Meaning
A withholding tax reserve is established by a buyer to cover potential tax liabilities arising from the indirect transfer of Chinese taxable assets. The PRC Circular 7 reserve protects the buyer from joint liability under Chinese tax regulations if the offshore seller fails to pay the required capital gains tax. This reserve is withheld from the purchase price and held in escrow until the tax is paid or cleared.
Regulatory Risk
Chinese tax authorities possess the power to recharacterize an offshore equity transfer as a direct transfer of Chinese property if it lacks a reasonable commercial purpose. If this recharacterization occurs, the offshore seller is liable for corporate income tax on the gain. The buyer can face fines and liability for failing to withhold the tax.
Reserve Mechanism
The creation of the escrow account allows the transaction to close while the tax position is being assessed and resolved. The buyer retains a portion of the purchase price, often ten percent, in the escrow account. These funds are only released to the seller after the seller submits proof of tax payment or a tax clearance notice from the Chinese tax bureau.
If the tax bureau demands payment, the escrow agent pays the tax directly to the government out of the reserved funds and releases the remainder to the seller.
Transaction Settlement
Negotiating the terms of the reserve requires careful drafting of the share purchase agreement. The agreement must specify who has the obligation to file the transaction documents with the Chinese tax authorities. This filing must be completed within thirty days of the signing of the transfer agreement to avoid penalties.
