Many families from Hong Kong, Taiwan, mainland China and Southeast Asia own businesses, factories or property in mainland China through a chain of offshore companies: often a British Virgin Islands or Cayman company at the top, a Hong Kong company in the middle, and a Chinese operating company at the bottom. When the time comes to sell, bring in an investor or restructure for the next generation, a common assumption is that selling the offshore company is outside China’s tax net because no Chinese company changes hands.
That assumption can be costly. China has rules that may tax an indirect transfer of Chinese assets, and families who now live in Australia may face Australian tax on the same gain. This article explains the issues in general terms. It is not tax advice. Advice from a Chinese tax adviser is needed on the Chinese side, and from a registered tax adviser in Australia on the Australian side.
What is an indirect transfer?
A direct transfer is a sale of shares in the Chinese company itself. An indirect transfer is a sale of shares in an offshore company that sits above the Chinese company, so that the Chinese assets change ownership without the Chinese company’s own shares being sold.
Under China’s indirect transfer rules, where a non-resident enterprise indirectly transfers Chinese taxable property (such as equity in a Chinese company or real property in China) through an arrangement that lacks a reasonable commercial purpose, the Chinese tax authorities may disregard the offshore company and treat the sale as if the Chinese assets were sold directly.
Factors that are generally relevant include:
- whether most of the offshore company’s value comes, directly or indirectly, from Chinese assets;
- whether most of its income is sourced from China;
- whether the intermediate companies have real substance, such as staff, premises, functions and business risk, or are holding shells;
- how long the structure has existed and why it was set up; and
- whether a direct sale would have been taxed in China, and whether the offshore sale is taxed elsewhere.
Possible consequences in China
- Tax on the gain. For a non-resident enterprise, a gain treated as Chinese-sourced is generally taxed at a withholding-type rate of 10%, subject to any relief available under a tax treaty. The exact calculation, and the treatment of individual sellers, should be confirmed with a Chinese tax adviser.
- Buyer withholding. The buyer may be responsible for withholding the tax from the price. For this reason, informed buyers increasingly ask for tax analysis, a price holdback, a reporting plan or an indemnity.
- Reporting. The parties may be able, or expected, to report the transaction to the Chinese tax authorities. Late payment can lead to interest and penalties.
- Individuals. China’s individual income tax rules also contain anti-avoidance provisions. A family member who sells personally should not assume the rules only apply to companies.
Safe harbours and exceptions
There are exceptions, but each has conditions. In general terms, buying and selling shares of a listed company on a public market may fall outside the indirect transfer rules, and certain internal group restructures that meet ownership and other conditions may qualify for relief. Tax treaty protection may also be available in some cases. Families should not assume an exception applies without specific advice and good records.
The Australian angle
If the seller, or the people who ultimately receive the proceeds, are Australian residents, Australian tax also needs to be considered:
- Australian capital gains tax. Australian residents are generally taxed on worldwide gains, so a sale of offshore shares by an Australian resident individual or trust may be subject to Australian CGT on the same economic gain that China taxes. Different rules may apply where the seller is a company.
- Foreign income tax offsets. Where foreign tax is paid on the same income or gain, a foreign income tax offset may be available in some cases, but it is subject to limits. Differences in timing, currency, cost base and who is treated as the taxpayer in each country can mean the offset does not fully cover the Chinese tax.
- Residency of offshore companies. If an offshore holding company is in practice controlled from Australia, it may itself be an Australian resident company, which changes the analysis.
- Trusts. Where a family trust holds the shares or receives the proceeds, the way gains and foreign tax credits flow to beneficiaries, and which beneficiaries are resident, matter.
- Timing. When the family member became an Australian resident, and the market value of the shares at that time, may affect the Australian gain.
Succession transfers can also be caught
Indirect transfer issues are not limited to sales to outside buyers. Gifting offshore shares to children, transferring them into a trust, reorganising a holding chain before a parent passes away, or dealing with shares on inheritance may involve transfers that the Chinese rules examine, particularly where no market price is paid. These steps may also have Australian consequences for the family members involved.
For this reason, it is often better to plan the succession structure well before a sale is on the table, rather than restructuring in a hurry once a buyer has appeared.
Composite example: a Hong Kong family in Sydney
This is a composite hypothetical drawn from common situations. Names and details are invented.
Mr Cheung moved from Hong Kong to Sydney several years ago and is now an Australian resident. His Hong Kong investment company owns a BVI company, which owns a manufacturing company in Guangdong. A buyer offers to purchase the BVI company. The Hong Kong and BVI companies have no staff of their own, and Mr Cheung makes all decisions from Sydney.
The buyer’s advisers ask for a withholding and reporting plan in China. Mr Cheung’s advisers also identify that, because he controls the Hong Kong company from Sydney, it may be treated as an Australian resident company, which could bring the gain into Australian tax as well. In addition, he had planned to transfer part of the shares to his daughter in Hong Kong before the sale. The family pauses, obtains Chinese and Australian tax advice, and decides on the order of the succession and sale steps before signing.
Frequently asked questions
We are selling the offshore company, not the Chinese company. Why would China tax it?
Because China’s indirect transfer rules may look through an offshore company that lacks a reasonable commercial purpose and treat the sale as a sale of the underlying Chinese assets. Whether the rules apply depends on the substance and history of the structure.
If tax is paid in China, will we also pay tax in Australia?
Possibly. Australian residents may be taxed on the same gain. A foreign income tax offset may reduce Australian tax in some cases, but it may not eliminate double taxation entirely. The interaction should be modelled before the sale.
Does this affect giving offshore shares to my children?
It may. Gifts and other transfers within the family can be examined under the Chinese rules and may have Australian tax consequences. Succession transfers should be planned with Chinese and Australian advice.
How Chua Tan Associates can help
Chua Tan Associates advises families across Australia who hold businesses and property in Greater China through offshore structures, including on sale and investment documents, restructuring for succession, trusts, Wills and estate planning. We are lawyers, and we work with registered tax advisers in Australia and with lawyers and tax advisers in mainland China, Hong Kong and Taiwan so that both sides of a transaction are considered together. We advise in English, Mandarin and Cantonese.
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Chua Tan Associates acts for families, executors, trustees and their professional advisers in estate planning, estate administration and estate disputes in Australia and across borders. To arrange a confidential consultation, please contact our Melbourne office on +61 3 9602 3988 or submit an enquiry. Advice is available in English, Mandarin and Cantonese.
Justin Chua (蔡智勋), lawyer and mediator, Chua Tan Associates, Melbourne. General information only, not legal or tax advice.
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