Since 2010，the China State Administration of Taxation (“SAT”) and the local authorities have increased scrutiny of equity transfer transactions between related parties. It is reported that local tax authorities in various provinces have successfully challenged equity transfer transactions between related parties and adjusted tax payments based on the “fair value” of the equity interest transferred in those transactions. According to a recent report by PwC in January 2013, the SAT is in the process of drafting a public notice to regulate the valuation methods of related parties’ equity transfer transactions.
According to the Corporate Income Tax Law of the PRC, taxpayers shall pay enterprise income tax for income originating from equity transfers and transfers of equity interest shall be conducted at fair value. In 2009, the Ministry of Finance and the SAT promulgated Circular 59 that confirmed that “fair value” was the valuation basis for equity transfers. In the same year, the SAT stipulated in Circular 698 that, where a non Chinese tax-resident transfers an equity interest in a Chinese tax-resident to its related party, the tax authority is empowered to adjust the transfer price based on reasonable methods, provided the transfer price does not comply with the arm’s length principle and results in a reduction of the taxable income. Further, the SAT clearly requested in Cai Shui Han  No.84 that tax authorities should strengthen investigations into anti-tax evasion on equity transfers and it encourages local authorities to explore using reasonable valuation techniques for equity transfers. Based on a report from PwC in recent years at least 20 equity transfer investigations have been carried out by local tax authorities and the tax adjustment amount has reached up to RMB2.37 billion.
Valuation Methods and Recent Developments
The SAT has not promulgated any guidelines on particular valuation methods that can be adopted by local authorities. According to reported cases, valuation methods employed by local tax authorities generally include the “income approach”, the “market approach” and the “cost approach”. The SAT acknowledges that valuation on equity is a very complex technical matter that local level tax bureaus may not have sufficient knowledge and skills to deal with it. So the SAT has decided to issue technical guidelines and provide more training to address potential tax avoidance tactics by companies. It has been reported that a public notice on related parties’ equity transfers is under joint review by various departments within the SAT, and we understand that it will be released to public in the coming months.
To respond to the increased scrutiny by the Chinese tax authorities on valuation of equity transfer transactions, we recommend that companies contemplating equity transfers amongst its PRC affiliates should take into consideration the overall regulatory environment and be prepared to address possible enquiries from Chinese tax authorities with respect to the fairness of the transfer price, specially if the transfer price is at cost where fair value may be difficult to determine and no appraisal is conducted by an independent firm. Prior consultation with the relevant tax authority and the obtaining of an appraisal from a qualified independent appraisal firm are recommended to reduce the uncertainty of the tax consequences of such transactions. We also recommend that companies contemplating such transactions closely monitor the development of SAT regulations in this area, which may be forthcoming soon and may further clarify the tax treatment of future transactions.
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