Editor’s Note

A typical red-chip structure is established when domestic enterprises or individuals set up holding companies in offshore jurisdictions as offshore listing vehicles, which then control domestic operating entities through equity holdings or contractual arrangements, enabling domestic entities to raise capital via indirect listing on overseas capital markets. Based on the control mechanism, red-chip structures fall into two categories: equity-controlled structures and VIE (Variable Interest Entity) agreement-controlled structures.

For instance, given foreign investment access restrictions in specific sectors such as value-added telecommunications services, offshore listing vehicles usually adopt the VIE agreement-controlled red-chip model. When the business scope of a domestic operating entity changes and it is no longer subject to foreign investment access restrictions, enterprises generally convert the VIE agreement-controlled structure into an equity-controlled red-chip structure.

A core step in dismantling a VIE structure is for the wholly foreign-owned enterprise (WFOE) to acquire equity in the domestic operating entity. In practice, two main approaches are adopted: first, the original shareholders directly transfer their equity in the domestic entity to the WFOE; second, the WFOE acquires equity by subscribing to a capital increase of the domestic entity. The tax obligations arising from direct equity transfer are relatively clear-cut. However, what tax disputes and risks are embedded in equity acquisition via capital increase? And how should such risks be addressed? This article analyzes these issues based on a practical case.

I.Case Introduction

1.Basic Facts

Individual Jia established Company A in China, with its principal business being internet micro-lending, and planned to take the company public. Restricted by domestic regulatory requirements, internet finance enterprises cannot list on China’s A-share market. In addition, internet micro-lending falls under sectors with restricted foreign market access, meaning the offshore listing vehicle cannot directly hold equity in Company A.

Against the backdrop of blocked A-share listing channels and foreign investment barriers to direct equity holding, after comprehensive assessment, Individual Jia chose to list on the New York Stock Exchange and set up a VIE agreement-controlled red-chip structure, under which the offshore listing vehicle exercises control over Company A through contractual arrangements.

The specific structure is as follows: Individual Jia holds equity in the Cayman Islands-incorporated company through his BVI holding platform; the Cayman company controls a Hong Kong company, which in turn controls a domestic WFOE. Prior to the restructuring, the WFOE controlled Company A (wholly owned by Individual Jia) via a package of VIE agreements, with no direct equity relationship between the WFOE and Company A.

Subsequently, Company A adjusted its business portfolio and exited the restricted online micro-lending business. Meanwhile, given that contractual control is less stable than equity control, the enterprise decided to dismantle the VIE structure to mitigate compliance risks and control uncertainty inherent in VIE agreements. Instead of adopting a direct equity transfer model, this restructuring was implemented through a capital increase.

Upon completion of the capital increase, Individual Jia’s shareholding in Company A was diluted from 100% to 1%, and the WFOE became a direct shareholder of Company A. All parties simultaneously terminated all VIE control agreements, converting the structure from contractual control to direct equity holding by the WFOE. The changes in equity and control structure before and after the restructuring are illustrated below:

•  Before dismantling: Individual Jia holds 100% equity in Company A directly; the WFOE exercises contractual control over Company A.
•  After dismantling: The WFOE holds 99% equity directly; Individual Jia holds 1% equity directly.

2.Position of the Tax Authority

Recently, a local tax authority served Individual Jia with a Tax Matters Notice, proposing to rule that the WFOE’s capital increase constituted an undervalued capital contribution. The subscription price was lower than the fair value of Company A’s net assets at the time of the capital increase, resulting in the dilution of Individual Jia’s shareholding ratio — which in substance constituted a low-price equity transfer.

Pursuant to the Measures for the Administration of Individual Income Tax on Income from Equity Transfer (for Trial Implementation) (Announcement of the State Administration of Taxation [2014] No. 67, hereinafter referred to as “SAT Announcement 67”), the tax authority assessed the deemed equity transfer income based on the share of Company A’s net assets corresponding to Individual Jia’s diluted equity stake. It sought to recover nearly RMB 100 million in individual income tax from Individual Jia under the tax category of income from transfer of property, plus late payment surcharges.

3.Position of Individual Jia

Individual Jia argued that he did not sign any equity transfer agreement with the WFOE, nor did he receive any equity transfer consideration from the WFOE. The economic benefits flowed into Company A rather than to him personally. Therefore, it is legally unfounded for the tax authority to directly impose tax on him under the “income from transfer of property” category.

II.Tax Law Analysis of Non-Fair-Value Capital Increase

The core of the tax dispute in this case is whether the tax authority should impose tax on original shareholders when their shareholding ratio is diluted due to a non-fair-value capital increase. To address this question, we first need to distinguish between fair-value and non-fair-value capital increases.

1.Fair-Value vs. Non-Fair-Value Capital Increase

Based on the arm’s length nature of the subscription pricing, capital increase transactions are divided into fair-value and non-fair-value types.

•  A fair-value capital increase refers to a transaction where the capital contribution paid by the new investor is broadly equivalent to the fair value of the investee’s net assets corresponding to the equity ratio obtained post-increase.
•  A non-fair-value capital increase refers to a transaction where the investor’s capital contribution does not match the aforementioned net asset share, with pricing significantly deviating from the market fair level. In essence, this constitutes a transfer of economic benefits between shareholders.

Non-fair-value capital increase mainly falls into two scenarios:

•  Premium capital increase: The investor’s contribution exceeds the fair value of net assets corresponding to its equity stake. The excess amount is recorded under capital reserve — capital premium, increasing the investee’s total net assets.
•  Discounted capital increase: The investor’s contribution is lower than the fair value of net assets corresponding to its equity stake, resulting in a benefit transfer from the original shareholders to the new incoming shareholder.

2.Tax Disputes over Non-Fair-Value Capital Increase

In practice, there is little controversy over premium capital increases. Multiple local tax authorities have explicitly stated that “a capital increase at a price greater than or equal to the fair value of the company’s net assets per share does not constitute an equity transfer and is not subject to individual income tax”.

The underlying tax principle is the realization principle of income: although the original shareholders’ ownership percentage is diluted by the new investor’s entry, the fair value of net assets corresponding to their equity also rises accordingly. The appreciation only exists as unrealized book gains, with no actual consideration received or disposable economic benefit inflow, and thus does not constitute taxable income.

However, for discounted capital increases, two sharply divergent positions exist in practice:

View 1: No Tax Liability

Tax authorities holding this view argue that capital increase and share expansion are corporate behaviors aimed at expanding capital and equity. The enumerated scenarios of individual equity transfer under SAT Announcement 67 do not include corporate capital increase.

The prerequisite for levying individual income tax on equity transfer income is the occurrence of an equity transfer — defined as an individual transferring equity to another individual or legal person. During a capital increase, the original shareholders do not dispose of any equity, receive no consideration, and derive no personal income.

This view adheres to the principle of tax statutory and respects civil legal form: without a transfer agreement and consideration received, no equity transfer is deemed to have occurred. Individual Jia’s argument in this case aligns with this position.

View 2: Tax Liability Arises

Tax authorities holding this view argue that if a capital increase is conducted below fair value and causes equity dilution, the new shareholder obtains more equity shares than it is entitled to, while the non-participating original shareholders hold fewer shares than they should. This reduction in economic interest essentially constitutes a low-price equity transfer and shall be subject to individual income tax under “income from transfer of property”.

The underlying logic follows the substance-over-form principle: piercing through the legal form of capital increase, the reduction in the original shareholders’ ownership ratio and the corresponding transfer of net asset value are regarded as an implicit equity transfer.

This approach is not without legal basis. Article 8 of the Individual Income Tax Law of the People’s Republic of China establishes the general anti-avoidance rule: where an individual implements other arrangements without reasonable commercial purpose to obtain undue tax benefits, the tax authority shall have the right to make tax adjustments using reasonable methods.

In practice, some tax authorities invoke this provision to adjust the tax liability of original shareholders. Meanwhile, pursuant to Item 5, Article 12 of SAT Announcement 67 regarding “unreasonable gratuitous transfer of equity or shares”, they determine that the original shareholder’s transfer income is obviously low, and assess the income in accordance with Article 14 — which provides that the competent tax authority shall sequentially apply the net asset appraisal method to determine deemed transfer income.

The tax authority in this case adopts this position. In its view, although Individual Jia received no cash consideration, the WFOE’s discounted capital increase severely diluted his shareholding, causing a substantial portion of net asset value originally belonging to Individual Jia to be gratuitously transferred to the WFOE. Such benefit transfer between related parties forms a valid basis for anti-avoidance adjustment.

III.How to Resolve the Dispute in This Case

The application of the anti-avoidance clause under Article 8 of the Individual Income Tax Law requires the simultaneous satisfaction of two elements:

1. The individual has implemented an arrangement without reasonable commercial purpose;
2. Undue tax benefits have been obtained.

The burden of proof for both elements rests with the tax authority. Only when these conditions are met can the tax authority assess Individual Jia’s “equity transfer income” under SAT Announcement 67. In other words, if the anti-avoidance elements are not established, the deemed assessment loses its legal premise.

In this case:

First, Company A has exited the restricted online micro-lending business, and the foreign investment access barrier has been substantially eliminated. Meanwhile, dismantling the VIE structure and converting to direct equity control — to enhance control stability and eliminate inherent VIE compliance risks — bears genuine commercial reasonableness. If the tax authority claims the arrangement “lacks reasonable commercial purpose”, it bears the burden of producing counter-evidence.

Second, from a holistic transaction perspective, Individual Jia has not cashed out from the WFOE. His economic interests remain indirectly embedded in Company A’s net assets through the chain: Individual Jia → BVI entity → Cayman company → Hong Kong company → WFOE. The shift from direct to indirect equity holding does not result in tax erosion, and thus does not satisfy the “obtaining undue tax benefits” element.

Third, under the principle of tax payment necessity, Individual Jia has received no cash consideration and lacks liquidity to settle a large tax liability. Requiring him to pay a substantial amount of back tax is also inconsistent with the ability-to-pay taxation principle.

Finally, even if the tax authority insists on proceeding with an anti-avoidance adjustment, imposing late payment surcharges is legally improper. Pursuant to Paragraph 2, Article 8 of the Individual Income Tax Law:

Where the tax authority makes a tax adjustment in accordance with the preceding paragraph and requires additional tax payment, it shall collect the additional tax and impose interest in accordance with the law.

Accordingly, for tax collection arising from anti-avoidance adjustments, interest shall be imposed, not late payment surcharges. Late payment surcharges apply to taxpayers who fail to pay tax within the statutory time limit—a scenario fundamentally different from the tax authority’s re-characterization of a transaction’s legal nature. The tax authority’s imposition of late payment surcharges on Individual Jia therefore constitutes an error of law application.

IV.Conclusion

As a representative tax dispute triggered by red-chip structure restructuring, this case vividly illustrates the latent tax risks faced by enterprises in overseas listing, cross-border investment and structural adjustment. For entities planning to establish or dismantle red-chip structures, tax implications across the initial equity design, future exit paths and restructuring plan selection must be fully evaluated at the scheme design stage to prevent risks proactively.

Faced with the complexity and uncertainty of tax law application—such as the longstanding debate over “whether non-fair-value capital increase should be deemed as equity transfer”—relevant parties are advised to proactively communicate and confirm positions with the competent tax authority,and engage professional tax counsel where necessary,to resolve tax risks at the front end.