On December 30, 2021, the Ministry of Finance (MOF) and the State Administration of Taxation (SAT) issued the Announcement on the Administration of Collection of Individual Income Taxes on Income from Equity Investments and Operations (MOF SAT Announcement 2021 No. 41). In the past, although authorized levies for partnerships were treated as a tax preference in many places, they were essentially a form of levy management and the system was designed, to some extent, to address the inherent problems in the tax system. After the prohibition of authorized levies, the problems caused by the flaws in the tax system have gradually come to the fore, among which the problem of double taxation on the transfer of partnership shares is particularly obvious.

I. Repeated Taxation on Transfer of Partnership Shares and Different Views in Different Regions

(I) Double Taxation on Transfer of Partnership Shares

As a matter of fact, even before the revision of the Individual Income Tax Law, the problem of double taxation on the transfer of partnership shares has been identified and discussed in various regions. The following two cases illustrate this issue:

1. Case I

Natural persons A and B each contributed 1 million yuan to set up partnership enterprise A, which was mainly engaged in equity investment. enterprise A obtained profits of 320,000 yuan through the transfer of shareholding, and agreed to distribute the profits in accordance with the proportion of capital contribution, but the profits were not actually distributed, but were used for reinvestment. Then, in the period when the profit is obtained, A should declare and pay individual income tax: taxable amount = (320,000 yuan/2-60,000 yuan)*20%-10,500=9,500 yuan. Subsequently, A transfers all the partnership shares held by A to C, and agrees that the transfer price is 1.5 million yuan, then A should pay individual income tax: taxable amount = (1.5 million yuan - 1 million yuan) * 20% = 100,000 yuan. Through the above calculation, it can be found that, for the profit of RMB 160,000 Yuan that A should distribute according to the agreement, the individual income tax of RMB 9,500 Yuan was paid as operating income, meanwhile, this part of the profit increased the value of the partnership share, and in the transfer of the partnership share, another 32,000 Yuan (RMB 160,000 Yuan * 20%) individual income tax was paid as the income from the transfer of property, which is a problem of double taxation.

Case 2

Natural persons A and B each contributed 1 million yuan to set up Partnership A, which was mainly engaged in equity investment. 320,000 yuan was added to the value of equity invested in Enterprise A. Subsequently, A transferred its share to C, and then transferred its share to C.

Subsequently, A transfers all the partnership shares held by him to C, and agrees that the transfer price is RMB 1.5 million, and C recognizes the investment amount of RMB 1 million after acquiring the partnership shares. A should pay individual income tax: taxable amount = (1.5 million yuan - 1 million yuan) * 20% = 100,000 yuan. After C obtains the partnership share, enterprise A transfers its equity interest and obtains 320,000 RMB profit, and agrees to distribute the profit according to the proportion of capital contribution, C should declare and pay individual income tax: taxable amount = (320,000 RMB/2-60,000 RMB)*20%-10,500 = 9,500 RMB. Through the above calculation, it can be found that, for the partnership investment equity appreciation of 160,000 yuan, in the transfer of partnership share, the corresponding increase in the value of the partnership share, as the transfer of property income to pay 32,000 yuan (160,000 yuan * 20%) of individual income tax, at the same time, in the transfer of equity, but also as the operating income to pay 9,500 yuan of individual income tax, there is a problem of double taxation.

(II) Different views on whether the transfer of partnership shares should be taxed or not

As there were no clear provisions on how the transfer of partnership shares should be taxed, there were two different views in practice:

One view is that, if the transferor of partnership share is an individual, it should be handled with reference to the provisions of the Announcement of the State Administration of Taxation on the Collection of Individual Income Tax on the Recovered Amounts from Individuals Terminating Investment and Operation (Announcement of the State Administration of Taxation No. 41 of 2011), and individual income tax should be paid on the basis of the income from the transfer of property. The Tax Bureau of Xiangxi Tujia and Miao Autonomous Prefecture, the Tax Bureau of Fujian Province, the Tax Bureau of Guangzhou Municipality, and the Ordos Municipal Government hold this viewpoint, which is mainly of the view that: an investor of a partnership enterprise who transfers his/her share of the enterprise's property should be taxed on the basis of the taxable income after deducting the original value of the property and the reasonable expenses from the transfer income, and taxed in accordance with the item of "Income from Transfer of Property". The project is taxable under the "Income from Transfer of Property" program.

Another viewpoint is that if the transferor of partnership shares is an individual, no personal income tax will be levied. Zhenjiang Municipal Taxation Bureau holds this view, which mainly believes that the retained income of the partnership has already been subject to individual income tax, and there is a problem of double taxation in the case of transfer.

After the revision of the Individual Income Tax Law, the Regulations for the Implementation of the Individual Income Tax Law were amended to provide that the transfer of a partnership's share of property by an individual belongs to the income from the transfer of property. So far, the taxability of the transfer of partnership shares by individuals has been finalized. However, the view of double taxation represented by the Zhenjiang Municipal Tax Bureau has not yet been resolved. Some places believe that the double taxation of the transfer of partnership shares belongs to the problems caused by the defects of the current tax system, which should be mitigated or avoided by other means of compliance.

II. Solutions to the problem of double taxation on transfer of partnership shares

(I) Authorized taxation at the partnership or partner level

Before the issuance of Circular 41, authorized levy was one of the means to solve the problem of double taxation on transfer of partnership shares, which included authorized levy at the level of transfer of partnership shares and authorized levy at the level of transfer of partnership shares by partners. However, there are some drawbacks in this program: on the one hand, the approved levy is a kind of "curve save the country" for eliminating the double taxation itself, which can't solve the problem fundamentally; on the other hand, after the announcement of the State Administration of Taxation (SAT) No. 67 of 2014 was issued, the inspection of individual tax on equity transfer has been tightened, and the approved levy on individual tax on equity transfer must be implemented in strict compliance with the legal provisions. must be implemented in strict compliance with the law. According to the Tax Collection and Management Law and other regulations, the authorized collection is limited to very limited circumstances, such as irregularities in the bookkeeping of partnerships, etc., so this option is less applicable.

After the issuance of Circular 41, approved levies at the partnership level are prohibited, but approved levies on transfers of partnership shares by individuals are not clear. Intuitively, the transfer of partnership shares by individuals is neither regulated by Circular 67 nor Circular 41, and can still be feasible. However, in the actual application, it is still necessary to pay careful attention to the tax-related risks. For example, in order to attract investment, many places have made fuzzy treatment to the legal nature of the authorized levy, and even treated it as a kind of tax incentives for negotiation with investors. Such behavior carries the risk of non-compliance with local government policy promises, and under the requirements of the principle of tax legislation, these local policies may be cleared and retrospective adjustments made to previous operations, triggering the risk of back taxes.

(II) Election to account on a single investment fund basis

In addition to the method of taxation, the tax rate is also a point that can be considered. On the issue of double taxation, a point of criticism also lies in the fact that after the transfer of partnership shares has already been taxed at the 20% tax rate applicable to the income from transfer of property, the transfer of partnership interests is also taxed as business income, which may be subject to a 35% tax rate. As a matter of fact, the biggest controversy over the tax rate of equity investment partnerships lies in whether the income from transfer of partnership shares should be taxed at the rate of 5%-35% on business income or at the rate of 20% 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 Wholly Owned Enterprises and Partnership Enterprises (State Taxation Letter 〔2001〕 No.84), the interest or dividends or bonuses distributed by a partnership enterprise for foreign investment shall not be incorporated into the income of the enterprise but shall be calculated and taxed separately according to the taxable item of "Interest, Dividends, Bonuses". and shall 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 Income Tax Policy Issues for Individual Partners of Venture Capital Enterprises (Cai Shui [2019] No. 8), according to which, according to No. 8, Venture Capital Enterprises (VC Enterprises) may choose to make an assessment of the income from equity transfers accounting on the basis of a single investment fund or on the basis of the annual overall 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% to pay individual income tax.

Therefore, there is still room for equity investment partnerships to plan in terms of tax rates. If it is a venture capital enterprise, it can choose to account for it as a single investment fund in accordance with the regulations of the General Administration of Taxation, so that it can enjoy the 20% tax rate at the level of transfer of equity in the partnership to realize the purpose of tax saving and reduce the impact of double taxation to a certain extent. However, from an overall perspective, the effect of this option is rather limited, and for the case of lower gains from equity transfers, i.e., where the applicable tax rate itself is lower than 20%, this option may, on the contrary, lead to an aggravation of the double taxation problem.

(III) Election of immediate distribution of equity transfer proceeds

Immediate distribution of gains seems to be the most prudent option in terms of tax issues, but it lacks rationality in terms of business purposes. After the distribution of the proceeds, if the partners wish to use the funds for reinvestment, they need to go through the capital increase procedures again. The business change procedures will consume a lot of time and may lead to loss of investment opportunities. In addition, for partnership funds, the investment objectives often need to be updated in a timely manner, and it is difficult to meet the business requirements of rapid transformation of investment objectives by distributing before capital increase. In terms of business scenarios, the two aforementioned cases are typical examples of rapid transformation of investment strategies. Take Case 2 as an example, the partnership is a platform carrier set up for investment projects, the partnership invests in start-up or growth stage enterprises, and the partners intend to realize the investment exit through the transfer of partnership shares after the equity has achieved a large increase in value. If the transferee wishes to change or partially change the investment strategy and transfer part of the equity, the issue of double taxation will arise. Since the shareholding platform may invest in multiple projects, A hopes to realize the overall transfer, so the requirement of transferring a part of the equity separately and distributing the transfer proceeds first cannot fit the business purpose either.

III. Policy outlook on the tax treatment of partnership share transfers

(I) Tax basis shift declaration

Combined with the previous two cases, it is easy to find that the core of the problem of double taxation of partnership lies in the "retained income", i.e., the profits not actually distributed by the partnership to the partners, which ultimately increase the market value of the partnership shares. Since the partnership is a taxable entity and is taxed directly through the acquisition of income, regardless of whether or not it is actually distributed, the retained income of the partnership is itself "after-tax income". However, whether or not distributions are actually made, and whether or not retained income is reinvested, can be determinative of the pricing of partnership shares. Although retained earnings may determine the value of partnership shares, under China's tax law, they do not enjoy the same tax basis; on the contrary, the tax basis of the partnership's equity interest and the tax basis of the partners' partnership shares are completely independent of each other.

Therefore, one of the fundamental ways to solve the problem of double taxation is to file a tax basis equalization return. In terms of tax law principles, the tax basis should maintain the "continuity principle", i.e., for property that has already been taxed, the tax basis should be increased accordingly to the fair value level of the tax period. In the aforementioned case, when A paid individual income tax on the income of 160,000 yuan, the tax basis of its partnership share should be shifted by 160,000 yuan, which is recorded as 1.16 million yuan. In this way, the individual income tax of 68,000 yuan [(1.5 million yuan - 1.16 million yuan) * 20%] should be paid on the subsequent transfer, avoiding the problem of duplicating the 32,000 yuan tax on the 160,000 yuan income. In the aforementioned Case 2, when A paid individual income tax on 500,000 yuan income, the tax basis of the partnership's equity should be divided into two, for the part attributable to B, the tax basis remains unchanged; for the part attributable to C, the tax basis of the corresponding leveling to the fair value of the equity. In this way, when the partnership subsequently transfers the equity, C should recognize the taxable income as (equity transfer price - fair value of equity at the time of acquiring the partnership share)/2, and B should recognize the taxable income as (equity transfer price - book cost of equity)/2.

(II) Implementation of double tax rate system

The "double tax rate system" is one of the means to eliminate economic double taxation. According to the double tax rate system, two tax rates are applied to the corporate income tax of a corporate enterprise, i.e. the higher tax rate is applied to the retained profits of the enterprise for the current period; and the lower tax rate is applied to the profits distributed to shareholders of the corporate enterprise for the current period, so that after the shareholders pay the personal income tax on the distributed profits, the actual tax burden of such part of the profits is comparable to that of the retained profits.

The double tax rate system can also be used to alleviate the duplicative taxation of partnership share transfers, but the logic of application is different. For the gains from the transfer of partnership shares, if they are not actually distributed to the partners but are used for retained reinvestment, a lower tax rate should be applied to the extent of tax exemption; if they have been actually distributed, they can be taxed according to the income from operations or transfer of property. Under the dual tax rate system, emphasis should be placed on the review of the partnership's tax declaration information, and if the partnership declares a lower tax rate, it should provide evidence of reinvestment-related information, such as the registration of industrial and commercial changes in the equity, bank transfer records, and so on.