Income taxes on partners of limited partnership and VC funds

By Yang Kaiguang and Che Qianli, Zhong Lun Law Firm
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A limited partnership private fund is not a subject of taxation, while its partners shall respectively pay income taxes. This effectively helps avoid double taxation. However, in accordance with the circular No.159 (2008), even if a fund does not distribute income to its investors, the investors shall still pay taxes.

Interest, dividend and bonus income obtained by partnerships. Interest, dividend and bonus income obtained by a natural person partner normally is subject to tax rate of 20%, in accordance with article 2 of circular No.84 (2001). However, recently, in certain regions, interest, dividend and bonus income obtained by a natural person partner have been included in its income from production or business operation and other income, subject to a tax rate of 5-35%. For a partner who is a resident enterprise, it shall normally pay tax at the rate applicable to it in accordance with article 83 of the Regulations on Implementing the Enterprise Income Tax Law, but there is dispute over it in practice.

taxes
Yang Kaiguang
Partner
Zhong Lun Law Firm

Income from transfer of target companies by a fund and distribution of gains to partners. A natural person partner normally pays tax at 5-35% in accordance with article 4 of the circular No. 91 (2000), but the preferential tax rate of 20% applies in certain regions. A partner who is a resident enterprise shall pay tax at the rate in accordance with article 2 of circular No. 159 (2008).

Income from transfer of fund units by a partner. Scenario 1: Under a single-tier structure, if an investor transfers its fund units, a natural person partner shall pay tax at 20%, while a partner who is a resident enterprise shall pay tax at the rate applicable to the enterprise.

Scenario 2: Under a fund of funds (FOF) structure, if an investor directly transfers its units in the FOF, a partner shall pay tax as stated in scenario 1. If an FOF transfers units of its funds, then its natural person partners shall pay tax at 5-35%, while its partners who are resident enterprises shall pay tax at applicable rates.

taxes
Che Qianli
Partner
Zhong Lun Law Firm

Taxes on partners of shareholders of a partnership in the process of organizational form change of the enterprise that intends to launch an IPO. While an enterprise changes its organization form, it often has undistributed profits and surplus reserve converted into share capital, but there are no explicit regulations on income taxes of partners of shareholders of a partnership. As seen from case studies, natural person partners of such enterprises shall pay personal income taxes or make an undertaking to pay back taxes, and its partners who are legal persons are not required to separately pay income taxes in the whole process of change of the organizational form, but there are disputes over whether taxes shall be paid in the annual final settlement.

VC funds

Circular No.8 (2019), published on 1 January 2019, specifies tax breaks for venture capital (VC) funds. In other words, a VC enterprise may select the unitary investment fund calculation for tax payment at 20%, or annual income calculation for tax payment at 5-35%. However, there are certain disputes during the implementation of the circular as follows.

Linkage between tax breaks for VC funds and types of filing with the Asset Management Association of China (AMAC). A difficulty in practice is whether a fund that is filed as an “equity investment fund” at the AMAC, but is substantially a “VC fund” satisfying tax break conditions, is entitled to tax breaks. The relevant authorities’ attitude toward this problem varies in different places.

A circular published on March 2018 by the Beijing branch of the China Securities Regulatory Commission (CSRC) specifies that whether a VC fund is entitled to tax breaks under pilot tax policies will be determined by considering the feedback of the AMAC.

The Circular on Tax Breaks for VC Funds, published by the Xiamen Branch of the CSRC, specifies that if a fund product that is actually a VC fund is wrongly filed as an equity investment fund in the AMAC filing system in the early stage, and really needs tax breaks, it may provide relevant explanations to the authority prior to 28 June 2019.

The Work Guide to Hot Issues of Income Taxes of Natural Person Partners of Venture Capital Enterprises, published by Shenzhen Asset Management Association, released online in March 2019, sets out that a fund filed as a “VC fund” or an “equity fund” at the AMAC may be temporarily filed at Shenzhen Asset Management Association for tax breaks.

In addition, the Guide to Request of Venture Capital Funds for Application of Special Provisions on Shareholding Reduction by Shareholders of Venture Capital Funds of Listed Companies, published by the AMAC, sets out the process of request of qualified VC funds for application of policies. To be on the safe side, qualified VC funds may request to change the fund type according to the above-mentioned guide.

Selection between the two calculation methods of VC funds. If a VC enterprise selects the unitary investment fund calculation method, it shall file with the tax authority; otherwise, it will be deemed to select the annual income calculation. Once a selection is made, it shall not be changed within three years.

Normally, if funds managed by a VC enterprise are generally expected to be profitable, it may consider selecting the unitary investment fund calculation method with a lower tax rate. If the funds managed by it generate low return and relatively high costs, but are able to use a tax loss carryforward, or need to apply prior-year losses against current income for tax purposes at the early stage, it may consider selecting the annual income calculation method, and apply for changing the tax rate to 20% when the funds generate high earnings after three years.

Does circular No.8 apply to natural person partners under the multi-tier nesting structure? If the VC fund indirectly invests in science and technology start-ups through other partnership funds, there are no explicit regulations on whether tax breaks under circular No.8 apply to natural person partners of a VC fund. The Shenzhen VC Guide, published online, sets out that whether a fund under the multi-tier nesting structure is entitled to tax breaks depends on the circumstances.

Yang Kaiguang and Che Qianli are partners at Zhong Lun Law Firm. Sheng Linting, an associate, also contributed to the article

private funds

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