This year will mark a half-decade since the release of Circular 698.  The confluence of local enforcement and increased exits by off-shore investors may make 2014 its most interesting year.

A Circular 698 Refresher

Prior to Circular 698, the PRC relied on cross-border payment disclosures to initiate investigations for potential tax evasion.  On 10 December 2009, the State Administration on Taxation (“SAT”) issued its “Notice on Strengthening the Administration of Enterprise Income Tax on Share Transfer Income of Non-resident Enterprises No. 698” (“Circular 698”) to enforce taxation offshore “indirect equity transfer” contract made to avoid PRC taxation.

Circular 698 requires disclosure by off-shore investors of certain indirect equity transfers.  An “indirect equity transfer” is the sale of an off-shore company holding PRC-resident entities.  If the transferred entity is in a jurisdiction with a tax rate lower than 12.5% or does not tax overseas income, then that entity must disclose the transaction to local tax administration authority of the Chinese resident entity within 30 days of its conclusion.  The disclosure must include, inter alia, the equity transfer contract, the relationship between the off-shore investor and the holding company’s funds and management, and the relationship between the holding company and the PRC resident’s funds and management.

If the foreign investor cannot show a reasonable business purpose for the off-shore transaction, then the State Administration of Taxation may treat the transfer as if it occurred on shore.

Why Circular 698 is an issue for 2014

Why bring up old news now?  One reason is that the accounting firm PWC reports that a supplementary circular may address the difficulty SAT faces in enforcing the Circular 698.  Other commentators suggest that it will widen the scope of the reporting requirements.  More pressingly, however, 2014 is likely to see increased exits by off-shore private equity funds from PRC investments.

While some of these exits may be IPOs that are likely to be exempt (an IPO on a foreign market is likely a reasonable business), more exits will to be off-shore sales of off-shore entities from off-shore sellers.  Given the lack of direct contact with the PRC, enforcement is questionable.

An off-shore seller will argue that there is no obligation for it to disclose to the PRC that it has made an off-shore sale of an off-shore entity (e.g., India is the only other major country taxing indirect transfers that are not related to real estate).  Recognizing this reporting issue, enforcement efforts beyond SAT’s perusal of company year-end reports and press releases may increase in 2014.

Even when the seller wishes to disregard the disclosure, the purchaser is unlikely to acquiesce for two reasons.  First, the PRC authorities have taken the position that the tax may be viewed as a withholding tax for which the purchaser or target company is liable.  Second, purchasers have argued that in the event that future Circular 698 disclosure is filed when the now-purchaser disposes of the company, its step-up in basis may disregarded.

Risk Allocation and Planning

Given these risks, the purchasers are now demanding a covenant in the purchase agreement obligating the seller to timely comply with Circular 698.   They also require an indemnity to ensure the seller bears any related liability associated with it.

While it is to late anticipate exits in 2014, investors targeting PRC subsidiaries this year may want to ensure that a reasonable business purpose underlies its off-shore acquisition structures (e.g., gaining revenue from non-PRC sources and conducting corporate activity from outside the PRC).