China: Withholding Tax Deferral on Profits Used by Overseas Investors for Direct Investment

published on January 5, 2018

In the past, if retained earnings of a foreign invested company were used to increase the registered capital, this transaction was deemed as a profit distribution triggering withholding tax on dividends.

The same applied when the retained earnings served for the establishment of a sister company in China. This is going to be changed according to a newly issued government circular:

Following the Circular of the Chinese State Council on Several Measures to Boost the Growth of Foreign Investment (Guo Fa [2017] No. 39), four authorities including the Ministry of Finance and the State Administration of Taxation ("SAT") jointly published the Circular "Cai Shui [2017] No. 88" ("Circular 88") on December 21, 2017 to specify the deferral of withholding tax liabilities on profits used by overseas investors for further direct investment in China.

Effective from January 1, 2017, foreign investor's profits from resident enterprises in China that are directly reinvested in encouraged investment projects will be entitled to the tax deferral and accordingly be temporarily exempted from withholding tax obligations, if relevant preconditions are fulfilled. The tax deferral policy will significantly ease the tax burden of foreign enterprises for their reinvestment in China without doubt and correspondingly motivate foreign enterprises to leave profits in China in a longer term.

• Preconditions

• Withholding Obligation and Follow-Up Administration

• Retroactive Implementation

• Our Observation

Preconditions

According to the Circular 88, to enjoy the tax deferral policy, the following four preconditions must be met:

• The investment must be made in the form of direct investment, including equity investment like capital increase, new enterprise incorporation and share acquisition by overseas investor, but excluding the capital increase, conversion into share capital, share acquisition of listed companies and share acquisition in related parties;
• Profits should be realized retained earnings that have been declared to be used for reinvestment;
• Funds (assets) for re-investment must be directly transferred to the account of invested party or share transferor, and may not be circulated in other domestic or overseas accounts;
• The re-investment must be made in the industries that fall into the encouraged investment projects listed in the "Catalogue for the Guidance of Foreign Investment Industries" or the "Catalog of Priority Industries for Foreign Investment in the Central-Western Region".

Withholding Obligation and Follow-Up Administration

Taxpayers are the overseas investors. The withholding agents are the subsidiaries that are deemed to distribute profits. Therefore, if the overseas investors want to apply for the preferential tax deferral treatment, they need to rely on the withholding agents to make the relevant process as follows:

• Foreign investors are responsible for providing the relevant supporting documents regarding its qualification for enjoying the preferential policy for the domestic enterprises;
• If the preconditions are assessed as being met to entitle the foreign investors for the benefits, the domestic enterprises shall perform the filing procedures at their competent tax authorities;
• If the tax authority verifies that the overseas investors do not meet the preconditions during the follow-up administration, it shall be subject to late payment fees for the overdue tax payment.

In addition, since the tax benefit is only tax deferral instead of exemption, the timing of tax liability is deferred to the time when the overseas investors actually recover the above reinvestment. This means that the deferred tax should be declared and settled within 7 days after actual receipt of payment, when the overseas investors recover the direct reinvestment through share transfer, stock repurchase, liquidation or other ways. If the relevant transaction meets the conditions of special tax treatment for re-organization, the tax deferral policy can still be enjoyed.

Retroactive Implementation

The tax deferral policy shall be implemented retroactively from January 1, 2017, i.e. it is applicable to the direct reinvestment contributed by profits after January 1, 2017. If an overseas investor is eligible for but does not enjoy such preferential policy in fact, it could file an application for re-enjoying the policy within three years from the date the relevant tax payment is made in practice to get tax being refunded.

Our Observation

Referring to the preconditions stipulated in the Circular 88, it can be noted that undistributed profits retained before the issuance of the Circular 88 can also be applied to the tax deferral treatment.

It is worth to note that foreign investors who have received dividends from a subsidiary in China to reinvest in 2017 may not apply for the tax refund. According to the Circular, if profit has been paid to the offshore bank accounts of the investor, it does not qualify to enjoy the tax deferral policy. The Circular clarified that the profit shall not leave China and shall directly be used for the reinvestment.

Circular 88 has not yet specified the documents to be prepared for enjoying the benefits and record filing procedures should be undertaken during the transaction process. It is expected that the SAT will promulgate more detailed administration rules in the future to clarify these practical problems.