By Ben Lu

Case Summary: 

Company A, a limited liability company, was jointly established by individual investors A and B with a registered capital of RMB 5 million. In October 2018, Company B, funded by individual C, entered into an equity transfer agreement with individuals A and B, under which Company B agreed to acquire 100% equity interest in Company A for a total consideration of RMB 8 million. According to the agreement, Company B was required to pay a 20% deposit (RMB 1.6 million) to individuals A and B within seven days of signing, while the remaining amount was to be settled before completing the industrial and commercial registration for the equity transfer. The registration was contingent upon Company B securing financing and notifying individuals A and B to proceed, with a deadline of June 2019. In April 2019, the competent tax authority asserted that since individuals A and B had already received part of the equity transfer consideration, they were required to declare and pay individual income tax on the equity transfer gains. However, individuals A and B contended that they had only received a deposit, and the industrial and commercial registration for the equity transfer had not been completed, thus they should not be required to declare taxes at that point. Consequently, a dispute arose between the taxpayers and the tax authority regarding the timing of tax liability.

Case Analysis:

Pursuant to the current Individual Income Tax Law and its Implementing Regulations, individuals deriving income from equity transfers must declare and pay individual income tax under the category of "property transfer income." However, the laws and regulations do not provide specific provisions on when the taxpayer is deemed to have "obtained" the income, thereby triggering tax liability. Relevant normative documents issued by the State Taxation Administration (STA) have provided more direct guidance on this matter.

I. Previous STA Provisions: Tax Liability Arises Upon "Completion of Equity Transfer Transaction"

The former "Notice of the State Taxation Administration on Strengthening the Administration of Individual Income Tax Collection on Equity Transfer Gains" (STA Circular [2009] No. 285, now repealed) stipulated in Article 1 that "after signing an equity transfer agreement and completing the equity transfer transaction, but before completing the change registration with the industrial and commercial administration, the parties involved must file tax declarations with the competent tax authority and obtain a tax payment certificate or an exemption/non-taxable certificate before proceeding with the registration." Article 2 further provided that "if an equity transfer agreement has been signed but the equity transfer transaction has not been completed, the enterprise must submit a 'Report on Changes in Individual Shareholders' to the competent tax authority when applying for equity change registration."

It is evident that under the previous STA document, the timing of tax liability was marked by the "completion of the equity transfer transaction." However, the term "completion of the equity transfer transaction" is broad and ambiguous. In practice, whether it is determined by the completion of the industrial and commercial registration, full payment of the transfer consideration, or the full performance of all rights and obligations stipulated in the equity transfer agreement remains uncertain and operationally challenging. From the perspective of the principle of tax legality and strict restrictions on tax enforcement, the standard that the equity transfer transaction is completed when all contractual obligations are fulfilled appears reasonable. However, this standard is still broad and could delay the tax collection process, resulting in delayed tax revenue.

To address this issue, the "Announcement of the State Taxation Administration on Issuing the Measures for the Administration of Individual Income Tax on Equity Transfer Gains (Trial)" (STA Announcement [2014] No. 67) repealed STA Circular [2009] No. 285 and provided clearer, more operable regulations regarding the timing of tax liability for equity transfer gains.

II. Current Valid STA Provisions on the Timing of Tax Liability for Equity Transfer Gains

Compared to STA Circular [2009] No. 285, STA Announcement [2014] No. 67 provides clearer and more practical rules regarding the timing of tax liability for equity transfer gains. Article 20 of this Announcement specifies that "if any of the following circumstances occur, the withholding agent or taxpayer shall declare and pay tax to the competent tax authority within 15 days of the following month: (1) the transferee has paid or partially paid the equity transfer consideration; (2) the equity transfer agreement has been signed and has become effective; (3) the transferee has actually performed shareholder duties or enjoyed shareholder rights; (4) the relevant authority has issued a judgment, registration, or announcement that has taken effect; (5) the acts specified in Items 4 to 7 of Article 3 of this Measure have been completed; (6) other circumstances where the tax authority determines, based on evidence, that equity has been transferred."

Notably, Article 20 identifies the effectiveness of the equity transfer agreement as a criterion for determining the commencement of tax liability. Whether it involves payment of the transfer consideration, actual performance of shareholder duties, or an effective court judgment or announcement, all these scenarios are on the condition that the equity transfer agreement is effective and valid. Without a valid agreement, the circumstances specified in STA Announcement [2014] No. 67 that trigger tax liability would be difficult to establish.

Additionally, according to Article 20(5) and (6), along with Article 3(4)–(7), if equity is transferred due to investment, debt repayment, or judicial or administrative enforcement, and the equity has actually been transferred to the counterparty, tax liability arises regardless of whether consideration has been paid or how it is paid.

III. Analysis

Based on STA Announcement [2014] No. 67, there are two primary scenarios in which tax liability arises for equity transfer gains:

(1)Where an equity transfer agreement is signed, tax liability arises upon the agreement becoming effective.

(2)Where no equity transfer agreement is signed, but equity is transferred due to investment, debt repayment, or judicial or administrative enforcement, tax liability arises when the equity transfer registration is completed.

For the first scenario, imposing tax liability solely based on the effectiveness of the equity transfer agreement—regardless of whether the consideration has been fully or partially paid, or whether the equity registration has been changed—appears overly stringent. It contradicts the principle in the Individual Income Tax Law and its Implementing Regulations that tax liability arises upon "obtaining income." It also conflicts with the provisions of Article 3 of the 'Notice on the Implementation of Certain Tax Issues Regarding the Corporate Income Tax Law' (STA Circular [2010] No. 79), which states that 'the recognition of income from the transfer of equity by an enterprise should occur when the transfer agreement becomes effective and the procedures for equity change are completed.' (at which point, the transfer agreement is naturally considered effective; any subsequent issues such as the invalidity of the equity change procedures would fall under a different category).

For the second scenario described above, it is reasonable and appropriate to determine that the individual income tax liability on the capital gains from the equity transfer by an individual shareholder has arisen when the equity originally held by the individual are transferred and registered under the name of the transferee. This aligns with the standard for determining the income recognition time for corporate shareholders' capital gains in the STA Circular [2010] No. 79.

The author believes that the occurrence of individual income tax liability on capital gains from equity transfers should be marked by "the completion of the equity transfer registration process." On the one hand, from the perspective of general business practices and commercial logic, when the equity transfer registration procedure has been completed, the principal rights and obligations of the equity transfer transaction have essentially been fulfilled. Thus, recognizing the occurrence of the individual income tax liability is fully consistent with the current financial accounting system and the requirements of relevant tax laws regarding income recognition and the triggering of individual income tax liability. On the other hand, in equity transfer transactions, when the procedure of equity transfer registration has been completed, the original individual shareholder, as the transferor, has already received a substantial portion, if not the entirety, of the equity transfer consideration, which means that the individual has the economic capacity to fulfill their tax payment obligations.

However, in practice, there are situations where all rights and obligations under the equity transfer agreement, except for the completion of the business registration of the equity transfer (which may not be for the purpose of tax avoidance but due to nominee holding, or failure to cooperate with the equity transfer registration), have been or are almost fully fulfilled. This includes cases where the majority or all of the equity transfer consideration has been paid, and the new shareholder has already performed shareholder duties or enjoys shareholder rights. In such cases, if the determination standard for the timing of the individual income tax liability on the original shareholder's capital gains is still rigidly based on the "completion of the equity transfer registration procedure," it would clearly lead to an improper loss of tax revenue for the state, and would also contradict the explicit provisions and spirit of the current Individual Income Tax Law and its implementation regulations. The author believes that in this case, the principle of "substance over form" in current tax law and tax enforcement practice can be applied, and the determination of when the individual income tax liability arises should be made when the majority or all of the equity transfer consideration has been received and the new shareholder has already performed shareholder duties or enjoyed shareholder rights.

IV. Conclusion

In conclusion, the author believes that although according to the STA Announcement [2014] No. 67, individual A and B are required to file and pay individual income tax on their equity transfer gains at the time the equity transfer agreement is signed and becomes effective, this interpretation contradicts the explicit provisions and legislative intent of the current Individual Income Tax Law and its implementation regulations, which state that individual income tax liability arises upon "obtaining income." As previously stated, the tax liability should be recognized as having occurred when the equity transfer registration is completed, at which point individuals A and B are required to report and pay individual income tax on their capital gains.