Under its World Trade Organisation agreement, the Chinese government has promised broader access to its markets. Even some previously prohibited industries, such as telecommunications, are expected to open up to foreign investors. These newly opened markets are dominated by state-owned enterprises (SOEs), which have extensive experience in the local market. Some have also created brands that have become household names in China.
Reluctance to lose control
SOEs have a pressing need to bring in new capital, new technology and new management methods by striking partnership deals with experienced foreign investors. However, they are seldom willing to lose control at the highest corporate level. Instead, they tend to carve out a piece of their operating assets (such as a business unit or a production plant), inject it into a new subsidiary and allow the foreign investor to invest in that subsidiary.
The foreign investor may only be interested in a certain division or business unit of the SOE, and thus is only willing to invest in an entity separated from the parent company. In order to fulfill these requirements, the SOE has to carry out a corporate reorganisation in order to isolate the targeted unit from its other assets.
Reorganisations always incur costs, including tax, but these can readily be reduced with proper planning. Otherwise, some of the tax costs will invariably end up being paid by the foreign investor in the cost of the acquisition.
A reorganisation, or spin-off, of this type is essentially an 'asset for equity' swap, where the domestic enterprise swaps a piece of its operating assets for the equity interest in a new foreign-invested subsidiary. Under current income tax law, an asset for equity swap falls into one of two types: an enterprise investing with part of its non-monetary assets, or an enterprise investing by transferring all of its assets as a whole. The income tax treatments of the two types are very different.
According to income tax regulations, when an enterprise invests externally with part of its non-monetary operating assets, the transaction must be split into two economic activities at the time of execution. This is construed to include a sale transaction of non-monetary operating assets, at a fair market value, and then an investment transaction, with the gain or loss for such a sale to be recognised and assessed for income tax purposes.
If an asset transfer is relatively substantial and if the recognition of gain within a single tax year imposes genuine financial difficulty on the transferor, upon approval by the relevant tax authorities, the gain can be amortised evenly over a period of five years, starting with the year of transfer.
For income tax depreciation or amortisation purposes, the cost basis of non-monetary assets received by the invested enterprise can be determined with reference to their re-appraised value.
In a whole-asset contribution, an enterprise must transfer all of its assets as a whole. This requires the transferor either to transfer all of its business activities as a whole (including all the operating assets and liabilities) without legally dissolving itself; or to transfer its 'independently accountable' branch(es) to another enterprise (the transferee) in exchange for an equity interest or shares in the transferee.
In principle, as in the case above, income tax regulations require a whole-asset contribution to be split into two economic activities, one being a sale of assets as a whole at a fair market value and the other being an investment transaction. The transferor must recognise the gain or loss on the sale of assets and pay income tax on it accordingly.
What makes a whole-asset contribution more favourable from a tax planning perspective is that an exception rule prescribed in the income tax regulations allows a deferred recognition of gain or loss on the sale of the assets, if the contribution fulfils certain conditions.
In a transaction where the 'non-stock consideration' (including cash and securities) paid by the transferee does not exceed 20 per cent of the face value of the shares received, upon approval by the relevant tax authorities, the transferor is allowed to defer recognition of the gain or loss. In that case, the transferor's tax basis, with regard to the shares received from the transferee, is determined with reference to the net book value of the assets being transferred. By the same token, the tax basis of the transferee, with regard to the assets received, is also determined by reference to the net book value in the transferor's book. No revaluation of the assets is allowed for income tax depreciation or amortisation purposes.
An SOE usually wants to spin off only part of its operating assets to form a new subsidiary. A tax-free whole-asset contribution will be difficult to achieve unless the assets to be spun off qualify, in aggregate, as an 'independently accountable' branch of the SOE.
Need to restructure
The assets of an SOE, such as a production plant or a business division, may not readily qualify as an 'independently accountable' branch. In that case, the SOE would need to restructure its operating assets prior to the transfer. Unfortunately, the income tax regulations do not provide a clear definition of what exactly an independently accountable branch is.
According to accounting regulations, an independently accounted entity must: have its own bank account; be able to prepare its own accounting books and financial statements; and be able to ascertain its own profit and loss position.
Due to the lack of any clearer definition and the absence of judicial precedence, the whole-asset contribution of an SOE is subject to interpretation by local tax authorities. Advanced rulings may need to be obtained before proceeding with any corporate reorganisation. It is possible to seek an exemption from income tax.
This article was written by Petrina Tam, partner and Kai Jiang, manager, of the Hong Kong office of PricewaterhouseCoopers.
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