyers have provided legal services to foreign-invested enterprises for their domestic investment projects under China’s legal environment, but once outbound investment is involved, particularly the foreign portion, they often take this as being the realm of foreign lawyers, and throw up their hands.

At a meeting of the international committee of the All China Lawyers Association (ACLA), the author put forward his idea that Chinese tax lawyers can serve as the chief architect in the outbound investment projects of Chinese enterprises. In this article the author explains, from a tax perspective, the issues on which a Chinese lawyer should focus in an outbound investment project.

The ideas set out are based on the author’s long practical experience accumulated in the course of his provision of legal services for the China investment projects of foreign clients. The application of these experiences to the outbound investment projects of Chinese enterprises can be said to be “returning the favour”.

If a Chinese company wishes to establish a company abroad, what issues does it need to pay attention to in terms of the equity structure? Pursuant to the general provisions in the section on property returns of tax agreements between countries, if a foreign shareholder holds more than 25% of the shares in a local company, it is required to pay taxes to the government of the place where the company is located when it transfers shares in that company. For example, when a foreign company that holds 25% of the equity of a Chinese company transfers such equity, it is required to pay a 10% withholding tax in China. In contrast, if it holds less than 25% of the equity, it is not required to pay tax.

Accordingly, if multiple Chinese companies simultaneously invest in a certain project abroad, the above-mentioned factor needs to be taken into account when designing the equity structure, and this is particularly so for financial investors. Compared to industrial investors, financial investors seek to achieve capital gains by divesting through such means as a transfer after a certain period of time. If they wish to be exempted from paying local tax during divestment, limiting their shareholding percentage to less than 25% in the course of designing the investment structure is a solution worth considering.

Should key technology be transferred to the company established abroad? In the course of providing legal services to foreign-invested enterprises, we have all had this kind of perception that, in general, foreign-invested enterprises had their head offices hold on to the key technologies because they worried about the relatively lax protection of intellectual property in China, or other factors. Chinese enterprises will also encounter a similar question in their outbound investment projects. The author recommends keeping the key technology with the head office of the Chinese company, and licensing such technology to the company established abroad
only if necessary.

The first reason for proceeding in this manner is the need to share costs. With the delegation of operating functions to the level of the subsidiary, the head office gradually transforms from a profit centre to a cost centre, ceases to directly derive profits, but assumes more functions, such as strategy formulation, technical research and development, etc., that require huge outlays. Under such a circumstance, the head office can only maintain its lifeblood by such means as licensing technology to its offshore subsidiaries, and charging them a licence fee to ensure its continuing operations.

The second reason is for tax planning considerations. In the course of technology licensing, the licensor is usually required to carry out follow-up guidance of the licensee. Accordingly, the consideration for a technology licence can be divided into a technology licence fee and a follow-up technical service fee or consulting fee.

Pursuant to the usual provisions of tax agreements between countries, technology licence fees are royalties and require the payment of the appropriate tax (similar to the withholding tax in China) in the place where the licensee is located. In contrast, whether a tax is payable in connection with a technical service fee or consulting fee in the place where the licensee is located is dependent on whether a permanent establishment is constituted.

If the licensor has not seconded personnel to the licensee to provide technical services, or if it has done so but the same does not constitute a permanent establishment, the licensor is not required to pay tax in the place where the licensee is located in respect of the technology service fee it charges. That is to say, the Chinese company is required to pay local taxes only on the royalty portion of the technology licence.

As to whether a “permanent establishment” is constituted, tax agreements generally specify that if the personnel seconded by one party stay with the other party for more than 183 days in any 12-month period, a permanent establishment is constituted.

Therefore, in the course of a Chinese enterprise’s outbound investment project, consideration can be given to the Chinese company licensing its key technologies to its locally established subsidiary. From the perspective of tax planning, if the follow-up technical service period can be limited to less than 183 days, a portion of the technology licence fee can be classified as a technical service fee, of which portion would be exempt from local tax.

The above-mentioned ideas are based on experience accumulated in applying tax treaties when representing foreign clients who were investing in China. However, given that tax treaties between countries are reciprocal, circumstances applying to foreign investors in China similarly apply to Chinese investors abroad.

Accordingly, in Chinese outbound investment projects, Chinese lawyers can fully “return the favour”, assisting Chinese investors in duly carrying out their tax structure design in order to maximize their tax benefits.

Hu Zhiqiang is a partner at Jingtian & Gongcheng in Shanghai. He can be contacted on +86 21 2613 6215 or by email at hu.zhiqiang@jingtian.com