The Impact of China’s Newly Revised Company Law the Corporate Tax System

On 19 December 2023, China’s newly revised Company Law was passed and the new Company Law will come into effect on 1 July 2024. The new Company Law has made significant revisions to the systems of shareholders’ responsibility for capital contribution, the company capitalisation system, the corporate governance system, the protection of shareholders’ rights, the establishment of companies, and exit mechanisms. Since the promulgation of the newly revised Company Law, there has been considerable interest in its effects regarding tax-related matters. The newly revised Company Law will play a positive role in optimising corporate governance, promoting market vitality, protecting employees’ rights and interests, encouraging innovation and promoting equity investment. Major changes such as corporate capital reductions caused by the revision of the Company Law are not purely legal or fiscal issues. They not only affect the interests of companies and shareholders, but also bring pose a tax compliance challenge to companies.

The tax burden of capital reduction and interest deduction risk brought about by the shortening of the subscription period for company registered capital

The most noteworthy amendments in the newly amended Company Law are the provision that a limited liability company shall pay all of its subscribed capital within five years from the date of its incorporation, and the adjustment of the capital contribution of a joint stock limited company to a paid-in system.

Risk of increased tax burden due to capital reduction

At present, most of the companies that have been established in China were formed in the era of paid-in capital under the old Company Law, and the amount of registered capital was high. In the context of the new Company Law, there may be a need for many companies to reduce their registered capital in order to lower the amount of paid-in capital required.

At the same time, it should also be noted that when a company reduces its registered capital, the income tax treatment will be different depending on whether the shareholder is an enterprise or an individual. The operating losses incurred by the invested enterprise shall be carried forward and made up by the invested enterprise in accordance with regulations. The investing enterprise shall not adjust or reduce its investment costs, nor shall these be recognised as investment losses. For individual shareholders, equity transfer income and other amounts obtained from invested enterprises are all taxable personal income, and personal income tax should be calculated and paid in accordance with the applicable regulations for the “property transfer income” item.

While completing the process of capital reduction of paid-in capital in accordance with the law, companies should also pay attention to relevant tax-related issues. Typically, capital reductions include reduction of subscribed capital, reduction of paid-in capital, withdrawal of shareholders, and reduction of capital to cover losses. In addition to making up for losses, close attention should be paid – in the other three cases – to the corresponding income tax matters in the process of capital reduction, even if this is purely under the subscription system of capital reduction. In addition, attention also needs to be paid to whether the capital reduction leads to changes in the proportion of shareholding, which might lead to income tax issues around transfers of equity.

Risk of deduction of interest expenses on connected debts

According to the relevant provisions of PRC tax law, if an enterprise investor fails to pay the full amount of capital due within the prescribed period, the interest incurred by the enterprise on its external borrowings, which is equivalent to the interest payable on the difference between the investor’s paid-in capital and the amount of capital payable within the prescribed period, is not a reasonable expenditure of the enterprise and should be borne by the investor in the enterprise, and may not be deducted from the computation of the taxable income of the enterprise.

After the implementation of the amended Company Law, if the shareholders of a limited liability company do not pay the full amount of the capital due within the agreed period or the statutory period of five years (whichever is shorter), the interest expenses incurred by the enterprise on external borrowing from the date of expiration of the period, which is equal to the interest accrued on the difference between the amount of paid-in capital and the amount of paid-in capital, shall not be deducted before tax.

Therefore, investors should consider the maximum contribution period, cash-flow situation, related debt-to-capital ratio, tax impact and other factors, and then determine the amount of registered capital.

Changes to the tax implications of shareholders’ non-monetary contributions

The new Company Law stipulates that shareholders can make capital contributions in money, or in kind, intellectual property rights, land use rights, equity, debt and other non-monetary property that can be valued in money and transferred in accordance with the law.

The existing tax policies in China have different provisions on the use of non-monetary assets for capital contribution by enterprise shareholders and natural person shareholders. From the perspective of enterprise income tax, the income from transfer of non-monetary assets recognised by outward investment in non-monetary assets can be evenly phased into the taxable income of the corresponding year within a period of not more than five years and the enterprise income tax shall be calculated and paid in accordance with the regulations. From the perspective of individual income tax, an individual investing in non-monetary assets shall recognise the income from the transfer of non-monetary assets based on the assessed fair value, and the balance of the income from the transfer of non-monetary assets less the original value of the assets and reasonable taxes and fees shall be the taxable income. If the taxpayer has difficulties in paying the tax in one lump sum, they may reasonably determine a plan to pay the tax in instalments and report the plan to the competent tax authority to be recorded. They can then pay the tax in instalments within a period of not more than five calendar years from the date of occurrence of the aforesaid taxable act. Individual income tax shall be paid in instalments within five calendar years from the date of occurrence of the aforesaid taxable act.

At the VAT level, according to the “Notes on Sales of Services, Intangible Assets and Real Estate”, if an individual contributes with the equity of a listed company, they shall pay VAT on the basis of the transfer of financial commodities, and the tax rate shall be 6% in general, while if they contribute with the equity of an unlisted company, they shall not fall within the scope of VAT. Individuals engaged in financial commodity transfer services are exempted from VAT. Therefore, there is a possibility of VAT exemption for natural person shareholders contributing to shares of listed companies.

In summary, as the assessment of the tax burden of non-monetary capital contribution is complicated, the tax burden corresponding to different forms of capital contribution varies greatly. Therefore, investors need to measure and consider the tax costs in advance when making contributions with non-monetary assets.

Tax compliance issues with allowing capital reserve to make up for losses

The new Company Law allows companies to use capital reserves to cover losses, which can be expected to play a positive role in the company’s operation and encourage investment.

Using capital reserve funds to make up for losses is equivalent to converting capital reserve funds into income or profits, that is, using the equity premium invested by shareholders to distribute profits. If the company’s net profit for the year after using the capital reserve fund to make up for losses is positive, the company can distribute profits. While the company uses the method of reducing registered capital to make up for losses, it shall not distribute profits until the cumulative amount of the statutory reserve fund and discretionary reserve fund reaches 50% of the company’s registered capital. If a company reduces its registered capital to make up for losses, the company shall not make distributions to shareholders, nor may it exempt shareholders from their obligations to pay capital contributions or share payments. In other words, although the company has reduced its registered capital, the company’s shareholders are not exempted from their obligations to pay capital contributions or stock payments. The capital reserve fund is not converted from the profits realised by the company. “No profit shall be distributed” is a common rule of profit distribution. Using the capital reserve fund to make up for losses creates conditions for the company to distribute profits in the future. It can be predicted that this change will become the focus of supervision by the tax authorities. Therefore, enterprises should pay attention to the compliance risks brought about by this operation.

Overall, owners’ equity in a Chinese company consists of four main items: paid-in capital, capital surplus, provident funds and undistributed profits. The first two items can be collectively referred to as the capital category and the last two items can be collectively referred to as the profit category. For the capitalisation of profits taking the form of undistributed profits being returned as share capital, the current tax rules are clear, generally regarding this as a distribution of profits and therefore as taxable. On the contrary, the income tax treatment of the capitalisation of profits, where it takes the form of paid-in capital and capital surpluses being used to make up for losses, is unclear. China’s current tax law in this regard will be further improved and refined in the near future.

Continuing to enhance the responsibilities of shareholders and managers for corporate tax compliance

Joint and several liability of shareholders for corporate tax obligations

The newly amended Company Law has added provisions for third parties outside the company, especially shareholders, to assume the company’s debts. The tax authorities may require a shareholder who abuses the corporate personality of the company to settle the tax payable by the company (ie, it may “piece the corporate veil”), and may also require each company controlled by that shareholder to pay the tax owed by any one of the companies.

In addition, in the past, once a company was registered for deregistration, the company’s civil subject status and tax subject status were extinguished, and the outstanding tax obligations might be extinguished due to the lack of a subject to undertake them. Therefore, it was necessary to require the company to fully fulfil its tax obligations before the company was registered for deregistration. The new Company Law provides a legal basis for the tax authorities to recover the tax incurred but not paid before the cancellation of the company, and the tax authorities may require the shareholders who have made a commitment to clear the tax to bear joint and several liability for the unfulfilled tax obligations of the company before the cancellation of the company.

Joint and several liability for taxes of liquidation obligors

The new Company Law stipulates that if the liquidation obligor fails to fulfil its liquidation obligations in time, or if it is negligent in fulfilling its liquidation duties, and it therefore causes losses to creditors, it shall be liable to pay compensation. Pursuant to Article 236(2) of the amended Company Law, the payment of taxes owed by the company shall have priority over the settlement of the company’s claims and the distribution of the shareholders’ surplus property. If the liquidation obligor fails to fulfil its liquidation obligations or is negligent in fulfilling its liquidation duties by settling its debts or distributing its remaining property before fulfilling its tax obligations, resulting in the company’s owed tax liabilities not being fully settled, the tax authorities have the right to request the liquidation obligor to compensate for the resulting damage to the taxing right.

Conclusion

To sum up, the latest revision of China’s Company Law is bound to have a profound impact on corporate financial and taxation management. By allowing adjustments to the capital structure of a company, the Company Law not only gives enterprises greater flexibility in financial management, but also tests their ability in fiscal and tax compliance management. Enterprises need to carefully find the right balance between compliance and economic benefits. During this process, continuing to pay attention to the updates of legal interpretations and the development trends of practical cases is crucial to ensuring the legality and efficiency of corporate operational decisions.