In order to raise capital and further expand its development through listing in the capital market, a proposed listed company needs to adjust its shareholding structure in accordance with the listing program, and especially for limited liability companies, it also needs to carry out share restructuring. With the full promotion of the registration system across the market and among all types of public share issuance, the listing conditions have become more diversified and inclusive, but issuers still need to ensure that they are in compliance with the issuance conditions, the listing conditions and the relevant disclosure requirements, and to respond to the regulator's inquiries around the qualifications of the main body, the history, the competition in the same industry, the related transactions, and the tax risks. In particular, the tax risk of changes in the shareholdings of individual shareholders is partly rooted in the way they hold their shares before the listing of the company. In order to avoid being unable to go public due to the existence of serious tax administrative penalties or tax-related criminal risks, companies need to be prudent in designing and constructing their shareholding structure.

I. Sources of risk of changes in equity of individual shareholders of a proposed listed company

(I) Transfer of capital surplus to share capital

Case 1: In May 2019, Company A's capital surplus was transferred to increase registered capital, and A, B and C, as natural person shareholders, did not pay personal income tax. upon enquiry about tax compliance, Company A replied that after the issuer's capital surplus was transferred to increase registered capital, the personal tax of the natural person shareholders amounted to a total of 7,330,200 yuan. As the transfer did not involve cash profit distribution, the amount of individual income tax to be paid this time was large, and there were difficulties for the natural person shareholders to fulfill their tax obligations.2023 On January 6, 2023, Company A applied for a deferral of payment of the individual income tax payable in respect of the transfer of capital stock to increase registered capital to the Q Tax Sub-bureau of the D Municipal Taxation Bureau, and issued a Letter of Undertaking to Withhold and Pay Tax on Behalf of the Individual Shareholders.

Capital increase, i.e. increasing registered capital, can enhance the economic strength of the enterprise and facilitate project investment. There are three forms of capital increase, including capitalization of capital stock, increase of capital contribution by original shareholders and investment by new shareholders. In practice, the three forms of capital increase can be mixed. In some cases of capital increase, the new shareholders are required to increase their capital at a high premium first, and then transfer the capital surplus generated to increase the registered capital, with the intention of enabling the original individual shareholders to avoid the transfer of equity at a high premium, which is extremely risky. According to the current laws and regulations, the main dispute of individual tax on capitalization of capital surplus lies in the confirmation of the scope of the subject of application of the policy of "no individual income tax on capitalization of capital surplus formed from the income from the issuance of stock premiums", and it is very easy for the limited liability company which has not yet completed the stock reform to be subject to individual income tax on the capitalization of capital surplus. (ii) Low or flat price

(II) Transfer of Equity Interests at Low or Flat Prices

Case 2: In January 2018, Li Moumou, a shareholder of Company C, reached an equity transfer agreement with Duan Mou, in which Li Moumou transferred all of his 20% equity interest in Company C (with an original value of RMB 5 million) to Duan Mou at par value, and both of them believed that they did not realize the value appreciation in the process of the transfer, and did not need to pay individual income tax. Later, the competent tax authority found that the price of the equity transfer was abnormal, and in accordance with the Net Asset Approval Method, the equity transfer was approved to have a revenue of RMB 30 million, and the individual income tax of RMB 200,000 was recovered.

Before the listing of the company, the equity restructuring of the limited liability company often carries out frequent equity transfers, and in order to avoid the high individual income tax obligation on the income from equity transfers or for other considerations, the individual shareholders have the motivation of transferring the equity shares at a low price or at a flat price, thus lowering the basis of individual income tax. The Measures for the Administration of Individual Income Tax on Income from Equity Transfer (for Trial Implementation) (Announcement No. 67 of 2014 of the State Administration of Taxation) clarifies that the determination of income from equity transfers should be in accordance with the arm's length principle, and that the price of an equity transaction is susceptible to tax adjustments unless there is a justifiable reason for the transfer of an equity interest at a low or flat price.

(III) Equity incentives

Case 3: J Partnership was a promoter shareholder of Company T. Before the IPO of the company, J Partnership held 7.01% of the shares, and its partners were middle and senior managers of Jinke Holdings and its subsidiaries. After the company's IPO, the audit found that J Partnership had obtained taxable income of nearly RMB 200 million from May 1, 2016 to March 31, 2018 from the reduction of its shareholding, and underpayment of value-added tax (VAT) and personal income tax (PIT), etc. was characterized as tax evasion.

In order to establish and perfect the benefit-sharing mechanism between laborers and owners, improve the level of corporate governance, and enhance the cohesion of workers and the competitiveness of the company, the company grants employees the qualification to participate in the company's decision-making as shareholders, share the operating profits as well as bear the market risks, and form the capital bonding relationship between the company and the employees, and many companies implement the employee shareholding incentives prior to the listing and filing of the report. Whether it is the establishment of a shareholding platform, or "0 yuan purchase", "1 yuan purchase" and other methods, the employees are employed to obtain equity incentives, is a non-cash form of wages and salaries, should be based on the acquisition of equity corresponds to the fair value of the market, less the cost of the balance of fees paid, calculate the amount to be paid, and then the amount to be paid is calculated according to the fair value of the equity corresponding to the market. The individual income tax shall be calculated based on the market fair value of the acquired equity, less the balance of the costs and expenses paid.

(IV) Transfer of Equity Interests with Betting Clause

Case 4: In June 2015, Company G acquired the equity interest of Tang, a shareholder of Company L, pursuant to the Equity Transfer Agreement of Company L at a transfer price of RMB14.5 million. The agreement stipulated that the equity payment was to be paid in cash in two installments, of which the second installment of the equity transfer price was to be paid in accordance with the conditions during the profit commitment period. For failing to withhold and pay the individual income tax on the equity transfer, the company was imposed a fine of nearly RMB 3.6 million for one hundred and fifty percent of the tax that should have been withheld and not withheld.

Equity transfer transactions are usually characterized by large amount and difficult valuation, and affected by multiple factors, the actual appreciation or depreciation of equity needs to be borne by the transferee of the risk of future value changes. Under the current tax policy for equity transfer, equity income is recognized at once when the agreement comes into effect and the change of equity is completed, which has left tax risks for both parties to the transaction. Equity transfer with a betting agreement is a "valuation adjustment mechanism" artificially embedded in the equity transaction, the core of which is to make two contingent agreements, positive and negative, on whether the target company can achieve a certain performance or goal, so as to realize a fair distribution of the risk of future changes in the value of the equity between the investment and financing parties. However, treating the betting period as a business whole and determining the taxable basis of the equity transfer on the basis of it still involves certain tax avoidance risks, and the amount obtained by the taxpayer from it, such as liquidated damages, compensation, indemnification, and recoveries under other names, may be counted as taxable income for personal income tax purposes.

II. Comparison of Tax Costs for Various Businesses under Different Shareholding Structures

Proposed listed companies often build a shareholding platform to achieve a stable shareholding structure, unified voting rights and convenient management during the listing review period. When the company is successfully listed, employees who have obtained equity incentives and former individual shareholders who are engaged in tax planning will focus on considering the tax cost of equity reduction in order to maximize the benefits of stock liquidation. In practice, shareholding platforms include both corporate and partnership systems, and the transformation of indirect shareholding platforms to direct shareholding by individual shareholders requires comprehensive dismantling of the cost of shareholding platforms as well as the tax obligations arising from subsequent transfers and distributions, and determining the tax costs of various businesses under different shareholding methods. Assuming that the shareholding platform and investee enterprises are general taxpayers and resident enterprises, the tax costs under different shareholding structures are as follows, centering on the business of equity transfer, capitalization and distribution of earnings:

(I) Tax burden cost of equity transfer under different shareholding structures

Among them, if the partnership-type shareholding platform complies with the relevant provisions of the Interim Measures for the Administration of Venture Capital Enterprises or the Interim Measures for the Supervision and Administration of Private Equity Investment Funds, in accordance with the Circular on Issues Concerning the Income Tax Policies for Individual Partners of Venture Capital Enterprises (Caixian [2019] No. 8), if a VC enterprise chooses to account for the VC enterprise on the basis of a single investment fund, the shareholding transfer proceeds and dividends and bonuses receivable by the individual partners from the fund dividend income, can be calculated at a 20% tax rate to pay personal income tax. However, due to the limited scope of application of this policy, in the case of large-value equity transfers, direct shareholding by individual shareholders has a tax advantage over shareholding by other shareholding platforms.

(II) Tax cost of dividend distribution under different shareholding structures

(III) Tax cost of capitalization under different shareholding structures

It is worth noting that the transfer of registered capital by legal person shareholders utilizing capital surplus other than capital premium is regarded as distribution of dividends and bonuses before monetary contribution in tax law, and is still subject to enterprise income tax in accordance with relevant regulations. Only, according to Article 26(2) of the Enterprise Income Tax Law, equity investment income such as dividends and bonuses between qualified resident enterprises shall be exempted from enterprise income tax. Therefore, under the aforementioned assumptions, legal person shareholders are not required to pay enterprise income tax on the conversion of share capital.

From a comprehensive point of view, different ways of shareholding have their own advantages and disadvantages. Shareholding by legal persons plays an important role in isolating production and operation risks, acting as a pool of funds for foreign investment and facilitating financing, etc., while shareholding by partnerships has the advantage that it is conducive to the introduction of external investors and the maintenance of stability of the control of the company. However, after the listing through the legal person to reduce the shares will make the actual controller not only have to bear the equity transfer of corporate income tax, value-added tax, etc., the legal person held by the dividends to the transfer of individual shareholders are also subject to personal tax, the overall tax burden is far more than the individual direct shareholding. With the Ministry of Finance and the State Administration of Taxation Announcement No. 41 of 2021 coming into force, partnerships holding equity, stocks, partnership property shares and other equity investments, in the way of individual income tax is also applicable to all checking and levying, building a partnership-type shareholding platform to take advantage of the tax pits to avoid tax has come to the end of the road, and individual shareholders direct shareholding, on the contrary, to show the advantages of tax saving.

III. Tax risk of changes in shareholdings of individual shareholders of a proposed listed company

(I) Underpayment of tax due to incorrect application of non-taxation policy

The currently effective policy on capitalization of capital surplus to share capital is set out below:

It is not difficult to see from the above provisions that no tax is levied on the capitalization of share premium issue of joint stock companies, which is the consensus of the existing provisions and the practice of levy management, and the main controversy lies in whether this policy is applicable to the capital surplus formed by capital premium issue of limited company stage which continues to be used for the conversion of share capital after share reform.Since the implementation of Caixa [2015] No.116 on January 1, 2016, there has been no clear distinction between the "capital surplus formed by share premium issue" and other capital surplus. "capital surplus formed by share premium issue" and other capital surplus, i.e., the situation of capital surplus formed by share premium issue being converted to share capital is generalized into the taxable scope, and even covers the conversion of joint stock companies together. However, after the implementation of No. 116, the original No. 198, No. 289 and No. 54 continue to be effective, and No. 116 does not change the taxable scope, but only grants small and medium-sized hi-tech enterprises the tax benefits of tax payment in installments. However, at the same time of the implementation of No.116, the Pilot Measures for Joint-Stock Enterprises were abolished, which lacked the support of the argument that "joint-stock enterprises" include two organizational forms, namely, joint-stock limited company and limited liability company, and the controversy of whether the capital increase of limited liability company with capital premium is taxable or not was even more serious. In addition, the caliber of law enforcement practices varies from place to place, and natural person shareholders are very likely to underpay tax due to the wrong understanding of the policy, which triggers the risk of subsequent payment of tax and late payment fees.

(II) Approved taxable income with low tax basis

Before and after the share reform, natural person shareholders, whether out of tax saving needs or on behalf of the shareholders to return to the original price or low price transfer of equity, objectively will form the tax basis is obviously low, according to Announcement No. 67, taxpayers declared that the equity transfer income is obviously low and without justifiable reasons, the competent tax authorities can approve the equity transfer income. If the pricing of equity transfer by the taxpayer is lower than the fair value of net assets or other circumstances stipulated in Article 12 of Announcement No. 67, and it does not belong to the situation that the production and operation suffers from significant impact due to policy adjustment, transfer to people with specific identity relationship, qualified internal transfer or other reasonable circumstances, the tax authorities have the right to approve the income from equity transfer in accordance with the net assets approval method, analogical method or other reasonable methods in turn.

(III) Shareholding platforms are unable to apply the approved levy

The Announcement of the State Administration of Taxation on Relevant Issues Concerning the Approved Collection of Enterprise Income Tax (SAT Announcement No. 27 of 2012) has made it clear that enterprises specializing in the business of equity (stock) investment shall not be subject to approved collection of enterprise income tax. With the implementation of the Announcement of the Ministry of Finance and the State Administration of Taxation on the Administration of Collection of Individual Income Taxes on Income from Equity Investments (Announcement of the Ministry of Finance and the State Administration of Taxation No. 41 of 2021), sole proprietorships and partnerships holding equity, stocks, partnership shares and other equity investments are also subject to the checking of accounts for the collection of individual income tax. As a result, the space for tax saving by utilizing the preferential policies of approved levy in the tax area to set up company-type and partnership-type shareholding platforms has almost disappeared. Moreover, as the local financial rebate policy has been further cleaned up nationwide, it is difficult to continue the planning method of building a shareholding platform to obtain financial rebates. Coupled with the focus of tax supervision and investigation of tax-related violations in the field of equity transfer of high-income people, the risk of taxpayers taking the risk of illegally applying the approved levy is extremely high.

IV Dispute Resolution of Changes in Equity Interests of Individual Shareholders of a Proposed Listed Company

(I) Proactive self-examination of tax risks and focus on tax compliance for changes in shareholdings

Taxpayers should fully understand the current effective tax policies and confirm whether the behavior of equity changes is taxable. In the process of capital contribution, equity transfer, overall change, profit distribution, capitalization of capital surplus, etc., taxpayers shall explain the reasonableness of the low price or difference in equity change, accurately account for the original value of equity, and ensure that the calculation of taxable income is correct; they shall self-check whether they have made tax declarations on equity change in accordance with the law, and paid the tax in full and in a timely manner; and if the change involves the withholding and payment of individual income tax, whether it has been withheld. If it involves the withholding and payment of individual income tax, whether it has been withheld and paid on behalf of the individual. If necessary, professionals such as sponsoring organizations and lawyers may also be engaged to assist in the verification of the above matters to ensure tax compliance of the business of equity changes.

(II) Actively communicate with the tax authorities and strive for non-payment or payment of tax in installments

The proposed listed company and natural person shareholders should communicate with the tax authorities in advance and actively understand the correct way of tax treatment. Taxpayers should make sufficient arguments around the capital premium and equity premium being essentially the same, no change in registered capital before and after the share reform, and the tax law not specifying that the capital premium conversion is taxable under personal tax, etc., and strive to obtain the recognition of the tax authorities that a limited company does not need to pay personal income tax on the capital premium conversion of share capital by obtaining the special confirmation documents from the tax authorities or conducting formal interviews with the tax authorities for confirmation. In case of non-payment of tax, in order to avoid excessive one-time payment of tax, the taxpayer should fully prove that he/she has difficulties in paying tax at one time, and strive for the application of tax incentives for payment by installment. If the taxpayer can pay the individual income tax in installments, the taxpayer shall submit the relevant information to the competent authorities for filing and allocate the amount of planned payment in accordance with the filing period, and follow up whether the relevant tax is paid in full in a timely manner, so as to prevent administrative and criminal risks arising from the non-payment or underpayment of tax.

(III) Carefully selecting the counterparty for equity transfer and strengthening the reasonableness of the low price

In accordance with Circular 67, the transfer of equity interests to a subject with a special status relationship may still be deemed to be justified even if the pricing is not fair. Therefore, the pre-listing individual shareholders' equity changes should be related to as far as possible to choose the subject of the transaction with their relatives, friends and other private social relations or other affiliations, so as to obtain the benefits of tax savings, and more likely to meet the tax reasonableness standards on the audit of the IPO.