On September 1st of 2023, the much-anticipated "Company Law of the People's Republic of China (Third Review Draft)" (also known as the “Review Draft of Company Law”) was reviewed by the Fifth Session of the Standing Committee of the 14th National People’s Congress and was made available for public comment. The Review Draft of the Company Law, which has been published so far, substantially amends about 70 articles on the basis of 218 articles in 13 chapters of the existing Company Law, of which the articles concerning shareholders’ capital contribution are particularly noteworthy. In this article, we will introduce the main amendments to the provisions on shareholders’ capital contribution in the Review Draft of the Company Law, and in conjunction with the relevant provisions on income tax, we will introduce the obligations of shareholders’ capital contribution and the tax treatment in the process of shareholders’ capital reduction in terms of both law and tax practice.

• Statutory Time Limit of the Capital Contribution Period

The statutory time limit regarding the contribution period by the shareholders of a limited liability company is the latest amendment in the Review Draft of the Company Law, which did not appear in the previous revised draft. According to Article 47 of the Review Draft of the Company Law, the capital contributions made by the shareholders of a limited liability company shall be paid in full by the shareholders within a period of five years from the date of establishment of the company in accordance with the provisions of the articles of association of the company.

The reason for the addition of this article is that, after the implementation of the current Company Law in 2013, there are cases whereby the limited liability system of companies are hollowed out and debts are evaded by means of agreeing on an excessively long period of capital contribution or maliciously prolonging the period of capital contribution, which makes it difficult for the interests of company creditors to be effectively safeguarded. The registered capital contribution system is to better protect the interests of company shareholders, so that shareholders can safely invest in production and operation, but it should not become an “umbrella” with which the shareholders may intentionally avoid their responsibility.

• Accelerated Expiration of the Capital Contribution Period

The current Company Law only supports the accelerated expiration of the capital contribution period in certain circumstances, specifically:

1. When the company enters into bankruptcy proceedings;

2. When the company is dissolved;

3. When legal enforcement is not possible and has the conditions of bankruptcy but does not apply for bankruptcy, maliciously avoiding debts to extend the period of capital contribution.

But according to the provisions of Article 53 of the Review Draft of Company Law, as long as the “company cannot pay the debts due” creditors can apply for accelerated expiration of the capital contribution period, which changes the original legal framework “in principle not accelerated expiration, exceptions to accelerate the expiration” of the normative position. From this perspective, we may see the judicial tendency to increase the protection of creditors.

• Loss of the Shareholding when Failure to Fulfil the Capital Contribution Obligation

Loss of the Shareholding when Failure to Fulfil the Capital Contribution Obligation is a newly added rule in the Review Draft of the Company Law. If a shareholder fails to pay their capital contribution in full on time, the company may issue a written notice to this shareholder giving a grace period for payment. If a shareholder fails to fulfil the capital contribution obligations before the given grace period expires, the company may issue a notice of loss of the shareholding to the shareholder which declares the shareholder has lost the corresponding shareholding of the unpaid capital contribution. The lost shareholding shall be transferred or canceled in a timely manner. This rule strengthens the rigid binding force of shareholders’ obligation of contribution to the subscription of capital.

• Tax Treatment of Shareholders’ Capital Reduction

In case the newly amended requirements on capital contribution under the Review Draft Of Company Law take effect, shareholders who find themselves lacking capital flow but still wish to continue operating the company, may take the reduction of registered capital as one viable option for the enterprise’s survival. In light of this, it is important to understand how to properly handle capital reduction in tax practice.

Capital reduction in tax practice is typically categorized into two types: proportional capital reduction and non-proportional capital reduction.

Proportional capital reduction refers to the reduction of capital contributions by all shareholders in proportion to their initial investment in the company. In such cases, the State Administration of Taxation’s Announcement No. 34 mandates that the assets equivalent to the initial capital contribution acquired from the investee enterprise shall be recognized as investment recovery. The investee enterprise’s accumulated undistributed profits and surplus reserves shall also be recognized as investment recovery. Further, the accumulated undistributed profits and surplus reserves of the investee enterprise calculated in proportion to the reduction of paid-in capital shall be recognized as dividend income, with the remaining portion recognized as income from the transaction of investment assets.

Non-proportional capital reduction, on the other hand, is a capital reduction directed to some particular shareholders, with the capital contribution of the remaining shareholders unchanged and the equity ratio adjusted accordingly after the capital reduction. In the tax treatment of capital reduction by shareholders under a non-identical ratio, the amount of capital reduction should first offset the paid-in capital of the company. Then, income tax should be calculated and paid according to the cost, dividend, and property transaction amount, consistent with the treatment of proportional capital reduction.

The corporate income tax on dividends, bonuses and other equity investment income from capital reduction by legal person shareholders is tax-exempted, while the individual income tax on capital reduction by natural person shareholders is subject to income tax at the rate of 20% of the income from the transfer of property.

• Conclusion

Since the implementation of the registered capital contribution, the abolition of the mandatory contribution period, minimum registered capital and initial contribution ratio under the 2013 Company Law, starting a company has been facilitated, entrepreneurial vitality has been stimulated, and the quantity of companies has increased rapidly in China. However, in practice, there are cases where the shareholders’ contribution period is too long, which affected the security of transactions and jeopardized the interests of creditors. The Review Draft of the Company Law has responded to these issues. Whether or not these provisions eventually come into effect in the future, it is highly likely that this legislative attitude will affect subsequent judicial practice, and we recommend that investors who set up company in China pay attention to it.

About Us

D'Andrea & Partners Legal Counsel and PHC Advisory Tax & Accounting (companies of DP Group) offer full-scale legal compliance, tax advisory support and consultancy to address any concerns related to this issue. If you have any inquiries, you are welcome to contact us: info@dpgroup.biz.

Disclaimer

The above content is provided for informational purposes only. The provision of this article does not create an attorney-client relationship between DP Group and the reader and does not constitute legal advice. Legal advice must be tailored to the specific circumstances of each case, and the contents of this article are not a substitute for legal counsel.