By Ben Lu

I. Case Summary

In March 2020, Jiangsu-based partnership fund Entity A acquired a 10% equity stake in Company A through capital injection, with an investment cost of 10 million RMB. Under the agreement, if Company A failed to meet the performance targets, Entity A had the right to demand that the actual controller and other shareholders of Company A buy back the 10% equity at a premium, calculated at an annualized return of 9%.

In March 2023, due to Company A's failure to meet the performance conditions, Entity A invoked the buyback clause. By May 2023, the parties reached an agreement for the buyback at a total price of 12.7 million RMB, reflecting a premium of 2.7 million RMB over the original investment amount, calculated at 90,000 RMB per year for 3 years.

The dispute centers around whether the premium payment of 2.7 million RMB should be considered interest income, thereby subject to VAT and its surcharges, or whether it should be treated as a capital gain from equity transfer, which would be exempt from VAT.

II. Analysis of the Buyback Clause as a Valuation Adjustment Mechanism

1.Essence of Equity Buybacks in the "Performance Clause"

According to the National Court’s Civil and Commercial Judgments Summary (2019), "what is commonly referred to as a 'performance-based agreement' in practice, more accurately described as a valuation adjustment agreement, is a type of agreement created between investors and the financing party during an equity financing transaction. It aims to address the uncertainties surrounding the future development of the target company, and typically includes provisions for equity repurchase, financial compensation, and other mechanisms to adjust the target company's valuation in the future." This shows that equity buyback, as part of these agreements, is essentially a valuation adjustment mechanism.

However, there are views in practice that regard such buybacks as debt-like investments due to the fixed return model, where the buyback price is often predetermined with a fixed rate of return. This leads to the confusion of equating such equity buybacks with debt investments.

2.Equity Buyback vs. Debt-like Investment 

Equity investments involve the infusion of capital into a company in exchange for equity stakes, which grants investors certain rights in corporate governance, decision-making, and profit-sharing. In contrast, debt investments, such as loans, do not entitle the lender to participation in the company’s management or governance.

According to the Enterprise Income Tax Law Implementation Rules of the People's Republic of China, an "equity investment" is an investment received by an enterprise that does not require the repayment of principal or payment of interest, and where the investor holds ownership of the enterprise's net assets. In contrast, a "debt investment" refers to an investment made by an enterprise directly or indirectly through its related parties, which require the repayment of principal and payment of interest, or compensation in another form with interest-like characteristics.  

The essence of equity investment is the potential for capital appreciation and participation in corporate decisions, not merely fixed returns. Therefore, despite the fixed premium in the buyback agreement, it does not convert the nature of the investment into a debt-like structure.

III. Conclusion: Nature of the Premium Payment in Equity Buyback

Based on the above analysis, the premium payment in an equity buyback scenario should be recognized as part of a capital gain from equity transfer, not as interest income. If the equity being repurchased is held by individuals or non-legal entities like partnerships or sole proprietorships, it will fall under the category of "capital gain from property transfer" as defined by the current individual income tax law and its implementing regulations, specifically under the "capital gain from equity transfer."  For legal entities, it will be classified as "revenue from property transfer" as stipulated in Article 6, Item (3) of the current Corporate Income Tax Law of the People's Republic of China, specifically referring to "revenue from equity transfer" as outlined in Article 16 of the Implementing Regulations of the Corporate Income Tax Law.

In either case, the premium payment does not constitute interest income and, therefore, should not be subject to VAT and its surcharges.