Tax Treatment of Capital Reductions: Formal Capital Reductions

(This article was originally published by ALM China Law & Practice on 5 August 2024)

The amended PRC Company Law took effect on July 1, 2024. New rules which introduce a time limit for the actual payment for subscribed capital have attracted widespread attention. Considering the effects of these changes, many companies may consider making a formal reduction of their registered capital.

In practice, there are various types of capital reductions and these can be categorized from different perspectives. For instance, from the perspective of whether there is an outflow of net assets of the company, capital reductions can be categorized into Formal Capital Reductions (i.e. there will be no outflow of net assets from the invested company in the process of the capital reduction, which includes reducing the unpaid registered capital or reducing the paid-in capital to offset losses) and Substantive Capital Reductions. From the perspective of the amount of reduction, capital reductions can be categorized into capital reductions at book value, at discounted value and at premium value. From the perspective of whether the capital reduction would cause a change in the shareholding ratio of the company, capital reductions can be categorized into proportional capital reductions and non-proportional capital reductions. The tax implications and accounting treatments vary under different modes of capital reduction. Therefore, it is important to identify the nature of the capital reduction so that the tax implications and accounting treatment can be accurately determined.

1.Changes to the registered capital system

China has followed a subscribed capital model since the implementation of the Company Law, revised in 2013, under which the subscribed capital could be paid according to a schedule determined by the company itself without a statutory time limit for the capital contribution. This model was successful in relaxing market access restrictions and stimulating market activity. However, it has also brought about prominent problems such as exorbitant subscription amounts and overlong payment time limits for the subscribed capital contribution. These characteristics   are not beneficial for reflecting the objective situation of the company's capital and attracting investment.

In view of the above, the revised Company Law which took effect on July 1st 2024 ( the "New Company Law") changes the subscribed capital model and stipulates that shareholders of a Limited Liability Company must pay the subscribed capital in full within a five-year time limit after the company's establishment. 

Specifically, Article 47 of the New Company Law stipulates that "the amount of capital contributions subscribed by all shareholders shall, in accordance with the articles of association, be fully paid up by the shareholders within five years as of the date of establishment". 

Pursuant to Article 266 of the New Company Law, companies established before its effective date must gradually make adjustments of their capital contribution time limit to be in compliance with the new law. The Regulations of the State Council on the Implementation of the Registered Capital Registration Management System of the Company Law which took effect on July 1st 2024 further clarified a three-year transition period from July 1, 2024 to June 30, 2027.

Considering the changes to the registered capital system mentioned above, some existing companies might not comply with the provisions of the New Company Law. They may not be able to facilitate the capital contribution in full within the statutory time limit because of exorbitant subscription amounts or other causes. On that basis, they may consider meeting the regulatory requirements by reducing the unpaid registered capital, the tax implications of which will be explained below.

2.Provisions on making up for losses by way of capital reduction

Before the enactment of the New Company Law, there were no explicit provisions limiting reductions of paid-up capital to offset losses, and it was common practice for companies to do so. The New Company Law now provides legal provisions on offsetting losses by way of capital reduction.

Specifically, according to Articles 214 and 225 of the New Company Law, when offsetting losses, discretionary surplus reserves and statutory surplus reserves must be used first in a priority order; then capital reserves can be used as stipulated if any losses remain. If there are still losses after using up the above reserves, companies can reduce their paid-in capital to offset losses, subject to the following limitations: the company must not distribute profits (i.e. to the extent they are converted from the paid-in capital) to its shareholders or exempt the shareholders from their capital contribution obligations by the amount of the unpaid registered capital. 

The method of making up for losses by reducing the paid-in capital can be effective for avoiding the dilemma whereby companies are unable to distribute profits to their shareholders for a long period of time due to the historical losses; it can also be effective for boosting the confidence of the investors. In light of the above, it is likely that in the future there will be more companies adopting this method to offset the losses when the New Company Law clearly stipulates that the paid-in capital can be used to offset the losses. 

Compared to Substantive Capital Reductions, Formal Capital Reductions do not lead to a net asset outflow from the company. From the perspective of the purpose of a capital reduction, Formal Capital Reductions can be divided into two different scenarios: (A) reducing the unpaid subscribed capital so as to ease an overly- large burden of unpaid subscribed capital contributions, which is the scenario that will attract widespread attention after promulgation of the New Company Law; and (B) reducing the paid-in capital to offset losses as newly clarified by the New Company Law. 

1.Scenario A: Reducing the unpaid subscribed capital to ease an overly-     large capital contribution burden

As mentioned above, under the New Company Law, shareholders may consider reducing the unpaid subscribed capital to avoid an overly- large capital contribution in future.

2.Scenario B: Reducing the paid-in registered capital to offset losses

As discussed above, the New Company Law clarifies reducing the paid-in capital as a method to offset losses, and the corresponding accounting and tax treatments are analyzed as follows.

（1）For the company:

With respect to the company, in practice there are different interpretations regarding the dispute mentioned above. 

Some tax authorities believe that reducing the paid-in capital to offset losses essentially means that the shareholder gives up the amount of investment cost that can be retrieved in the future, which should be regarded as a donation from the shareholder to the invested company. As a result, the reduced capital should be regarded as donation income and be subject to enterprise income tax. The legal basis of this opinion is the Announcement of the State Taxation Administration on Several Issues concerning Taxable Income for Enterprise Income Tax (Announcement [2014] No.29), pursuant to which, since the amount of the reduced paid-in registered capital is recorded as undistributed profit, the tax authorities may consider the reduced paid-in capital to be treated as income for accounting purposes. As such, based on Announcement [2014] No.29, the company would have to recognize the reduced paid-in capital as income and thus subject to enterprise income tax accordingly. 

Different from the aforementioned position, some other tax authorities believe that the amount of reduced capital used to offset losses should not be recognized as taxable income for tax purposes, since it is just an internal adjustment between accounts of Owner's Equity, without any tax implications. 

（2）For the shareholders:

With respect to the shareholders, there is also a lack of clear guidance for the related tax treatments. It is understood that the tax treatments of the shareholders should be coordinated with that of the company. That is, if the amount of the reduced paid-in capital is recognized as taxable income of the company and becomes subject to enterprise income tax, the shareholder should be allowed to deduct the corresponding investment loss. Otherwise, this approach will lead to a double-taxation problem where one party (i.e. the company) must recognize income while the other party (i.e. the shareholder) could not be allowed to deduct its investment loss accordingly. To the contrary, if the company does not recognize the reduced paid-in capital as income for tax purposes, the shareholder does not need to recognize any investment loss or make adjustments on the tax base of the company accordingly. 

Between the two viewpoints above, it seems the balance leans towards the view that reducing the paid-in capital to make up for losses merely results in an internal accounting adjustment between the Owner's Equity accounts. It should not affect the taxable income of the company. Meanwhile, the shareholder's tax base with regard to his investment in the invested company should not be affected either.

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