In the past, many high net worth individuals (HNWIs) have built partnership shareholding platforms in tax depressions in order to enjoy tax incentives such as approved levies and fiscal refunds to realize tax savings. However, with the Notice on Administration of Collection of Individual Income Tax on Income from Equity Investments (Notice No. 41 of the Ministry of Finance and the State Administration of Taxation of 2021) coming into effect, coupled with the strict investigation of illegal financial rebates in recent years, the original tax advantages of partnership-type shareholding platforms have gradually disappeared, and HNWIs have chosen to dismantle their shareholding platforms and return to the original state of direct shareholding. The dismantling of the shareholding platform will also generate a high tax burden, what kind of dismantling can HNWIs choose to realize the optimal tax saving effect? This article is intended to discuss.

I. Why choose to dismantle the shareholding platform?

Before CaiShui 2021 Announcement No. 40 came into effect, HNWIs could reduce their individual income tax burden by indirectly transferring their equity interests in the target company through the partnership-type shareholding platform, and if the local government gave a certain percentage of fiscal rebate, the actual tax burden paid by HNWIs would be further reduced. However, with the abolition of the approved levy policy, if HNWIs transfer the equity of the target company, they can only pay individual income tax in accordance with the way of checking the accounts, which is higher than the tax burden of directly transferring the equity of the target company. Therefore, without taking into consideration of other factors such as guaranteeing the founder's right of control and improving the convenience of equity change, from the angle of tax burden only, it is a general trend for HNWIs to choose to dismantle their shareholding platforms. The trend is to dismantle their shareholding platforms.

For example: assuming that the income from transferring equity is 10 million, the cost of equity investment is 1 million, the cost of production and operation of the partnership enterprise such as salary is 100,000, HNWIs enjoy the approved levy policy by building a partnership-type shareholding platform, and assuming that the approved taxable income rate is 10%, the personal income tax to be paid for transferring equity in the target company will be 284,500, after the abolition of the approved levy policy, if HNWIs choose to dismantle the shareholding platform, it will be a big trend from the perspective of tax burden only. After the abolition of the authorized levy policy, if the transfer of equity interest in the target company is still made through the partnership-type shareholding platform, the individual income tax payable will be 3,049,500, which is an increase of 90.67% in tax burden, but the direct transfer of equity interest in the target company will be subject to an individual income tax of 1,800,000, which is a reduction of 69.42% in tax burden compared to the indirect transfer of equity interest in the target company under the checking and levying of income tax.

II. What options are available to dismantle a shareholding platform?

Since the partnership-type shareholding platform is subject to the principle of pass-through taxation and each partner is the taxpayer of the partnership, the partnership itself is not the taxpayer of the income tax and has no income tax liability in the liquidation process, HNWIs are liable for personal income tax for dismantling the shareholding platform. From the perspective of tax policy and practice, there are two ways for HNWIs to dismantle their shareholding platform, specifically:

(i) Adopting the liquidation method

According to Article 16 of the Circular of the Ministry of Finance and the State Administration of Taxation on the Issuance of the Provisions on Individual Income Tax for Investors of Wholly-owned Individual Enterprises and Partnership Enterprises (Cai Shui [2000] No. 91), the income from the liquidation of a partnership enterprise shall be deemed to be the income from the production and operation of the year, and the investor shall pay the individual income tax. Therefore, when HNWIs dismantle the partnership-type shareholding platform, the liquidator shall first liquidate the assets and liabilities of the partnership and calculate the liquidation income, which shall be regarded as the annual income from production and operation of the partnership, and then the HNWIs shall declare and pay the IIT to the tax authorities in accordance with the “income from operation”.

(ii) By way of divestment

According to the Announcement of the State Administration of Taxation on the Collection of Individual Income Tax on Money Recovered by Individuals on Termination of Investment and Operation (Announcement of the State Administration of Taxation No. 41 of 2011), money recovered by an individual on termination of investment for various reasons is taxable income subject to IIT and shall be subject to IIT in accordance with the provisions applicable to the item of “Income from Transfer of Property”. The amount recovered is taxable income subject to individual income tax and shall be calculated in accordance with the provisions applicable to the item of “income from property transfer”. Therefore, when HNWIs dismantle the partnership-type shareholding platform and the partnership enterprise is dissolved, it is the termination of investment by all partners, and they can declare and pay individual income tax to the tax authorities in accordance with the “income from transfer of property”.

III . Which method of dismantling the shareholding platform can realize the optimal tax saving effect?

(i) Comparison of taxable elements under two ways of dismantling the shareholding platform

According to Cai Shui [2000] No. 91, liquidation income = fair value of all assets/properties of the partnership at the time of liquidation - liquidation expenses - losses - liabilities - retained profits from previous years - paid-in capital, with a tax rate of 5-35%; according to the State Administration of Taxation Bulletin No. 41 of 2011, the taxable income from the transfer of property = income from transfer of shareholdings obtained by an individual/default/compensatory/ According to SAT Announcement No. 41 of 2011, the taxable income from property transfer = income from equity transfer/default payment/compensation/recovery under other names - the original actual capital contribution - related taxes and fees, with a tax rate of 20%. From this point of view, the taxable elements under the two dismantled shareholding methods can be mainly categorized into the elements of income, deduction, and tax rate, which are shown as follows:

1. Income element

Under the liquidation method, the income element is the fair value of all assets or properties of the partnership at the time of liquidation; under the divestment method, the income element is the income from the transfer of equity, liquidated damages, compensation, indemnification, and recovery of money under other names, but the attribute of fair value is not emphasized.

2. Deductive elements

Under the liquidation method, the deductible elements are liquidation expenses, losses, liabilities, retained profits from previous years and paid-in capital, which are more deductible elements; under the divestment method, the deductible elements are the actual amount of the original capital contribution and related taxes, which are less deductible elements.

3. Tax rate elements

Under the liquidation method, the applicable tax rate is 5-35%, and the tax rate of 35% applies to the income exceeding 500,000 RMB; under the divestment method, the size of the income element and the cost element will not affect the application of the tax rate, and the tax rate is 20%.

(ii) Impact of the income element on tax liability under the two methods of dismantling the shareholding platforms

1. Impact of the income element on tax liability under the liquidation approach

Under this approach, if the liquidation is non-monetary, the determination of the fair value of the assets or property in the liquidation of the partnership has a critical impact on the level of the HNWI's personal income tax liability. In practice, the fair value of assets or property in liquidation is determined by whether the partnership holds an equity interest in a public company or a non-public company. Usually, if the equity interest is held in a public company, the fair value will be calculated according to the closing price per share of the target company on the transfer date, which is a fairer and more transparent price. If the equity interest is held in a non-public company, the fair value will be determined by evaluating the net assets of the target company, and the valuation method adopted at this time will also have an impact on the determination of the fair value. Therefore, if HNWIs choose to dismantle their shareholding platform in this way, the determination of fair value is an important factor for them to consider the tax burden.

2. Impact of the income element on tax liability under the divestment approach

After the dismantling of the shareholding platform by divestment, which is characterized as income from equity transfer, HNWIs can further declare the income from equity transfer in accordance with the original capital contribution at par, and in general, it is difficult for tax authorities to make tax adjustments to the income from equity transfer in practice, which can reduce the tax burden of HNWIs, specifically:

(1) It is difficult for the tax authorities to authorize the equity transfer income of HNWIs by the Announcement of the State Administration of Taxation on the Issuance of the Measures for the Administration of Individual Income Tax on Income from Equity Transfers (for Trial Implementation) (Announcement of the State Administration of Taxation No. 67 of 2014). According to Article 2 of the Measures, “The equity referred to in these Measures refers to the equity or shares invested by natural person shareholders in enterprises or organizations established in China (hereinafter collectively referred to as invested enterprises, excluding sole proprietorships and partnerships)”, it can be seen that the Measures regulate the tax relationship of the transfer of equity by natural person shareholders, and are not applicable to the termination of the investment in partnership It does not apply to the termination of investment in a partnership or the transfer of partnership shares. Therefore, if the high net worth individuals terminate their investment in the partnership and the income from the transfer of equity is approved by the tax authorities in accordance with the provisions of Article 11 of the Measures, it is an error in the application of the law by the tax authorities.

(2) It is difficult for the tax authorities to determine that the termination of the HNWI's investment in the Partnership constitutes the implementation of an arrangement that does not have a reasonable business purpose and the acquisition of undue tax benefits. According to Article 8 of the Individual Income Tax Law, the tax authorities may adopt anti-avoidance provisions to adjust the tax on individual income. The first anti-avoidance provision refers to the anti-avoidance of connected transactions and the second anti-avoidance provision refers to the anti-avoidance of non-distribution of profits by the enterprise, which are obviously not applicable to the recovery of the investment of the partnership by the high net worth individuals, and as for the third underpinning provision, it is necessary to make specific judgment based on the specific transactions to determine that the recovery of investment of the partnership by the high net worth individuals belongs to the implementation of unreasonable business purpose and obtains undue tax benefits. It seems to be difficult to determine that the recovery of investment by HNWIs in partnerships is an arrangement for unreasonable business purposes.

(3) It is difficult for the tax authorities to approve the HNWIs' individual income tax under Article 35 of the Tax Collection and Administration Law. According to the Article, “Where a taxpayer has one of the following circumstances, the tax authorities shall have the right to approve the taxable amount ...... (vi) Where the tax basis declared by the taxpayer is obviously low and there is no justifiable reason for it”. This article is the basis on which the tax authorities can approve the income from equity transfer of HNWIs, and the application of this article can be blocked if the HNWIs are able to provide justifiable reasons, e.g., the HNWIs can propose that the repurchase price agreed in the partnership agreement at that time is the original capital contribution amount.

(iii) Impact of the deductible elements and tax rate elements on tax liability under the two methods of dismantling shareholding platforms

1. Impact of deductible elements and tax rate elements on tax liability under liquidation mode

Under normal circumstances, to remove the shareholding platform by way of liquidation, it is necessary to focus on the loss and liability items in the deductible elements. If the losses and liabilities of the partnership are large, even exceeding the assets of the partnership, the income from liquidation will be zero, and HNWIs do not need to reconsider the tax burden of removing the shareholding platform by way of divestment, and will have a more economical tax burden by way of liquidation.

2. Impact of Deduction and Tax Rate Elements on Tax Liability under Divestment Approach

As mentioned above, there are only two deduction elements to be considered for the removal of the shareholding platform by way of divestment, i.e., the original actual capital contribution and the relevant taxes and fees, and usually, the relevant taxes and fees are mainly the stamp duty, the amount of which will not be too high, therefore, in general, the removal of the shareholding platform in such a way will result in a smaller deduction than that in the liquidation way, but the tax rate of such a way will be fixed, and the tax burden will be more economical in case of the losses, liabilities, etc., of the partnership. If the amount of partnership losses, liabilities and other deductions is small, and at the same time the income is higher than 500,000 yuan, the tax basis is basically the same as the liquidation or divestment method, but the divestment tax rate is 15% lower than the liquidation method, and the divestment method is more economical in terms of tax burden.

IV. Suggestions for choosing the way to dismantle the shareholding platform

(i) Considering all factors and consulting tax professionals

From the foregoing, it can be seen that the consideration and measurement of tax burden is extremely complicated, and it is necessary to comprehensively consider the elements of income, deduction and tax rate. Once there is a deviation in the calculation and improper application of tax policies, it may lead to an increase in tax burden instead of a decrease, deviating from the original track of reducing tax burden. However, this is also an opportunity, so if they can correctly, accurately, finely, and comprehensively consider various factors, make use of tax policies, and legally and reasonably make tax arrangements, they can effectively reduce the cost of tax burden and realize the maximization of economic benefits. Therefore, it is necessary for HNWIs to ask tax professionals to intervene in advance to help them plan before dismantling their shareholding platforms, so as to avoid failures in applying policies and measuring tax liabilities.

(ii) Actively communicate with tax authorities to minimize tax risks

Currently, Shanghai, Beijing and many other places have issued specific regulations on prior tax rulings, aiming to improve the certainty of tax administration and safeguard the legitimate rights and interests of taxpayers. In practice, taxpayers may apply to the tax authorities for written advice on how to apply existing tax laws, regulations, rules and normative documents to specific complex and significant tax-related matters that are expected to occur in the future, and in general, the prior ruling advice will not be arbitrarily revoked. From the perspective of legal effect, the prior ruling has a strong guiding effect on the way of dismantling the shareholding platform chosen by HNWIs. Therefore, HNWIs can submit the relevant information of partnership and investment structure to the tax authorities in advance, actively communicate with the tax authorities and apply for a tax ruling, so as to improve the legality and certainty of tax treatment and minimize the tax risks at the front end.