Corporate restructuring: Income tax and risk management in China

By Li Rongfa. Grandway Law Offices

Following the promulgation in 2010 of the Circular on Several Issues Concerning Corporate Income Tax Treatment for Corporate Restructurings, known as the No. 59 Circular, which has long been criticized by taxpayers, the Ministry of Finance and the State Administration of Taxation published a series of documents giving specific and detailed guidelines as to income tax treatment of corporate restructurings. Yet taxpayers had a feeling of total disorientation until the State Administration of Taxation issued the Announcement on Several Issues Concerning Administration of Collection of Corporate Income Tax on Corporate Restructurings (the No. 48 Announcement) to replace the preapproval and filing mechanism with subsequent regulation by tax authorities in connection with special tax treatment of corporate restructurings. Implementation and application of the No. 59 Circular has changed radically as a result of this procedural change.

李荣法 LI RONGFA 国枫律师事务所合伙人 Partner Grandway Law Offices
Grandway Law Offices

According to the No.48 Announcement, companies will be allowed to choose income tax policies for their restructurings at their discretion, as compared with the previous regulations that required them to follow whatever policies the tax authorities may approve in advance. While the new rule provides taxpayers with much more flexibility in applying special tax treatment, it is worth mentioning that it adds burdens and risks to restructuring enterprises. Therefore, enterprises must assess risks appropriately before applying any special tax treatment and take control measures accordingly.

Assessing tax treatment policies and identifying risks at the stage when the corporate restructuring programme is developed. First of all, the enterprise should consider the different tax implications of ordinary and special tax treatments on its restructuring programme. According to the No. 59 Circular, if ordinary tax treatment is applied to the enterprise’s debt restructuring, the gains or losses of restructuring must be recognized in the current period and fair value of the asset involved may be used as its new tax base. On the contrary, if special tax treatment is applied, the enterprise is allowed to recognize part of the gains or losses of restructuring, or it may leave them unrecognized at all, in the current period. The gains or losses to be recognized evenly in coming years will be included as taxable income, or the gains or losses can be recognized on a one-time basis in the future when the asset involved in the restructuring is disposed of or transferred. Therefore, financial considerations have a direct impact on what tax treatment to be selected.

Second, it is crucial to communicate and coordinate with the competent tax authority regarding the restructuring programme in a timely manner. Although enterprises are allowed to apply special tax treatment to their restructurings without going through pre-approval and filing procedures now, tax authorities are still empowered by the Law on the Administration of Tax Collection to adjust taxes filed by enterprises or even conduct special tax inspections on the enterprises. To avoid future risks of tax adjustment or inspection, enterprises must have sufficient communication with tax authorities before applying special tax treatment to their restructurings.

Third, the parties involved in a restructuring must fulfil especially the duty of tax filing and statement fully and in a timely manner. The parties shall submit relevant materials to duly complete the filing procedures. The leading party should take the initiative to file a tax return with its competent tax authority. After that, the other parties shall undergo formalities for filing tax returns with their respective competent tax authorities on the strength of the report forms, attached schedules and other filing materials that have been accepted by the leading party’s tax authority. When filing annual tax returns, the enterprises shall submit a statement of relevant issues, including whether there are any other equity or asset transactions relating to the restructuring in the last 12 consecutive months before the restructuring, whether such transactions are steps of the restructuring, and whether they have been treated as corporate restructuring.

Fourth, the legal risks of different tax treatments must be assessed. In view of the regulations in effect, the major risk of applying different tax treatments is that an enterprise that selects special tax treatment for its restructuring may risk failing to get the subsequent acceptance of tax authority. In this case the enterprise will have to make tax adjustments (adjusting its taxable income and the tax base of the relevant asset), pay additional tax and a late fee. These may have an impact on the implementation of the original restructuring programme.

The follow-up management and risk control after tax treatment policy is selected. If an enterprise applies general tax treatment for its restructuring, it must recognize gains from the restructuring and pay taxes duly in the current period. Financially it must adjust the tax base of the asset involved in the restructuring in a timely manner so that it will be able to benefit from these tax arrangements in the future.

If special tax treatment is applied to the restructuring, the enterprise needs to take the following actions. Firstly, the income deferral must be recorded and stated accurately. The gains from debt restructuring or total proceeds of asset (equity) transfer required to be recognized should be recorded accurately, and a statement of the amount recognized in the current year and amount carried forward to subsequent years has to be provided when the corporate income tax for the year is paid. Secondly, a special statement needs to be submitted at the time when any asset (equity) involved in the restructuring is transferred or disposed of. In addition to how deferred income tax liabilities are treated, the statement should highlight the comparison (including changes and reasons) between tax bases of the restructured asset (equity) at the time of application of special tax treatment and at the time of transfer or disposal.

An enterprise that applies special tax treatment to its restructuring should also pay attention to coordination and cooperation with the competent tax authority, which generally follows up subsequently to learn about dynamic changes to the relevant asset or equity in the 12 consecutive months before and after the restructuring. The enterprise must report changes of the asset involved in the restructuring in a timely manner. Since tax authorities maintain accounts for restructurings to which special tax treatment is applied, the enterprise must ensure data consistency of its annual filings, avoiding any notable unreasonable or abnormal changes. When the restructured asset is disposed of, the competent tax authority will run appropriate assessment and review procedures to see if there is any abnormality. If any issue is identified, the tax authority will order tax adjustments.

Li Rongfa is a partner at Grandway Law Offices

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