China’s Indirect Transfer Tax Rules and Implications for Cross-Border M&A Amid Evolving Enforcement

Circular 7 remains a cornerstone of China’s approach to taxing indirect transfers and continues to influence the structuring of cross-border M&A transactions. While Circular 7’s formal provisions have not changed, the way it is enforced has evolved markedly.

In 2015, China’s State Taxation Administration (STA) issued Circular 7 (STA Announcement [2015] No. 7), a regulation that empowers Chinese tax authorities to levy a 10% withholding tax on capital gains from offshore share transfers involving Chinese Taxable Property (CTP), including Chinese subsidiaries, permanent establishments, and immovable property.

Compared with its initial introduction, Chinese tax authorities are now far more proactive in asserting taxing rights where offshore transactions generate substantial gains linked to Chinese assets. In practice, demonstrating offshore commercial substance alone rarely suffices. Authorities evaluate whether Chinese assets constitute a “majority” of total deal value and may deploy transfer pricing audits as leverage to compel compliance with their assessment.

The key practical question for taxpayers is no longer whether Circular 7 theoretically applies, but instead whether tax authorities will exercise discretion to impose the 10% withholding tax. This decision increasingly turns on two factual dimensions: whether the offshore structure has genuine, defensible substance and whether the contribution of Chinese assets can be credibly shown to be nondominant in the overall transaction value.

FRAMEWORK UNDER CIRCULAR 7

Circular 7 authorizes the STA to tax offshore share transfers that effectively shift the ownership of CTP. Whether the 10% withholding tax is imposed depends on whether the transaction lacks a reasonable commercial purpose.

The STA evaluates this using an eight-factor test that examines commercial rationale, organizational substance, and proportional value attribution. One factor refers to whether the offshore entity’s value is derived “mainly” or “in a majority” from Chinese assets—yet the regulation deliberately leaves “majority” undefined, granting tax authorities broad interpretive flexibility.

In practice, this discretion allows the STA to consider relative value, business function, and profit allocation across the corporate group rather than apply a fixed numerical benchmark. Where authorities conclude that Chinese assets form the core of transaction value or that offshore substance is nominal, they tend to impose the 10% withholding tax.

Conversely, where the offshore structure demonstrates operational substance and Chinese assets clearly represent a minority of total value, authorities have historically accepted nontaxable positions.

Circular 7 also sets out procedural expectations for reporting indirect transfers. While the formal statute of limitations was removed in 2017, unreported transactions remain subject to audit under China’s general anti-avoidance rules, leaving multiyear exposure unless adequately documented.

HISTORICAL PRACTICE AND WHAT’S CHANGING

For several years after Circular 7 was introduced, enforcement remained pragmatic. Local tax bureaus generally refrained from taxing offshore transactions where the seller maintained genuine management substance abroad and Chinese assets accounted for a limited portion of group value. These informal benchmarks offered predictability for cross-border investors.

Today, that tolerance has narrowed. Provincial tax bureaus now routinely require detailed valuation analyses, organizational charts, and intercompany agreements to verify that offshore operations are substantive and that Chinese assets are properly valued. Where contemporaneous evidence is weak—or where profits realized from the transaction are substantial—authorities increasingly assert taxing rights, even if the seller’s offshore substance appears adequate.

Transfer pricing audits have emerged as a powerful enforcement tool in this process. Rather than contesting the share transfer itself, tax authorities often reopen historical transfer-pricing records to test whether the Chinese subsidiary’s margins were understated. If they determine that prior pricing allocated too little profit to China, they can effectively recharacterize part of the group’s value as China-sourced, supporting a finding that Chinese assets represent a “majority” of transaction value.

This tactic provides significant leverage: taxpayers sometimes concede partial withholding to avoid extensive retroactive adjustments.

This convergence of transfer-pricing and indirect-transfer enforcement marks a clear shift toward an economic-substance standard. The STA’s increased coordination among local bureaus has also reduced regional inconsistency, signaling that taxpayers should expect a more uniform national approach in evaluating Circular 7 cases.

PRACTICAL IMPLICATIONS FOR CROSS-BORDER TRANSACTIONS

The current enforcement climate requires a more integrated compliance approach. Tax authorities now view Circular 7 and transfer-pricing enforcement as complementary, using both to evaluate whether capital gains from offshore share transfers should be taxed in China. Companies engaging in cross-border M&A involving Chinese subsidiaries or assets should prepare for heightened scrutiny and assume that any substantial gain linked to Chinese operations may trigger a tax inquiry.

To mitigate risk, parties should consider taking the following actions:

• Prepare contemporaneous valuations that credibly separate Chinese and non-Chinese asset value.
• Align transfer-pricing documentation with M&A valuation assumptions to avoid inconsistencies that invite audit challenges.
• Maintain clear records showing decision-making, personnel, and operations outside of China that demonstrate genuine offshore substance.
• Build contractual protections—representations, covenants, indemnities, and holdbacks—addressing potential Circular 7 exposure and postclosing adjustments.
• Where appropriate, conduct early dialogue with competent tax authorities to clarify evidentiary expectations and manage review timelines.

Ultimately, defending a nontaxable position under Circular 7 depends less on formal structure and more on credible economic evidence that Chinese assets do not constitute the dominant component of overall deal value. Consistent documentation across valuation, transfer pricing, and transaction files is the strongest protection against tax reassessment.