Since the Announcement on Administration of Individual Income Tax Collection on Business Income from Equity Investments (Announcement No. 41 of the Ministry of Finance and the State Administration of Taxation of 2021) came into effect, the space of authorized taxation for sole proprietorships and partnerships engaging in equity investments has been blocked, and all kinds of investment enterprises and investment funds under partnership structure have been under the focus of the tax authorities, which has implicated some new types of tax risks. It is understood that when reviewing the tax declaration information of enterprises, the tax authorities of a certain place proposed that the transfer of partnership shares by partners should also be declared for tax payment in accordance with the business income, and a tax rate of 5%-35% should be applied, which triggered a dispute between tax enterprises.

I. Case Introduction: Transfer of Partnership Share by Natural Person, Tax Bureau Requires Taxation by Business Income Penetration

Recently, Huatax lawyers received a consultation from an enterprise that a local tax authority, when reviewing the tax declaration information provided by a partnership-type shareholding platform enterprise, suggested that: as this type of partnership is mainly engaged in equity investment, the value of the partnership share is mainly reflected in the equity interest held by the partnership. The transfer of partnership shares by a partner is essentially for the purpose of transferring all the equity interests held by the partnership, and should be taxed through, i.e., it should be treated as a transfer of equity interests by the partnership and be subject to individual income tax in accordance with business income. Due to the high value of the partnership share, the tax on business income will be directly applied to the top tax rate of 35%, which is 15% higher than the property transfer income tax rate of 20%, and even after deducting the cost of production and operation, the tax burden has been greatly increased.

This case is easily reminiscent of the case in which Jade Company was required to pay land value-added tax on the transfer of equity interest in Xinglong Company. In the case, Jade Company agreed to transfer its 20% equity interest in Xinglong Company, because Xinglong Company's main assets are real estate, the former Suzhou Industrial Park Local Taxation Bureau requested to penetrate the tax on the transfer of equity interests in Jade Company to levy land value-added tax and other taxes. The Jiangsu Higher People's Court held that, through the external form of equity transfer, the Jade Company realized the appreciation of land value and obtained corresponding economic benefits, therefore, the behavior of the Jade Company essentially constituted the transfer of state-owned land use rights, and supported the tax authorities to levy land value-added tax.

These two cases have one thing in common, that is, the tax authorities did not strictly follow the legal form to determine the tax obligations of the taxpayer, but took into account the economic substance of the transaction, based on the principle of substantive taxation, the transactions involved in the case of the penetration of the tax. So is this penetration reasonable? In the context of Notice 41 coming into effect, what kind of situation will arise for equity investment partnerships?

II. Tax law is the basic principle and substantive taxation cannot be abused.

(I) According to the tax law, the transfer of partnership shares by a natural person shall be taxed as income from property transfer.

After the revision of the Regulations for the Implementation of the Individual Income Tax Law, Article 6(1)(h) stipulates that the transfer of partnership share by an individual belongs to the income from property transfer. If there was any controversy in the past as to whether partnership shares are property, this issue should be said to have been resolved after the revision of the Implementation Regulations of the Individual Income Tax Law. The tax items and tax rates for the transfer of partnership shares by natural persons have been made very clear, that is, they are taxed according to the income from the transfer of property, applying a fixed tax rate of 20%.

Article 8 (6) of the Legislative Law provides that the basic system of taxation, such as the establishment of tax types, the determination of tax rates and the administration of tax collection, shall be retained by law. Article 9 provides that "If the matters provided for in Article 8 of this Law have not yet been enacted into law, the National People's Congress and its Standing Committee shall have the right to make a decision authorizing the State Council to enact administrative regulations ...... on some of these matters first, in accordance with actual needs." From this, it can be seen that the basic system of taxation can only be created and adjusted by laws and administrative regulations, which is the principle of tax law. The principle of tax law is the highest principle of tax law, and its connotation includes the legalization of tax elements and the clarification of tax elements. Statutory elements of taxation require that the elements of taxation as the basic system of taxation must be stipulated by laws and administrative regulations authorized by the National People's Congress; clear elements of taxation require that the elements of taxation as the basic system of taxation must be clear and stable, and that no ambiguous stipulations can appear.

Tax items are one of the elements of taxation, which must be stipulated by law or administrative regulations, and at the same time, the provisions must be clear, stable and have a fixed connotation. Tax items must not overlap and cross over, so that an act may belong to one tax item and be categorized under another tax item at the same time. At present, there is no legal basis to support the taxation of the transfer of partnership shares under the tax item of business income, while the taxation of the transfer of partnership shares under the income from transfer of property is clear and unambiguous according to the regulations for the implementation of the Individual Tax Law.

(II) Substantive taxation should follow the necessary limits and the tax items cannot be adjusted arbitrarily.

Principle of Substantive Taxation means that whether a particular behavior should be taxed or not should not be determined only on the basis of its appearance and legal form, but should be judged on the basis of the actual situation, especially on the basis of its economic purpose and economic substance, to determine whether it is in line with the elements of taxation or not. It can be seen that there is a certain contradiction between the principle of substantive taxation and the principle of tax law, which is a breakthrough of the principle of tax law. The legitimacy of this breakthrough stems from the principle of tax equity, that is, in order to avoid the taxpayers' malicious planning, the use of legal forms to avoid tax obligations, resulting in the same or similar tax-related behavior of the tax burden is unfair, and anti-avoidance regulation of taxpayers.

In a sense, the principle of tax fairness is the ultimate pursuit of tax law, a value at the highest level. However, the pursuit of the principle of tax fairness must be embodied in the form of legal norms, and must be realized through tax legislation, law enforcement, justice and law-abiding. This is because the understanding of legal value is not uniform, and different citizens may have different views, while the tax law is formulated through the legislative process of the National People's Congress, reflecting the "public will" and being the voice of legal value. If there is a loophole in the tax law, it should be remedied by amending the law, but in practice, the tax law should be insisted on as the only guideline for tax collection, that is, the principle of tax law is still the highest principle in practice, and the tax law itself is the best way to realize tax fairness.

After the value game, the principle of substantive taxation can only be understood as a subordinate principle, and its application must follow the necessary limits and must be clearly authorized by law, which is embodied as the anti-avoidance provision in the tax law. The anti-avoidance provision is the "self-breakthrough" of the tax law, which is that the legislator recognizes that for reasons such as the legislator's incomplete consideration and legislative lag, there are bound to be some loopholes in the tax law, which makes the tax law deviate from the intention of tax fairness in its application, and therefore allows the tax law to carry out self-negation and adjust the relationship between the levy and the payment when necessary, and pulls the levy and collection of taxes back to the normal track. normalized track. According to the Law on Administration of Tax Collection and related laws, the adjustment of anti-avoidance tax is more reflected in the adjustment of the basis of tax calculation and does not include the adjustment of tax purpose.

To sum up, the substantive tax provisions expressly stipulated in the tax law are limited to the adjustment of the tax basis, and the substantive tax should follow the limits stipulated in the tax law, and cannot go beyond the authorization of the law to arbitrarily adjust the tax items. The transfer of partnership shares by a natural person should not be taxed on the basis of business income penetration.

(III) Even if the tax law is broken to apply the principle of substantive taxation, the tax items should not be changed.

Even if the current tax law is not taken into account, the adjustment result of substantive taxation should be to restore the economic substance of the transaction, rather than to construct a new transaction model. The core of substantive tax adjustment is restoration, i.e., it must fit the original purpose of the transaction. For example, in the case of Jade Company, in the legal form of Jade Company is the transfer of the equity of Xinglong Company, but in the economic substance, Xinglong Company in addition to real estate, almost no other assets, but only contain real estate "vessel", the purpose of the transaction is to achieve the transfer of real estate and ultimate control of the transfer of real estate. Based on this, the tax authorities adjusted the transfer of equity by Jade as a direct transfer of real estate by Jade and levied land value-added tax accordingly.

In the process of transferring partnership shares, even if the principle of substantive taxation is adopted to break through the tax law, from the perspective of economic substance, the purpose of the transaction is to realize the transfer of the ultimate control of the equity held by the partnership, and the transaction is more closely related to the transfer of equity held by the partners in the partnership rather than the transfer of the equity held by the partnership itself. Therefore, the adoption of the principle of substantive taxation should be adjusted and recognized as a direct transfer of equity investment held by the partnership by the partners, which also belongs to the income from the transfer of property according to the implementation regulations of the Individual Tax Law and should be subject to the individual income tax rate of 20%. The tax authorities, based on the principle of substantive taxation through taxation, defined the subject of the transfer as a partnership enterprise, resulting in a change in the tax item to business income, which is contrary to the original purpose of the transaction.

III. The original purpose of Circular No. 41 is to plug the loopholes and not to overdo it.

It is understood that the emergence of the aforementioned case is closely related to the introduction of the Ministry of Finance and the State Administration of Taxation Announcement No. 41 of 2021. For the sake of efficient management and convenient financing, private equity funds and venture capital enterprises at this stage mostly adopt the organizational structure of partnership, and before the issuance of Circular No. 41, partnerships holding equity investments can adopt the approved levy method to declare tax if they meet the conditions. Compared with the checking of accounts, the approved levy can reduce the tax burden, and some localities have expanded the applicable conditions of the approved levy without authorization for the purpose of attracting investments, resulting in a large number of partnerships applying the policy of approved levy in violation of the law. Approved levies have actually broken through the legal limitations of taxation and become bargaining chips for the government and enterprises. To address this issue, the Ministry of Finance and the State Administration of Taxation jointly issued Circular 41, which became effective on January 1, 2022.

According to Announcement No. 41, sole proprietorships and partnerships holding equity investments such as equity, stocks, and partnership property shares are subject to the check-and-collect method of calculating individual income tax. Partnership enterprises holding equity investments can no longer apply the approved levy provisions.The intention of Circular 41 is to plug the loopholes of local approved levy and restore the tax burden of partnerships with equity investments to the normal state, but there are different degrees of deviations at the legislative and law enforcement levels:

Firstly, at the legislative level, the approved levy is a form of tax collection under the Tax Collection and Management Law, which has a clear basis in the above law.Announcement No. 41 does not distinguish between different situations and abolishes the approved levy for equity investment partnerships, which will result in some partnerships that do meet the conditions for approved levy not being able to apply the approved levy policy. In our opinion, the approved levy should be implemented in strict accordance with the conditions stipulated in the law, and should be allowed for those that do meet the conditions; for those that do not meet the conditions, the approved levy should not be approved in breach of the provisions of the tax law.Announcement No. 41 should aim at cracking down on the breach of the approved levy in breach of the tax law and should not exclude all the equity investment partnerships from the approved levy in an across-the-board manner. The announcement should focus on combating the behavior of breaking the approved collection of tax law, instead of excluding all equity investment partnerships from the approved collection in a broad-brush manner.

Secondly, at the level of law enforcement, some local tax authorities regarded Circular 41 as a wind vane for special inspection, so that they misinterpreted the spirit of Circular 41 and deviated from the original intention of restoring the tax burden to the normal state, and formed the logic of law enforcement that is strict and high tax, which gave birth to the case at the beginning of this article. In our opinion, tax enforcement belongs to the act of public law, and follows the basic principle that no authorization is prohibited by law. For the law does not explicitly authorize the adjustment of anti-avoidance tax, the tax authorities can not arbitrarily implement the penetration of taxation, not to mention the adjustment of tax items, for taxpayers to impose tax obligations.

IV. How Equity Investment Partnerships Respond to the Introduction of Announcement No. 41

The result of Circular 41 is the increase of the macro tax burden of the equity private placement and venture capital industry. In the case that the collection method has been locked, more attention can be paid to the planning space of place of registration, organization form and tax rate.

(I) Choice of place of registration

As a matter of fact, at this stage, the policies for equity investment partnerships vary greatly from place to place, and many places have special tax incentives, but some of them are suspected of being local tax depressions and may not be recognized. When choosing the place of incorporation, attention should be paid to whether the tax incentives have been legally and effectively filed to avoid the risk of policy changes.2021 In January 2021, the Notice on the Pilot Policies of Corporate Venture Capital Enterprises Related to Corporate Income Tax in Zhongguancun National Innovation Demonstration Zone (Cai Shui [2020] No. 63) came into effect, whereby the income from transfer of equity interests held for more than three years to a corporate-type venture capital enterprise in the Demonstration Zone If the proportion of the income from the transfer of equity interests held for more than 3 years exceeds 50% of the total annual income from the transfer of equity interests, the enterprise income tax for the year shall be levied at half of the annual enterprise income tax in accordance with the proportion of shareholdings held by individual shareholders as at the end of the year; and the income from the transfer of equity interests held for more than 5 years shall be exempted from enterprise income tax for the year in accordance with the proportion of shareholdings held by individual shareholders as at the end of the year. For venture capitalists whose main investment target is start-up enterprises, they may consider similar places of incorporation to enjoy preferential policies on long-term shareholding transfers.

(II) Choice of organizational form

Partnerships have long been recognized as being able to eliminate the economic double taxation inherent in corporate enterprises and are therefore a better choice for investment, but this recognition may not be universally applicable. Particularly in the context of multi-layered nested structures, the merits of partnerships versus corporations are debatable. For example, a natural person holds shares in Company A, which invests in Partnership B, which invests in a target company, Company C. The partnership invests in Company C, which distributes dividends and bonuses. For the dividend and bonus distributed by Company C, since Partnership B does not have the qualification of a resident enterprise, it may not be able to enjoy the dividend tax exemption policy, but needs to pay 25% enterprise income tax by Company A after the first distribution, and when Company A distributes the dividend and bonus to the natural person, it also needs to withhold and pay 20% individual income tax, which results in an effective tax burden of 40%. If a natural person holds shares in Company A, Company A holds shares in Company B, and Company B invests in Company C, the target company. Company B is exempted from enterprise income tax on the dividend and bonus distributed by Company C. Company A is exempted from enterprise income tax on the dividend and bonus distributed by Company B. Only when Company A distributes the dividend and bonus to the natural person, it can withhold and pay 20% individual income tax on behalf of the natural person, and the actual tax burden is 20%.

The choice of organizational form needs to consider the type of target company in addition to the special requirements of tax policy. For example, if the investor's strategy is long-term value investment, the target company is in a mature and stable period, and the main income is dividends and bonuses, it is more favorable to have a nested company structure. If the investor's strategy is venture capital, angel investment or speculative investment, the target company is in the start-up phase, and the main income is the appreciation of the equity value that may be realized after a number of years. In this case, the investor invests through a partnership, which applies a tax rate of 5%-35%, whereas if the investment is made through a company, in addition to the 25% corporate income tax of the investing company, there is also a 20% personal income tax on dividends paid by the company to the investor, with an effective tax burden of 40%, making the use of a partnership structure more favorable.

(III) Choice of tax rate

The biggest controversy over the tax rate for equity investment partnerships lies in whether the income from equity transfers should be subject to a 5%-35% tax rate on operating income or a 20% tax rate on income from property transfers. According to the Circular of the State Administration of Taxation on the Implementation Caliber of the Provisions on Individual Income Tax for Investors of Sole Proprietorships and Partnership Enterprises (Guo Shui Han [2001] No. 84), the interest or dividends and bonuses distributed by sole proprietorships and partnerships on foreign investments shall not be incorporated into the income of the enterprises but shall be computed and taxed separately under the taxable item of "Interest, Dividends and Bonuses". Instead, they should calculate and pay individual income tax separately according to "interest, dividend and bonus" taxable items. The State Taxation Letter [2001] No. 84 on dividends and bonuses has made separate provisions for dividend income tax, while there is no provision for equity transfer income, i.e., the income from equity transfer should be taxed as operating income. However, the understanding of the income from transfer of equity of partnership enterprises is not uniform in different places, and some places have given the policy that the income from transfer of equity can also be taxed separately.

Strictly speaking, this policy is a local preference with no basis in the supreme law, and there was a rumor in 2018 that the General Administration had asked to clean up such policies, but it ultimately failed to come to fruition, but instead gave birth to the Notice on the Issues of Income Tax Policies for Individual Partners of Venture Capital Enterprises (Cai Shui [2019] No. 8), which, according to the requirements of No. 8, allows Venture Capital Enterprises (VC Enterprises) to choose whether they are interested in accounting for the income on a single investment fund basis or on a yearly basis in its entirety. If a VC enterprise chooses to account for the fund on the basis of a single investment fund, the equity transfer income and dividend and bonus income to be shared by its individual partners from the fund shall be calculated in accordance with the tax rate of 20% for the payment of individual income tax. Therefore, there is still room for equity investment partnership to plan in terms of tax rate, and it should choose the appropriate accounting method to realize the purpose of tax saving in accordance with the regulations of the General Administration of Taxation.