Discount capital increases dilute shareholding percentages of original shareholders and are not prohibited by Company Law. Is it possible to reduce tax by increasing registered capital at a discount to dilute shareholding percentages and then transferring shares? Is this practice accompanied by tax risks? I will deal with these issues.

I. Tax on share transfer will decrease considerably after a discount capital increase.

Assume that Company A has registered capital of RMB 10,000,000 and two shareholders, both of whom are natural people. Shareholder A contributed RMB 7,000,000 and holds 70% shares and Shareholder B contributed RMB 3,000,000 and holds 30% shares in Company A. When the company’s net assets have increased to RMB 10,000,000, Shareholder A wants to transfer all shares to Shareholder B. If the share transfer is based on their original shareholding percentages, Shareholder B would pay personal income tax of at least RMB (30,000,000- 3,000,000)×20%=5,400,000 according to SAT Announcement 67. 

If Shareholder A increases the registered capital by RMB 90,000,000 based on its original interests in the registered capital to dilute Shareholder B’s shareholding percentage to 3% and therefore takes up the company’s net assets of 5,700,000. Then when transfer the shares, Shareholder would pay personal income tax of (5,700,000-3,000,000 ） ×20%=RMB 540,000. In SAT Announcement 67 the first priority is to calculate income from equity investment on the basis of the value of net assets at the time of share transfer. Tax authorities are difficult to re-evaluate the share transfer price that is apparently low after a discount capital increase. In this case, Shareholder B’s personal income tax on the 30% share transfer decreases considerably.

II. Currently, there is no legal basis for tax on discount capital increases, but tax authorities might adjust taxes.

In the Chinese income tax system the time of obtaining taxable income is decided according to when the income is earned. Despite the change of shareholding percentages of original shareholders caused by the capital increase, none of the original shareholders has transferred shares or received considerations and the increased capital is paid to and property of the legal entity. In existing law an increase in owners’ interests does not necessarily create an obligation to pay tax. Therefore, there is no legal basis for tax on net asset premiums owned by shareholders because of a discount capital increase. Currently, tax authorities of Fujian Province, Dongguan City and Dalian City agree with this.

Nevertheless, local tax authorities may have different opinions. Some hold discount capital increases for share transfer are arrangements for no reasonable commercial purpose and therefore adjust net assets belonging to original shareholders. In cases like the above one tax authorities may calculate based on Article 8.1 (III) of Personal Income Tax Law Shareholder B’s earnings from the share transfer as if the company’s net assets were RMB 30,000,000 at the time of the share transfer followed by the capital increase.

Some tax authorities even see shareholding percentage changes caused by discount capital increase as “share transfer”. The Ningbo Administration of Taxation put forward a decision making rule in the Answers to Frequently Asked Questions about Enterprise Income Tax by the Local Administration of Taxation in Ningbo that (1) capital increases at a price equal to or higher  than the fair value of net assets per share are not share transfer that needs to pay personal income tax on; and (2) in capital increases at a par price or below the fair value of net assets per share, the transfer of the fair value of net assets owned by original shareholders should be seen as share transfer that needs to pay personal tax on in tax law.

In sum, discount capital increases could considerably reduce tax on share transfer, but local tax authorities have different opinions on whether such increases are taxable.People should ensure their discount capital increase will not damage the company or other shareholders and get well acquainted with local tax policies before the capital increase. To achieve common prosperity, tax authorities will take tougher action against tax avoidance by rule abuse, for example discount capital increases.