With the Notice on Administration of Collection of Individual Income Tax on Income from Equity Investments and Operations (Notice No. 41 of 2021 of the Ministry of Finance and the State Administration of Taxation) coming into effect, the tax advantages of holding equity, shares, partnership shares and other equity assets in partnerships are no longer available, and many investors have begun to dismantle their partnership investment structures and return to the original state of direct shareholding by natural persons. However, the dismantling of the investment structure will also result in a high tax burden, and in addition, even if the partnership is canceled, all types of transactions that occurred prior to the cancellation may still be subject to retroactive adjustments. Recently, a local tax bureau has made public a case of multi-layer nested partnership write-off, and the partners were recovered tax. This article will analyze the tax risk of dismantling the partnership investment structure in light of this case.

Ⅰ. Introduction of Case: Multi-layer Nested Partnership Write-Off and Partner's Tax Recovery of 4 Million 

(Ⅰ) Investment Structure

Company J was established in 2004, registered in Province Y, mainly engaged in the manufacture of computer, communication and other electronic equipment, etc. In 2014, Enterprise Z (limited partnership) was established, registered in Province S. Enterprise Z was a platform for employee shareholding of Company J. Its partners were mainly employees of Company J. Immediately after the establishment of Enterprise Z, it acquired 5.6 million shares of Company J by way of directional issuance, with a share price of RMB2.5/share, and the value of the shareholding was worth RMB4 million. Yuan/share, and the value of the shareholding totaled 14 million yuan. in 2017, J company debuted on the stock market with an issue price of 21 yuan/share, and the value of Z enterprise's shareholding totaled 117 million yuan.

In 2018, the shares of Company J held by Enterprise Z were released from lockup, and the holdings were successively reduced to 3 million shares.In July 2020, some of the partners of Enterprise Z withdrew, and A and 9 other people newly joined the partnership. In the same month, A and 9 others established P Enterprise (limited partnership) with registered office in City H. In August 2020, A and 9 others transferred their partnership shares of Z Enterprise to P Enterprise. In December 2020, A and 9 others established A Enterprise (limited partnership) with registered office in City A. Subsequently, A and 9 others transferred their partnership shares of P Enterprise to A Enterprise.

(Ⅱ) Cancellation

In June 2021, Enterprise P, Enterprise A and Enterprise Z were successively registered for business deregistration.

(Ⅲ) Tax treatment

In August 2022, the Inspection Bureau of A Municipal Taxation Bureau issued a Decision on Tax Treatment to A and 9 other persons, stating that from December 1, 2020 to March 31, 2021, A and 9 other persons had not declared and paid the full amount of personal income tax on the income obtained from Enterprise A, and it was decided that the total amount of 4 million yuan of personal income tax of the 9 persons should be recovered.

(Ⅳ) Dispute analysis

In this case, since July 2020, the investors of Enterprise Z began to undergo significant changes, and a multi-layer nested partnership investment structure was formed by December 2020, followed by the fact that after only half a year, all of Enterprises A, P, and Z were written off in June 2021, and the design of the investment structure obviously had its specific purpose.

From the content of the Decision on Tax Treatment, between December 2020 and March 2021, A and nine other persons obtained income from Enterprise A. As the main asset of Enterprise A was the partnership share of Enterprise P, corresponding to the underlying asset, i.e., the shares of Company J. This part of the income might be the income from the transfer of the shares of Company J by Enterprise Z or the dividend bonus distributed by Company J. And according to the provisions of the tax law, the direct shareholding by natural persons can apply the dividend and dividend differentiated individual income tax policy, and the dividend and dividend obtained through partnership shareholding cannot apply the tax reduction and exemption policy, and there is no necessity to build a multilayered nested partnership if it is only for the purpose of obtaining the dividend and dividend, and from this, it can basically be deduced that, during the period of December 2020 to March 2021, Enterprise Z transferred a large number of shares of Company J, and that A and other 9 did not file a full individual income tax return on this portion of income.
On the other hand, there may be two reasons why the partnership was able to write off smoothly without A and other 9 persons paying full tax. First, because the investment structure itself adopts a multi-layer nesting model, and each layer of the partnership is located in a different province, the information on the tax administration is not sufficiently smooth among provinces, which resulted in the failure of the tax authority in charge of Z enterprise to pass the detailed information to the tax authority in charge of A enterprise in a timely manner when Z enterprise transferred the shares. At the same time, the competent tax authority of Enterprise A did not know the details of the transfer of shares by Enterprise Z in a timely manner, which led to the inaccurate declaration of the income from the transfer of shares. Secondly, City A, where Enterprise A is located, may have introduced tax policies such as authorized levy and fiscal rebate, which made A and other 9 persons only need to bear a lower tax burden in the stock transfer.

Ⅱ. the three major tax-related risks that need to be paid attention to in the dismantling of multi-layer nested partnership investment structure

(Ⅰ) Risk of tax adjustment for past transactions

According to the "Provisions on Individual Income Tax Levied on Investors of Sole Proprietorships and Partnerships" (Cai Shui [2000] No. 91) and the "Circular of the State Administration of Taxation on the Caliber of Implementation of the Provisions on Individual Income Tax Levied on Investors of Sole Proprietorships and Partnerships" (Guoshuai Han [2001] No. 84), for transfer of shares by partnerships, the individual partners shall pay the Individual Income Tax, with applicable tax rates ranging from 5% to 35%. For the multi-layer partnership nested model, the layers are penetrated to the topmost partner for taxation. Since the transfer of shares of listed companies by partnership shareholding platforms usually fetches a high premium, especially as the original shareholders, the shares will increase significantly in value after the listing of the company, and the highest tax rate of 35% is often applied in the transferring process. In addition, according to the Notice of the Ministry of Finance and the State Administration of Taxation on Comprehensively Pushing Forward the Pilot Project of Business Tax to Value-added Tax (Cai Shui [2016] No. 36), the transfer of shares is also subject to a value-added tax calculated at a rate of 6%. In contrast, for direct stock transfers by natural persons, a fixed tax rate of 20% applies to personal income tax, while VAT is exempted. In comparison, partnership shareholding platforms do not seem to have any tax advantage as the subject of stock transfer. However, in practice, many places have introduced the approved levy policy for investment attraction considerations, allowing partnerships and sole proprietorships to apply the approved levy for filing personal income tax returns of individual partners, which is able to reduce the income tax liability rate to 1%-3%, thus realizing a significant reduction in tax liability.

After Circular 41 came into effect, the phenomenon of abusing the approved levy policy has been widely noticed by the tax authorities, and many localities have made retrospective adjustments to the share transfer transactions before the introduction of Circular 41, requesting to change to paying back the individual income tax according to the checking and collection method, and recovering the VAT if it has not been declared and paid in accordance with the law. It is noteworthy that, because the partnership itself is not liable for income tax, non-individual income taxpayers, even if the partnership has been canceled in accordance with the law, there is no legal obstacle for the tax authorities to recover the individual income tax directly from the partners. As for value-added tax, although the partnership is a taxpayer, many tax authorities will require the partners to assume supplementary liability for the partnership's value-added tax obligations on the basis of the judicial interpretation of the Company Law (II), which requires the partners to conceal the tax debts of previous periods by the liquidation team in the dissolution and liquidation process of the partnership, and to adopt a false liquidation report for write-off. Therefore, in the case of dismantling of partnership investment structure, the personal income tax and value-added tax of past transactions may face the risk of tax adjustment.

(Ⅱ) Risk of tax on dismantling of investment structure

In addition to the possibility of tax adjustments for past transactions, when the investment structure is dismantled, if the partnership shareholding platform still holds the shares of the subject company, or the shareholding platform still has monetary funds that have not been allocated to the partners, the shares and funds will be restored to the partners due to the dissolution and liquidation of the partnership, and this "restoration" constitutes a taxable act for personal income tax. Only at this time should be applied to what kind of tax levied personal income tax is controversial: a view that this situation has been Cai Shui [2000] No. 91 express provisions, individual partners need to pay personal income tax in accordance with the business income. However, there is also a view that this situation is a termination of business and should be subject to individual income tax in accordance with the provisions of the Announcement of the State Administration of Taxation on the Collection of Individual Income Tax on the Recovered Amounts from Individuals on Termination of Investment and Business Operation (Announcement of the State Administration of Taxation No. 41 of 2011) according to the income from the transfer of property. In addition, if the reversion object is listed company shares, it is a gratuitous transfer of shares from the partnership to the partners, which should be treated as deemed sales, and the partnership is required to determine the sales amount and calculate the value-added tax payable in accordance with Cai Shui [2016] No. 36.

(Ⅲ) Risk of multiple tax authorities demanding fulfillment of tax obligations

Under the multi-layer nested partnership model, if each layer of the partnership has a different place of registration, it also faces the risk of multi-location tax authorities claiming tax jurisdiction and requiring the top layer partners to fulfill their tax obligations. This risk arises mainly due to the current lack of clarity as to where the partners are taxed. According to the provisions of Cai Shui [2000] No. 91, the production and operation income obtained by the investor from the partnership enterprise shall be declared and paid by the partnership enterprise to the competent tax authority of the place where the enterprise is actually operated and managed for the payment of personal income tax payable by the investor, and the personal income tax return shall be copied to the investor. It can be seen that the system design of "separation of taxpayers and filers" applies to business income, and the taxpayers of business income are the partners, but the filers are the partnership enterprises, and it seems that no conclusion can be drawn from Cai Shui [2000] No.91 only as to which layer of the partnership enterprises have the obligation to file tax returns for the multi-layer nested partnership structure. In the present case, Enterprise A, P, and P, are the partners in the partnership. In this case, the competent tax authorities of the places where Enterprises A, P and Z actually operate and manage have the right to require the partnership to fulfill the tax declaration obligation according to the provisions of Cai Shui [2000] No. 91.

It should be noted that the partnership is not the partner's personal income tax withholding obligation, but a proposed tax declaration obligation, if the partnership fails to fulfill the relevant obligations in accordance with the law, can not be applied to the withholding or has been withheld without payment and other provisions of the partnership's responsibility, can only be pursued as a taxpayer's responsibility of the partners. In reality, in the case that the partnership enterprise does not fulfill the obligation to declare according to law, the competent tax authorities of enterprise A, enterprise P and enterprise Z may not only shift the responsibility to each other, but also neglect to recover the tax from the nine partners, or may claim the partners to pay the back tax for the consideration of increasing the local tax source. If there is no prior coordination of tax collection rights within the tax authorities, the partners will face the risk of multiple taxation.

Ⅲ.  Five Suggestions to Address the Tax-Related Risks of Dismantling Multi-Level Nested Partnership Investment Structures

(Ⅰ) Retroactivity Defense

From the policy background, the recent cases of partnership structure dismantling tax recovery that broke out one after another in many places are related to the entry into force of Circular 41, and some tax authorities even directly invoked Circular 41 in their handling decisions.Circular 41 explicitly stipulates that its entry into force will be January 1, 2022, and according to the principle of non-retroactivity of the law, if the past transactions or dismantling of the partnership structure took place before January 1, 2022, then the tax on them will be subjected to a retroactivity defense. prior to that date, the tax adjustments made to them cannot be based on Circular 41 as a legal basis. Before Circular 41 came into effect, there was no law prohibiting equity investment partnerships from applying the approved levy policy, so if the tax authorities did not have a clear legal basis, they could not make tax adjustments to the enterprise.

(Ⅱ) Defense of recovery period

According to the provisions of the Tax Collection and Administration Law, if the tax authorities are responsible for underpayment of tax, the tax recovery period is three years; if the taxpayer underpays the tax due to miscalculation or other mistakes, the tax recovery period is three years, which can be extended to five years under special circumstances; cases of evasion and fraud are not subject to the limitation of the recovery period. In the case of partnership transactions or dismantling of partnership structure in the past, the core of the dispute lies in whether it is "underpayment of tax" and how the underpayment of tax is caused. For the first dispute, it ultimately comes down to the legality of the approved local levy policy, for which the mainstream view is that the approved local levy policy violates the principle of tax law and the enterprises have less room for defense. For the second dispute, as the approved levy policy is often enjoyed by the enterprise and the local administrative authorities (including the dispatching authorities) by way of signing a contract, and the enterprise will also report to the tax authorities after obtaining the approved levy policy, and obtain the Approved Levy Notification issued by the tax authorities, the tax authorities have the main responsibility for the enjoyment of the approved levy by the enterprise, no matter in terms of the legal form or in terms of the protection of reliance. On the other hand, the enterprise does not engage in tax evasion in applying the approved levy policy by falsifying book documents, concealing income, inflating costs, refusing to declare upon notification of declaration or making false declarations, and declares tax using the approved levy method entirely with the approval of the tax authorities, which cannot be considered as constituting tax evasion by the enterprise. Therefore, if the time of occurrence of tax liability for past transactions or partnership structure dismantling is more than three years from the time of tax inspection, it has exceeded the tax recovery period.

(Ⅲ) The defense of superior law

For partnership share transfer transactions or partnership structure dismantling occurring after the effective date of Circular 41 and applying the authorized levy, the legality support for the authorized levy can be found at the level of the superior law. The Law on Administration of Tax Collection makes clear provisions on the conditions for authorized collection, among which "books of account should be set up but are not set up" and "accounts are in disarray or cost information, income vouchers and expense vouchers are incomplete and difficult to check" are the legal grounds for authorized collection. These authorized levies may also exist for equity investment partnerships. In fact, as early as 2012, the State Administration of Taxation ("SAT") had already issued the Announcement on Relevant Issues Concerning the Approved Collection of Enterprise Income Tax (SAT Announcement No. 27 of 2012), which required that enterprises specializing in equity (stock) investment business shall not be subject to the approved collection of enterprise income tax, but did not provide any exceptions to the tax payment method for equity investment partnerships. Since 2012, the Partnership Law has not been amended, and other relevant laws and regulations, such as the Accounting Law, have not been adjusted in relation to the bookkeeping of partnerships, yet Circular No. 41 was issued out of thin air, requiring that equity investment partnerships must be taxed by checking the books and accounts, which is not based on and supported by the higher law. The enterprises involved in the case may propose a normative document review from the perspective of legal status to see whether Circular 41 is in compliance with the higher law.

(Ⅳ) Defense of division of liability

As mentioned before, in cases where the partnership has been canceled, the tax authorities in some cases recovered the VAT on past transactions from the partners. In addition, for the transaction of distribution of shares to partners during the dissolution of the partnership, some tax authorities also required the partners to pay back the VAT that the partnership was liable for. As a matter of fact, whether it is a past transaction or a dissolution distribution, the VAT payer is always the partnership, not the partners. The main legal basis for the tax authorities to pursue the penetration of the tax is the Judicial Interpretation of Company Law (II), but the application of this rule is subject to strict conditions, which must be "without liquidation in accordance with the law, and fraudulently obtaining the company registration authority to handle the legal person's deregistration with the use of a false liquidation report". If the liquidation group in accordance with the law to carry out the liquidation work, the truthful liquidation report, but due to the responsibility of the public authorities did not timely recovery of value-added tax to the partnership, this part of the tax should not be borne by the partners.

(Ⅴ) Defense of double taxation

In reality, partners may realize investment withdrawal by transferring partnership shares or dissolving the partnership enterprise, and there may also be double taxation problems if the withdrawal is made by transferring shares. As a virtual body of income tax, the production and operation income obtained by the partnership enterprise is subject to the income tax obligation of the partners. According to Cai Shui [2000] No. 91, the individual income tax of individual partners is prepaid monthly or quarterly, and remitted annually. In other words, all the income obtained in the course of production and operation of the partnership has already been subject to income tax in each year. If the partnership adopts the dissolution method to realize the structure dismantling, according to Cai Shui [2000] No. 91, in the liquidation of the enterprise, the portion of the fair value of all the assets or properties of the enterprise, after deducting all the liquidation expenses, losses, liabilities, and retained profits of the previous years, which is in excess of the paid-in capital, shall be regarded as the income from the liquidation. In other words, even if the profits of the previous years are not actually distributed to the partners, because they are all tax-paid profits under the rule of "first divided, then taxed", they must be deducted as the tax basis in the liquidation, or else there will be a duplication of tax bases. Otherwise, there will be a duplication of tax bases. However, if a partner withdraws by transferring the partnership shares, since the undistributed profits of previous years are taken into account in the pricing of the partnership shares, i.e., the undistributed profits have already been included in the transferring income in an equal amount, but the partner's deduction is only the cost of acquiring the partnership shares, i.e., the paid-in capital, which results in the income equivalent to the undistributed profits being taxed repeatedly in the transferring of the partnership shares. The transferor may raise the defense of double taxation from the point of view of economic substance.