Case Study: Tax Treatment of Capital Gains – Part 2: Calculating Capital Gains Tax
Through Ines Liu
Hong Kong entered into a Double Taxation Agreement (DTA) with China in 2006. The treaty acts as a means of avoiding double taxation and combating tax evasion, improving the ties between the two jurisdictions by strengthening their respective tax laws, encouraging competition and promoting investment. A fourth protocol was signed on April 1, 2015, modifying four key aspects of the DTA. One such aspect was a tax exemption for capital gains realized by foreign investors who sell shares of a company based in China, which was examined in the first part of this case study. The second part of the case study will address the questions Company A should be aware of when applying for a capital gains tax exemption and how to calculate the capital gains tax on shares. restricted.
Calculation of capital gains tax via the sale of restricted shares: scenario
A leading global venture capital holding company had an incorporated subsidiary in Hong Kong (Company A). Company B was a private Chinese company and decided to become a listed company. Before Company B went public, Company A purchased restricted shares * of Company B. Company A planned to sell its shares after a 12 month restricted share trading period. Subsequently, Company A transferred 20 million RMB from Company B, which was 32% of the total shares of Company B. Company B then launched a share reform program to increase the registered capital in order to to meet the requirements of the China Securities Regulatory Commission. The registered capital of Company B was 70 million RMB and was expected to increase to 100 million RMB. The remaining 30 million RMB consisted of the following:
- Contributed surplus: 13 million
- Reserve of legally acquired surpluses: 7 million
- Retained profit: 10 million
Due to the change in share capital, the percentage of share of company A has decreased to 30 percent. Thus, the question arises: how are the various components of the remaining 30 million RMB of registered capital taxed?
* Restricted stocks are not freely tradable, and for many investors, restricted stocks can constitute a large part of their net assets.
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Definitions and axioms
Let’s first look at the definition of technical terminology:
- Share capital: Capital approved by government authorities and invested by shareholders.
- Contributed Surplus: The amount of money a business earns from sources other than its profits.
For example, when a company issues and sells shares at a price higher than their face value. The contributed surplus figure helps both investors and the business distinguish between non-operating and operating income.
- Earned excess reserve: Profits are not paid out as dividends but reinvested in the main business or used to pay down debt.
- Retained profit: Profit that has not been distributed in the form of dividends to shareholders.
- Capital gain = Sale price – Cost of the investment.
- Value-added share: Total proceeds after subtracting the deductible investment cost.
- Capital contribution: The registered capital increase converted from net assets.
Regulations issued by the National Tax Administration (SAT), namely Guo Shui Han (2009) opinion n Â° 698, Article 3, clarifies the treatment of capital gains:
“Gains from the disposal of equity refer to the amount of the balance after deduction of the cost price of equity from the price of disposal of equity. The cost price of equity refers to the amount of the capital contribution actually paid to the Chinese resident company at the time of the investment and the acquisition of a stake by the transferor of the capital, or the amount of the capital transfer actually paid to the initial transferor of said capital at the time of purchase of these shares.
Thus, the investment cost refers to the consideration originally paid by Company A to acquire the shares of Company B. Therefore, the 20 million RMB which was transferred from Company B will be treated as the cost of the investment in the calculation of capital gains tax.
Given the PRC Corporate Income Tax (IS) Act and its rule of execution, as well as Opinion n Â° 698, shares that have been converted from excess capital cannot be considered as the investment cost in calculating capital gains tax. However, when converting the share capital from the legal surplus for the year and from the retained earnings, it was split into two taxable events: 1) the profit declared as a dividend; and 2) dividends reinjected into company B. Thus, the conversion of the reserve surplus and retained earnings can be considered as a capital contribution, and can therefore constitute the deductible investment cost in the calculation of the capital gains tax.
In addition, when reforming the shares of Company B, Company B also converted retained earnings into capital reserves. Chinese tax authorities imposed a 10% withholding tax on dividends upon conversion. Therefore, this capital reserve can be considered as the capital contribution and part of the cost of the investment.
A new circular for sale actions
According to Circular 53, entered into force on September 1, 2016, the section relating to the accounting for transfers / sales of trading securities stipulates that any transaction taking place before September 1, 2016 must be subject to a VAT rate of 6% on the real part of the transaction. added value. In addition, article 10 states that âTaxable events which occurred before this date but which have not been dealt with are treated in accordance with this provision of this circular. “ In light of this, Dezan Shira & Associates attempted to negotiate with the tax authorities that the legislation does not apply to Company A’s transaction, however, they claim that the legislation has retroactive effect, therefore, Company A would have to pay withholding tax on the sale of shares.
Circular 36 is the fundamental regulation on fiscal expansion of the VAT reform. It clarifies the perimeter of taxpayers, the perimeter of taxable activities, etc. Here is a summary of the points relevant to the case taken from the circular:
- Article 1: stipulates that those liable for VAT include all legal and natural persons.
- Article 6: Clarifies that foreign entities carrying out taxable activities in China must pay VAT through its withholding agent.
- Article 12: Specifies that taxable activities in China refer to any purchaser of services located in China.
- Article 13: stipulates that activities not subject to VAT must be carried out outside of China.
Therefore, from the above analysis, it can be inferred that the capital gains tax on the sale of restricted shares should be subject to withholding tax and VAT on taxable activities in China.
In this second part of the case study, the question of calculating capital gains tax was raised. It is crucial to define the cost of the investment in order to calculate the capital gain. However, the conversion of capital during the share reform seen in this case study is a particularly unique situation, and current tax regulations do not extend to the injection of capital. Therefore, it is advisable to consult the relevant tax authorities for proper advice in this regard. In addition, as Circular 53 indicates, any transaction carried out before September 1, 2016 must be subject to a VAT rate of six percent on the actual part of the added value. This recent development affects the situation explored in the first part of this case study, which dealt with tax exposure and the implication of capital gain, which is also subject to VAT on taxable activities in China.
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