September 16th, 2022

Private Equity, M&A and Tax

Public Notice 7 Risks: How Tax Liability Insurance can help

By: Martijn de Lange

Introduction

A contentious tax risk in M&A transactions with a Chinese component considers the application of Public Notice [2015] No. 7 (PN7) to indirect transfer of shares, and deal parties often struggle how to allocate and account for it in negotiations. Tax Liability Insurance (TLI) can help bridge the gap by transferring PN7 risks from deal parties to the insurance market, as BMS’ tax liability insurance broker Martijn de Lange explains in this note.

PN7 in a nutshell

Ever since the introduction of Circular 6981 and Bulletin 242, the application of Chinese indirect transfer of shares rules has been a contentious issue for buyers and sellers in M&A transactions with a Chinese component. Even though the introduction of PN7 in 2015 has taken away some uncertainties, the issue remains prevalent in transaction negotiations to date.

PN7 seeks to ensure that Chinese income tax cannot be avoided through the interposition of an offshore company (in)directly owning “Chinese Taxable Assets” (Offshore Company).3 In short, in case a sale or reorganisation of Offshore Company shares lacks “bona fide business purposes”, PN7 re-characterises the transaction as a direct transfer of Chinese Taxable Assets, subject to tax under Chinese General Anti-Avoidance Rules.4

PN7 provides a reporting mechanism for transactions involving an indirect transfer of Chinese Taxable Assets. Although reporting is voluntary, penalties are due if a transaction deemed to lack bona fide business purposes is not reported to Chinese tax authorities (CTA) by the seller, buyer or the Chinese resident company whose equity is transferred within 30 days of the transaction.

    Bona fide business purposes

    In practice, the main uncertainty under PN7 is to determine whether a transaction is undertaken with bona fide business purposes. All facts and circumstances are to be considered; however, the following seven factors are of vital importance:

    s/nFactor

    1

    Whether the equity value of the Offshore Company is mainly derived directly or indirectly from Chinese Taxable Assets

    2

    Whether the assets of the Offshore Company mainly consist directly or indirectly of investments in China or whether the income of the Offshore Company mainly consists directly or indirectly of income sourced from China

    3

    Whether the functions performed, and risks assumed by the Offshore Company and its direct or indirect subsidiaries that hold Chinese Taxable Assets can justify the economic substance of the organisational structure

    4

    The length of time the shareholders, business model and relevant organisational structure of the Offshore Company has been in existence

    5

    Whether foreign income tax is paid on income from the indirect transfer of Chinese Taxable Assets;

    6

    Whether it would have been possible for the sellerto directly invest in and directly transfer the Chinese Taxable Assets rather than indirectly invest in and indirectly transfer the Chinese Taxable Assets; and

    7

    How a tax treaty or an arrangement applies to the indirect transfer of the Chinese Taxable Assets.


    PN7 further clarifies when an indirect transfer is deemed to lack bona fide business purpose.5

    The assessment on the presence of bona fide business purposes is normally not disputed in transactions where the target’s income and business operations are predominantly in China and where there are limited commercial reasons for the interposition of the Offshore Company (for instance, the Offshore Company is a pure holding company located in the British Virgin Islands). Deal parties would typically agree that PN7 applies, and seller reports the transaction with the CTA and settles taxes due. However, things get more complicated in transactions involving multinational groups, as illustrated by the example below.

    Example

    Example Graphic

    A US based private equity fund (Seller) intends to sell 100% of the Offshore Company shares to a Singapore based private equity firm (Buyer). Since the transaction involves an indirect transfer of shares in a Chinese resident company (Sub 3), PN7 must be considered. If the transaction lacks bona fide business purposes under PN7, the CTA could collect an amount of ~USD 15m in taxes and penalties from either the Seller, Buyer or Sub 3.

    In the negotiations, Seller argues that the transaction has bona fide business purposes and there is no need to report. Among other things, Seller points to the following:

    • Approx. 70% of Offshore Company’s equity value is derived from Japan and Korea;
    • Approx. 35% of Offshore Company’s income is derived from China;
    • There are sound commercial reasons for the interposition of Offshore Company, for instance, Hong Kong functions as regional headquarters for the business;
    • The shareholding/organisational structure has been in place for more than 5 years; and
    • Offshore Company has significant economic substance in Hong Kong with the C-suite and enabling functions located there.

    Seller’s position is supported by a “should level” opinion from a reputable law firm.

      Buyer, on the other hand, argues that the CTA might take a different view and successfully argue the lack of bona fide business purposes. For instance, they could argue that the equity value attributed to China (Sub 3) is understated as it does not consider the size and uniqueness of the Chinese market. Further, they could argue that the interposition of the Offshore Company was tax-driven rather than based on commercial reasons. Buyer doesn’t want to assume the risk of paying USD 15m, and requires Seller to report the transaction and settle taxes.

      Clearly, these conflicting positions can put the transaction at risk.

      Risk allocation in practice

      It follows that deal parties may find it challenging to allocate and account for PN7 risks. So how do buyers and seller deal with this in practice? Buyers often try to negotiate a specific seller indemnity spanning the duration of the statute of limitation with financial security such as an escrow. Unfortunately, this is not viable if the seller is looking for a ‘clean exit’ from its investment and not willing to stand behind potential PN7 liabilities arising after the transaction. Further, arranging financial security is often time-consuming and expensive.

      Matthew Lau, partner at Morrison and Foerster, notes:

      “Transactions involving multinational groups or non-Chinese target companies with substantive business operations pose particular challenges from a PN7 perspective. Because it is often commercially untenable to have a long-standing escrow against a seller (especially financial seller) if the practical risks are low, buyers could be left without any creditworthy protection against the residual PN7 risks, which may nevertheless involve a significant exposure amount.”

      How TLI can help

      In case deal parties are not able to reach a commercial agreement on the allocation and accounting of PN7 risks, TLI can help bridge the gap. A TLI policy offers a quick and capital-efficient solution to take the PN7 risk off the negotiation table by covering a potential financial loss arising from a successful challenge by the CTA of the agreed PN7 position. This way, no party bears the PN7 risk and indemnities and escrows can be avoided. Lau, notes the following:

      “A tax insurance policy can be a particularly useful tool in cases where there is genuine disagreement between buyer and seller as to the extent of the PN7 risks from a transaction, which can be difficult to reconcile given the broad potential scope of PN7, the relatively long statute of limitations period and the fact that CTA policies and national and local audit practices are constantly evolving.”

      Insurable PN7 risks

      Before considering insuring a PN7 risk, insurers will require a “should level” opinion from a reputable law or advisory firm supporting the technical soundness of the position. Such advice should detail:

      1. the substantive tax-technical analysis;

      2. financial exposure; and

      3. likelihood of the CTA’s success in challenging the PN7 position before the tax court.6

      Until recently, insurers were not keen to insure Chinese tax risks, but there are now insurers in the market that underwrite PN7 risks falling within specific parameters. Amongst other things, it is required that:

      (i) The interposition of the Offshore Company has a commercial rationale as opposed to a pure tax planning structure.

      (ii) The determination of the equity value and income derived from the Chinese Taxable Assets is not (too) arbitrary.

      (iii) There is economic substance outside China, including key management.

      Accordingly, multinational groups or investment funds acquiring or exiting non-Chinese target companies with exposure to China may find insurance for PN7 risks particularly interesting.

      Cover

      A TLI policy protects against ‘losses’ arising from an insured PN7 position. These losses include:

      (i) tax due following the CTA’ assessment or determination

      (ii) interest and non-criminal penalties (if applicable)

      (iii) defense costs incurred by the insured in defending a challenge from the CTA

      (iv) tax gross-up for payments made under the policy (if applicable)

      The cover period is aligned with the applicable statute of limitations, which is 10 years from the transaction date.

      Costs

      The premium is a percentage of the insured amount and a one-time-only payment. Premiums for PN7 risks would range between 4.5 and 6.5% of the limit of liability insured. Pricing primarily depends on factors such as (i) the strength of the position; (ii) the amount of the financial exposure and (iii) the insured’s tax dispute history. Additionally, insurers charge underwriting fees to cover their costs for seeking external counsel advice on the insured PN7 position.

      Claims

      A TLI policy only offers value if it pays out in case of (valid) claim. Most insurers nowadays have in-house claims teams to ensure a streamlined and fair claims process, and practice illustrates that claims under TLI policies are being handled with due care. BMS always carefully considers claims experience and claims handling procedures when determining which insurer is best positioned to underwrite a PN7 risk. We also support clients in case of claims.

      Information and process

      In order to approach insurers and obtain indicative pricing and other terms for a PN7 risk, BMS needs to receive the following information:

      1. copy of the tax opinion/memo

      2. details of the M&A transaction

      3. calculation of the potential financial exposure

      A TLI policy can be put in place within 2-4 weeks and BMS will guide you all along the way.

      Conclusion

      A contentious tax risk in M&A transactions with a Chinese component considers the application of PN7. Deal parties often struggle to account for it, and it can become a challenge in the negotiations. This is where TLI steps in. A TLI policy offers deal parties a quick and capital-efficient solution to take the risk off the negotiation table by covering a potential financial loss arising from a successful challenge of the agreed PN7 position. This way, no party bears the risk and indemnities and holdbacks can be avoided.

      1 Guoshuihan [2009] Circular No. 698.

      2 Bulletin of SAT [2011] No. 24)

      3 Chinese Taxable Assets are (i) assets attributable to an establishment in China; (ii) immovable property in China; and (iii) shares in Chinese resident companies.

      4 PN7 exempts a share sale of an Offshore Company through normal trading on a stock exchange or when it would have been exempt from Chinese income tax under an applicable tax treaty if the seller sold the Chinese Taxable Assets directly. Note that a 10% rate applies to indirect transfer involving immovable property in China and shares in Chinese resident companies and a 25% rate applies to indirect transfers involving assets attributable to an establishment in China.

      5 These factors are: (i) 75% or more of the equity value of the Offshore Company is derived directly or indirectly from Chinese Taxable Assets; (ii) At any time during the one year before the indirect transfer of Chinese Taxable Assets takes place, 90% or more of the asset value of the Offshore Company (excluding cash) is comprised directly or indirectly of investments in China, or 90% or more of its income is derived directly or indirectly from China; (ii) The functions performed and risks assumed by the Offshore Company and any of its subsidiaries that directly or indirectly hold the Chinese Taxable Assets are limited and are insufficient to prove their economic substance; and (iv) the foreign tax payable on the gain derived from the indirect transfer of the Chinese Taxable Assets is lower than the potential Chinese tax on the direct transfer of such assets. PN7 also provides a “safe harbour” for qualifying internal reorganisations, which is not further discussed.

      6 Insurers usually won’t require a percentage to be attributed to the chance of success if challenged, rather they would expect to see a ‘should’ level of opinion.

      De Lange Martijn

      Martijn de Lange

      Managing Director

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      Wong Aris

      Aris Wong

      Managing Director

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      Andrews Dean

      Dean Andrews

      Head of Tax Liability Insurance

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