Realising PRC Profits

More on what you need to know about structuring international private equity investments in the People’s Republic of China. By John Forry of Eisner and Steven Bortnick of Pepper Hamilton

The authors in previous articles in the February and April 2009 issues of Private Equity Manager identified selected points affecting international private equity investments in the People’s Republic of China (PRC), focusing on tax efficiency at the investors’ and the PRC portfolio company’s levels and on legal and related considerations. This article briefly identifies selected tax planning opportunities for US investors holding PRC private equity investments and then turns to general exit planning for PRC private equity investments.

Initially it should be recalled that a new PRC Enterprise Income Tax Law came into effect on 1 January 2008, and a new Anti-Monopoly Law became effective on 1 August 2008, with many details under these laws remaining yet unclear. While citations for a number of the points below may be found in the lengthier article referred to in the opening note above, reliance upon the points raised in this and the prior articles should be preceded by confirmation of evolving PRC and other rules and by consultation with professional advisers appropriately authorized to provide PRC and other relevant legal and tax advice.

US income tax planning during holding of PRC private equity investments can be a tricky proposition. Dividends paid from a PRC portfolio company to a US taxable investor not only may be taxed by the PRC as local source income under the PRC income tax treaty with the US, but currently may be taxed to a US individual at a US rate of 15 percent as qualified dividends if certain conditions are met, and otherwise taxed to a US investor at US ordinary income tax rates, subject to a US foreign tax credit for PRC income taxes.   

What about risks of US taxation of PRC portfolio company distributions even if they are retained in a non-US holding company? At least two US federal income tax issues must be addressed: First, if the PRC or foreign holding company is a controlled foreign corporation under US income tax rules, such dividends or other passive income payments usually trigger current US taxation of substantial US shareholders of the holding company.  However, an exception generally applies for dividends from a related corporation organized and with substantial trade or business assets within the same country – here, this may be satisfied if the PRC portfolio company is owned through a PRC holding company. A temporary expansion of this exception has applied to dividends from such a PRC portfolio company even if paid to a holding company in a foreign country other than the PRC.  

Second, if the PRC or foreign holding company would otherwise be a passive foreign investment company under US income tax rules, such dividends or other passive income payments usually will trigger current US taxation or unattractive later taxation of any US shareholders of the holding company. However, passive income and assets generally exclude active business income and assets of a corporation owned at least 25 percent by the holding company – here, active PRC enterprises if owned at least 25 percent by the PRC or other foreign holding company.

Alternatively, it may be possible to make an election solely for US tax purposes to treat active enterprises owned by the PRC or foreign holding company not as corporations but as partnerships or branches owned by the holding company, so that income from them is not taxed as dividends or other passive income.
In addition, under US tax principles interest on a shareholder loan usually must be accrued into income over time, even if payment of interest is not required until maturity or another exit event.  One way to avoid this is the use of a hybrid financial instrument – i.e., an instrument treated as debt in the PRC or other country of the issuer and equity in the US. However, even if the instrument is treated as equity in the US, careful review is required in order to ensure that certain deemed dividend rules applicable to preferred stock do not apply to require acceleration of the taxation of dividends or the conversion of capital gain into ordinary income.

As to structuring for exit from a PRC private equity investment, private equity investors first must take account of potential PRC taxes on alternative exit gains:

Disposition of assets of the PRC portfolio company may avoid lengthy negotiations on hidden liabilities of the company which can adversely affect the value of a share purchase or merger.  However, clearly the asset sale will generate taxable income for the portfolio company. Moreover, PRC value added tax – currently 17 percent – and other business taxes on individual asset sales may be avoided where PRC tax authorities agree that the sale constitutes substantially the whole of the business of the portfolio company – but such a ruling may only come after the sale is made or may be decided differently depending upon the applicable local tax bureau.  Furthermore, appreciation in the value of land in the hands of the selling portfolio company may be subject to land appreciation tax of up to 60 percent.

In addition, under the new income tax law, liquidation income from a PRC company is taxed as dividend income to the extent of accumulated earnings and the balance of any gain as profit from the transfer of investment assets. This liquidation tax treatment was originally applicable also to foreign enterprises receiving such profits, but that clause was later deleted in the new income tax law.

If the portfolio company has been a foreign invested enterprise which previously received PRC tax benefits as noted further above, those benefits may need to be paid back if it ceases business within 10 years after their commencement following its disposition by private equity investors. With respect to direct sale by the foreign owner of a PRC enterprise, previously taxation of gain at 10 percent applied and under the new income tax law most PRC investment earnings paid to non-resident enterprises are subject to withholding tax at 20 percent, currently reduced to 10 percent by implementing regulations. Shortly before promulgation of the new income tax law the PRC government denied that it intended to impose capital gains taxation on share transfers. Since income derived by foreign enterprises from the transfer of PRC property is generally taxable, if share transactions are not to be taxed, then regulations will need to create an exemption.

Alternatively, under most income tax treaties of the PRC, capital gain from the disposition of property generally is not taxable to a resident of the treaty country if not attributable to a permanent establishment in the PRC of the foreign seller – this argues for using a foreign entity entitled to tax treaty benefits to dispose of a private equity investment in the PRC. However, many PRC treaties reserve the right of the PRC to tax disposition of ownership interests of 25 percent or more and, just as in the case of planning for distributions to investors, contain limitation-of-benefits clauses. Moreover,  the new income tax law empowers PRC tax authorities to make reasonable adjustments where an enterprise implements an arrangement with no reasonable commercial purpose other than to reduce its taxable income or profit.

If a PRC investment fund is established to hold the PRC portfolio company, as permitted in certain local jurisdictions of the PRC, apparently capital gain on its disposition of company interests will be taxed by the PRC at 20 percent – again not particularly favourable, compared to the PRC rates applicable to capital gains of foreign funds as discussed above.  

One frequently considered alternative – as discussed further below – is to dispose of interests in a foreign holding company which in turn owns the PRC portfolio company. Generally PRC taxation does not apply to gains on such a disposition, except to the extent PRC owners are involved. However, the new income tax law does not appear to permit the purchaser of a portfolio company’s shares (or a holding company’s interests) to obtain a stepped-up tax basis in the company’s PRC assets without triggering company recognition of profit from appreciation in the assets and possible asset transfer taxes as described above. A PRC enterprise that is reorganised currently must recognise profit from the transfer of its assets and the tax bases of the relevant assets are then revised according to the transaction prices – thus even the transfer of a subsidiary from one entity to another will be treated as a taxable event. This suggests that a purchaser which is unwilling to maintain the portfolio company’s structure as is may incur significant PRC taxes.

What of non-PRC taxation of exit profits at the investors’ countries’ level?

To date most PRC private equity investments have been held through companies established in the Cayman Islands or British Virgin Islands. Additional currently favorable holding company jurisdictions include Hong Kong, Mauritius and Singapore. Accordingly – as noted immediately above – one alternative exit for investors is to sell their interests in the foreign holding company. One such sale strategy is to list the foreign holding company on the Hong Kong Stock Exchange, which may be favourable for a public offering of shares in such a holding company because of the inapplicability of requirements under the US Sarbanes-Oxley Act or similar rules. However, only Bermuda, Cayman Islands, Hong Kong and PRC companies are currently approved for listing on the Hong Kong Stock Exchange (neither British Virgin Islands nor US companies are approved).

For US investors, if the foreign holding company is a controlled foreign corporation, gains may ultimately be taxed as ordinary income up to the accumulated earnings of the corporation – thus this classification should be avoided by assuring that the foreign holding company is not owned more than 50 percent in voting power or value by US persons each owning 10 percent or more of the voting power. In addition, unfavorable US taxation of US shareholders in case the foreign holding company is treated as a passive foreign investment company can be avoided if the foreign holding company owns at least 25 percent directly or indirectly of PRC enterprises with active business income and assets, or lesser percentages of active PRC enterprises which are treated not as corporations but as partnerships or branches for US tax purposes. In these circumstances, disposition gains to taxable US investors should receive capital gains treatment for US income tax purposes.

US tax-exempt investors will not be taxed on such disposition gains as unrelated business taxable income, if any debt financing incurred for the private equity investments is incurred by one or more entities classified as corporations for US income tax purposes below the level of the investors themselves or below a partnership through which they hold their interests.

For investors in other countries, measures should be considered to assure similar favourable capital gains treatment or tax exemption on such disposition gains.

Alternatively, a disposition which qualifies as a tax-free reorganisation for US and/or other investors may be considered:

For example, recently liberalised US tax rules may enable a tax-free acquisition of a Cayman company with PRC operations in a so-called reverse subsidiary merger. In this approach, the acquiror may establish a Cayman acquisition subsidiary that can utilize a local Cayman scheme of arrangement to be amalgamated with and into the target holding company. This also may permit payment to selling shareholders by a combination of (non-taxable) voting shares of the acquiror plus (taxable) cash or other non-share consideration.

In such a transaction, the existence of the target foreign holding company continues, so that PRC regulatory issues regarding change of ownership of private equity investments in one or more PRC portfolio companies will likely be avoided.

John Forry is a principal with the accounting and tax advisory firm of Eisner based in New York and a professor of international finance at several US and European graduate schools. Steven Bortnick is a partner with the law firm of Pepper Hamilton. Those interested in exploring further the points raised here and additional related matters may consult the authors’ article, “Structuring International Private Equity Investments in the People’s Republic of China”, published in March 2009 in The Banking Law Journal.