Potential pitfall associated with reorganizations involving Chinese subsidiaries.

AuthorJi, Frank

Since first opening the door to the outside world a little over 30 years ago, the government of the People's Republic of China has exhibited a general policy that encourages foreign investments. However, doing business in China remains challenging for many U.S. taxpayers, as China's business regulations and culture vastly differ from those of the United States. When a U.S. company wants to reorganize a worldwide structure that includes Chinese entities, tax issues should be carefully considered to avoid any unforeseen Chinese tax liability. The example below demonstrates how Chinese tax issues could derail a "perfectly" planned reorganization for U.S. income tax purposes.

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Example: The existing structure is as follows: A U.S. holding company (USCo 2), a C corporation, is the direct sole shareholder of two U.S. companies (USCo 2 and USCo 3), which are also C corporations. The three U.S. corporations file a consolidated U.S. corporation income tax return to report their combined federal income tax liability. USCo 2 is also the sole owner of a wholly foreign owned enterprise (WFOE) in China. Because WFOE is treated as a foreign corporation by default, the consolidated U.S. corporate income tax return filed by the U.S. corporations includes a Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations, to report WFOE's activities. Exhibit 1 illustrates the existing structure. For business reasons, management would like to reorganize the structure by having USCo 2 transfer all of its equity interest in WFOE to USCo 3 without any consideration. After this reorganization, USCo 3 will become the sole shareholder of WFOE. Because there is no plan to dispose of any of WFOE's shares, for U.S. income tax purposes, WFOE is still owned by the consolidated group that comprises USCo 1, USCo 2, and USCo 3. The postreorganization structure is shown in Exhibit 2.

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This proposed reorganization is not a taxable transaction for U.S. income tax purposes because all of the parties involved in the transaction are within a consolidated group. For U.S. income tax purposes, the transaction is interpreted as USCo 2 making an in-kind dividend to USCo 1 by initially transferring the equity interest in WFOE to USCo 1, followed by a subsequent transfer of the equity interest in WFOE to USCo 3 as an equity contribution. Because all of the U.S. entities...

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