Protect Against Public Notice 7 Risks with Tax Insurance
Key Takeaways
- In transactions involving Chinese assets, the application of Public Notice [2015] No. 7 (PN7) remains a key negotiation point between buyers and sellers.
- Each party may have different views on the application of the rules and whether a tax filing is to be made.
- There is an increasing uptake in the use of tax insurance to bridge competing interests, helping to facilitate faster negotiations and optimal outcome.
PN7 is a common tax issue in PRC M&As
PN7 addresses the China income tax implications arising from indirect transfers of taxable assets in China by non resident enterprises. PN7 is designed to prevent the avoidance of Chinese tax using offshore intermediary holding structures. Where such arrangements lack reasonable commercial purpose, Chinese tax authorities may recharacterise an indirect transfer as a direct transfer, subjecting the resulting gains to Chinese corporate income tax.
PN7 includes both safe harbour provisions and automatic deeming rules under which certain transactions are deemed to lack reasonable commercial purpose. Where neither applies, the transaction must be assessed under the “bona fide business purposes” test, often creating uncertainty and execution risk for deal participants.
PN7 also provides a reporting mechanism for transactions involving an indirect transfer of Chinese Taxable Assets. Whilst reporting is voluntary, penalties may be due if a transaction deemed to lack bona fide business purposes is not reported to local tax authorities by the seller, buyer or the Chinese resident company whose equity is transferred, within 30 days of the transaction.
Bona fide business purposes
The biggest PN7 question is whether the deal has a bona fide business purpose.
Seven key factors to be considered when analysing bona fide business purposes include:
| 1 | Whether the main value of the transferred offshore company’s equity is mainly directly or indirectly derived from Chinese taxable property. |
| 2 | Whether the assets of the transferred offshore company mainly comprise of direct or indirect investments situated in Chine, or whether the revenue of the transferred offshore company is mainly sourced directly or indirectly from China. |
| 3 | Whether the actual functions performed by, or actual risks assumed by the transferred offshore company and its underlying affiliates that directly or indirectly hold Chinese taxable property, can prove that the enterprise structure has economic substance. |
| 4 | Whether the transferred offshore company’s shareholders, business model and relevant organisational structure have stable duration. |
| 5 | Whether the indirect transfer is subject to foreign income tax. |
| 6 | Whether the indirect transfer can be substituted with a direct transfer of the relevant PRC taxable properties. |
| 7 | The applicable tax treaties or arrangements in China with respect to the income of indirect transfer Chinese taxable property. |
- The Board, c-suite and strategic management of the business to be transferred sits outside China
- The interposition of the intermediary holding entity has a commercial rationale.
- The net asset value, equity value or gross asset value of the China operations does not constitute a major part of the business being transferred.
- Business to be transferred does not derive a significant portion of its revenue directly or indirectly from China.
- The group has substance or activities outside of China in addition to its China operations.
Given that the transaction involved an indirect transfer of shares in a China resident company, PN7 risk could arise. Where the transaction lacked bona fide business purposes (based on the seven factors above), China tax authorities may re-characterise the transaction and deem any gains as direct transfers of China taxable property and subject said gains to CIT.
Seller was confident that the risk was low and was able to obtain an opinion from external advisors and the analysis of various factors fit within the appetite of insurers.
- A multinational PE fund sold shares in an offshore company (Offshore HoldCo (UK)) to an offshore buyer.
- Offshore HoldCo owned shares in a China resident company.
- The majority of Offshore HoldCo’s NAV and revenue came from subsidiaries in Germany, Singapore and Malaysia.
- The group has long-standing structure and economic substance in UK with the Board, c-suite and strategic management located there.
- Aon secured competitive terms from the market.
- Seller was protected against the risk that the Buyer would seek to recover PN7 tax liabilities and penalties under contractual recourse.
- Buyer gained protection against potential China tax risk and therefore did not require part of the transaction consideration to be held in escrow, which improved the IRR for the Seller.
- The negotiation process was faster for both parties, with the Seller achieving a clean exit, with sales proceeds fully distributed to its LPs, enabling fund closure.
“In 2023, Aon placed the first tax liability insurance policy covering PN7 exposure – an important market milestone. Since then, awareness of the solution has increased and insurers have become more comfortable underwriting PN7 risks. While initial appetite was limited to exposures arising from the bona fide business purpose test, coverage has expanded to include a wider range of PN7 uncertainties, including historical cost base issues, offshore share disposals following IPOs, and take private transactions. This progression reflects the market’s growing willingness to deliver practical solutions for complex tax risks in China. When incorporated into a broader risk management framework, effective management of PN7 exposure can enhance deal certainty and unlock additional value for investors and shareholders.”
Martijn de Lange, Managing Director, Transaction Solutions, Asia-Pacific