Meaning
Regulatory bulletin issued by the State Taxation Administration of China governs the taxation of capital gains derived by non-resident enterprises from the indirect transfer of Chinese taxable assets. A transaction falls under sta circular 7 when a foreign company sells shares in an offshore holding entity that owns a Chinese subsidiary. If the offshore structure lacks commercial substance, the Chinese tax authorities may reclassify the sale as a direct transfer of the underlying assets.
This rule stops applying if the seller can prove that the transaction was driven by legitimate business purposes rather than tax avoidance.
Reporting Obligation
Disclosure of the transaction is not strictly mandatory for the offshore seller, but failure to report can lead to significant penalties for the buyer. Under the rules of sta circular 7, the buyer acts as the withholding agent and is responsible for paying the tax if the seller defaults. Both parties often conduct a joint assessment to determine whether the deal should be reported to the local tax bureau.
Reporting within thirty days of signing the transfer agreement can provide a safe harbor against certain penalties.
Substance Test
Analysis of the offshore entity focuses on its staff, assets, functions and risks to determine if it has a genuine economic presence. The tax authorities evaluate under sta circular 7 whether the interposed company exists solely to facilitate the transfer of the Chinese asset without paying local tax. Factors such as the duration of the entity’s existence and its historical business activities are weighed against the tax benefits of the structure.
If the entity is deemed a shell, the entire gain is subject to the standard corporate income tax rate. The assessment also considers the source of the funds used for the original investment and the degree of control exercised by the parent company. This deep dive into the corporate history ensures that only artificial structures are penalized.
Tax Liability
Calculation of the tax due is based on the difference between the sale price and the original investment cost of the Chinese subsidiary. When a transfer is caught by sta circular 7, the non-resident seller must pay a ten percent tax on the gain. This payment is settled in the jurisdiction where the Chinese assets are located.
The buyer is incentivized to withhold this amount from the purchase price to avoid becoming liable for the seller’s tax bill.
