A previous article noted that foreign investors have to carefully select the proper investment holding vehicle for a mainland investment that will bring about the best result in terms of dividend distribution. Now, we will discuss the tax implications of future disposal.

Based on the Income Tax Law on Foreign Investment Enterprise, foreign investors of a foreign investment enterprise (FIE) are subject to withholding tax on any gain derived from the mainland on the disposal of a mainland entity's equity interest. Such withholding tax had been set at 20 per cent and was subsequently reduced to 10 per cent. Therefore, if a foreign investor disposes of its interest in a FIE or even a domestic enterprise, it is subject to 10 per cent withholding tax on the gain so derived. The gain from the disposal of interest is the balance of the sales proceeds after deduction of investment cost and capital surplus and the undistributed profits that the investor is entitled to and will be transferred to the new acquirer due to the change of ownership. As China adopts a withholding tax system and the taxpayer in this case is a foreign entity, the tax withholding agent will be the mainland entity to be transferred.

To avoid the withholding tax, the holding vehicle and structure is very important. There are different general rules that can be observed:

How many layers of entity would be used for investment holding purposes; and

Which country should the direct holding entity be incorporated in.

There are different corporate philosophies in the first item; some companies prefer a simple holding structure, while others don't. Companies which go for simple holding structures work on single layer holding vehicles and therefore the second item is the key to the success in tax saving. Companies which do not mind having complicated structures work on at least two layers of holding vehicle, and then they don't worry too much about the second item as transfer will not happen at the direct ownership level.

Let's look at the second type first. When we talked about mainland withholding tax on capital gain, we referred to the disposal of mainland direct interest, ie, the transaction is within the mainland jurisdiction and thus mainland withholding tax applies. Therefore, the only way to avoid such tax is to transact outside of the mainland jurisdiction. There are two ways to do it. The two ways include:

- Two layers of foreign investment holding and interest disposed at the upper layer level, therefore, the disposal is totally outside of the mainland jurisdiction. As there is no change in the background of the immediate holding vehicle of the mainland entity, there is no obligation for the mainland entity to report any change to the mainland authorities and also no mainland withholding tax will be imposed as the transaction is outside of the mainland jurisdiction.

- Instead of disposing of the mainland entity's interest direct, the foreign investor disposes of the interest of the foreign immediate holding. As the transaction is outside of the mainland jurisdiction, mainland withholding tax does not apply as well. There may be implications in terms of other formalities as the background of the immediate holding has changed.

In both cases, the foreign investor would be more casual in selecting the holding vehicle and usually go for a tax haven country holding company. This is because the gain so derived will also be exempt from tax in the home country.

Then there is the case that foreign investors prefer simple holding structures and wish to opt for a structure which brings best tax result from both dividend receipt and capital gain purposes. Then a tax treaty shopping is necessary. By looking at the different tax treaties signed between China and foreign countries, many tax treaties provide preferential rates for both dividends receipt and capital gain. The tax efficiency will even be bettered if the home country provides tax exemption or low tax treatment to the same income.

For example, the Sino-Mauritius tax treaty provides exemption from withholding tax on capital gain if the interest is not mainly constituted by real property and the dividend withholding tax is reduced to 5 per cent; also Mauritius only taxed this income at a low effective tax rate of 3 per cent.

After selecting the most tax efficient holding vehicle, the foreign investor would not have too much reservation in disposing of the mainland interest direct. On top of tax treatment, disposal of direct mainland interest would involve work on various formalities with different authorities for changing the investor on records.

The author is Partner, China Tax & Business Advisory, Ernst & Young, Hong Kong.

(HK Edition 06/02/2005 page4)