Theoretical Analysis on the Dispute over the Taxation on the PE Premium

By the news, the original shareholder of the company invested by the private entity (PE) is demanded to pay the enterprise income tax for the premium produced from the investment, and that has arisen wide arguments among the public. And such arguments mainly come from the legislative blank and the different understanding of the taxation administration and the company from their own stance on the issue. To us, despite no direct laws issued on it, a definite conclusion could be made from the existing Corporate Law, enterprise income tax law and basic legal theory that no company income tax shall be levied on the premium.

I. The problem

To suppose the registered capital of company A is 50 million yuan with shareholder A owning 10% of the total option. A PE decides to invest 300 million yuan to the company basing on the value assessment of the company which will make the PE own 50% of the total shares after the investment. Also, with the investment, the registered capital of the company will be increased to 100 million yuan, and the rest 250 million yuan will be the capital surplus fund. The capital increase by PE will also make the share option owned by shareholder A down to 5% which enjoys the entity of 350 million × 5%. For this, some local taxation administrations holds that the original shareholder gains more value when it contributes no additional capital after the premium which could increase the overall value of the company. While, on the other hand, to the company, share options in the hands are just the entity in the company, which could not be realized unless be disposed. (See “The taxation in PE investment”. Issue 9th of 2012, Century Weekly).

II. The analysis

(1) By the Corporate Law

As provided in Article 168 of the Corporate Law, “The premium income derived from the shares issued above par value by a company limited by shares, and other income which, according to the rules set by the financial department under the State Council, should be enlisted into the capital surplus fund shall be put into the capital surplus fund of the company.”To suppose the company A in the above case is a company limited by shares. Then it could be applied the article when premium income gained by it, and shall be listed into the capital surplus fund of the company. Despite the article only regulates the incorporated company, there should be no reason to exclude the company with limited liability. The premium after the increase capital invested by PE of a company with limited liability shall also be listed in the capital surplus fund.

It is also regulated by Paragraph 1 of Article 169 of the Corporate Law, “The surplus fund of a company shall be used to make up for the company’s losses or to expand production and operation of the company, or shall be converted into an increase in the company’s capital. However, the capital surplus fund shall not be used for making up the losses of the company.”Then, why the capital surplus fund shall be legally prohibited to make up the losses of the company? After all, the fund shall be functioning as the “capital” as implied by its name, namely to be used in production and company operation expansion. Therefore, once the fund is applied to make up the losses, it actually plays the role of profits while the profits are divided among the shareholders, which makes the capital surplus fund after the capital increase go back to the shareholder’s pocket in making up the losses, and also jeopardizes the credit of the company with the inadequate contribution.

The distribution of profits shall be levied the income tax to the individual as well as the company, while the company income tax, though demanded by Article 6 of Enterprise Income Tax Law, is normally exempted with the profits distribution among the shareholders. And also for the reasons above, the capital surplus fund shall not be seen as the profits when it’s not applied in losses making up, therefore no tax shall be levied hereby. The taxation on premium derived from the PE investment is, in essence, taxation on the capital surplus fund un-transferred to the registered capital, which will be quite unreasonable.

(2) By the Enterprise Income Tax Law

First, from the aspect of transfer, as provided in Article 6 of Enterprise Income Tax Law, “Income obtained by Enterprises from various sources in monetary and non-monetary terms shall be the total income, including…(3)income from transfer of property;…”and Article 16 “Where Enterprises transfer assets, the net value thereof may be deducted from the taxable income.”Then, here comes the question whether the premium after the investment by PE belongs to the income from the property transfer? Judging in form, the shares held by the shareholder A down from original 10% to the current 5%, and such decrease mainly comes from the dilution of the capital increase rather than the share transfer. In other words, the share gained by PE is from the capital increase instead of the share transfer, and for this reason the premium of PE is not the consequence of property transfer which shall not be regulated by the article of Enterprise Income Tax Law.

Second, it’s also foreseeable that the taxation of the enterprise income on premium from the PE investment to shareholder A could result in the double taxation when it will sell the share in the future.

Third, from the objective view, before the profits realization by shareholder A’s share transfer or the company liquidation, the investment of PE will be no way to make shareholder A gain profits from it, and thus it’s wrong to levy the income tax at the moment.

III. The conclusion

For the premium from the investment by the PE fund shall not be levied the enterprise income tax.

The essay is quoted from DeBund Newsletter, issue 4, 2012.

Attorney-at-law of DeBund Law Offices

Bridge IP Law Commentary is a website focus on the introduction of commercial laws in China, especially the intellectual property laws. All the posts here are our original works. And all news or cases referred here are from public reports, and our comments or analysis are of due diligence, neutrality and impartiality, representing our own opinions only and are our original works. You may contact us shall you have any opinions or suggestions.

Email: Bridge@chinaiplawyer.com, Tel: 8621-5213-4900,
You can also find us on Facebook, Twitter and Linkedin.

Short Link: