Offshore private equity groups holding Chinese assets face tougher tax obligations under new rules.

In a clarification of six-year-old regulation, the move will make it more difficult for PE firms to use Chinese asset sales as a means to avoid tax, and will impose financial penalties on those deemed to be tax avoiders.

But a consultant has warned that the most difficult hurdle will be the stringent reporting obligations.

Rules were initially implemented in 2009 by China’s State Administration of Taxation (SAT) to tackle loopholes that allowed foreign investors to avoid paying mainland corporate tax if the assets were sold through offshore shell companies.

Those rules stipulated that foreign firms would have had to pay mainland tax without “reasonable commercial purpose” for indirectly selling an interest in a Chinese company through an offshore holding company. What “reasonable commercial purpose” meant was never made clear.

But effective from February 3, SAT has partially replaced these rules with a seven-question checklist. It will find a foreign firm taxable if 75% of its equity value is derived from its China assets.

Foreign firms are also asked if 90% or more of the foreign entity’s assets have been derived from its Chinese assets over the past year, or if at least 90% of its income comes from such assets.

Another litmus test is to see if the functions of the offshore foreign company are relevant to the asset in China, which would help to determine whether it has a business purpose there.

Other rules have expanded the tax net, such as by including Chinese property ownership as taxable assets, as opposed to just equity ownership of companies.

The changes have been welcomed for adding clarity to the tax threshold, but the biggest challenge faced by private equity will be the reporting obligation, said Andrew Choy, partner at accountancy group EY.

“[The reporting obligation] will have a huge impact, which is more significant than the taxable scope,” he said. “Under the old rules, [SAT] only put a reminder that the buyer or portfolio company will have to assist the seller to fulfil the reporting obligation.”

The new SAT regime will make both the tax reporting and withholding obligation the buyer’s responsibility, unless the seller has fulfilled its own reporting and payment responsibility.

If a seller’s transaction does not appear to have a business purpose other than avoidance of Chinese taxes, the buyer will be required to withhold 10% of the gains realised in the sale. Failure to settle the tax bill will see penalties imposed on both parties.

“This new system is pretty smart from SAT’s point of view, because they know the easiest way to get the tax is from the one who pays for consideration,” Choy said. “If I am a seller and selling off my investment in China and once I get the money, I may just walk away. It is difficult for [SAT] to find me or trace me.”

The new regime comes as part of what appears to be concerted effort in China to clarify investment rules for foreign companies.

Beijing recently concluded a consultation on a draft investment law which seeks to recognise variable investment entities (VIEs). These are structures that offshore investors use to circumvent investment restrictions on sensitive industries, such as technology and telecommunications.

However, the use of such structures has often left foreign investors in limbo regarding their legal status.

Formal recognition of VIEs would appear to be a welcome change for overseas firms, but concerns have been raised that they will face foreign-ownership restrictions like any other investor.