Procedure for Income Tax on Reorganized Debts of Enterprises

State Administration of Taxation No. 6

The Procedure for Income Tax on Reorganized Debts of Enterprises hereby promulgated shall enter into effect as of March 1, 2003.

                                                                        Jin Renqing

                                        Commissioner of the State Administration of Taxation

                                                                  January 23, 2003

Procedure for Income Tax on Reorganized Debts of Enterprises

Article 1 In order to improve the administration of income tax on reorganized debts of enterprises to prevent the loss of tax revenue, this Procedure for Income Tax on Reorganized Debts of Enterprises and the rules for the implementation thereof are formulated.

Article 2 By reorganization of debts mentioned in this Procedure, it refers to all operations involving the alterations of liability conditions between the creditor (enterprise) and the debtor (enterprise).

Article 3 Reorganization of debts include the forms and manners cited below:

(1) Repayment of a debt in cash that is lower than the taxable costs of a debt;

(2) Repayment of a debt with a non-cash asset;

(3) A debt to be turned into capital, including the transformation of a debt of a state-owned enterprise into shares;

(4) Alteration of other conditions of a debt, such as extention of the term of repayment of a debt, extention of the term of repayment of a debt plus additional interest, extension of the term of repayment of a debt with a decrease of the principal or the interest thereof, etc.

(5) A mixed reorganization of debts in two or more of the forms cited above.

Article 4 When a debt is to be repaid by a debtor (enterprise) with a non-cash asset, unless otherwise provided for the reorganization or liquidation of an enterprise, income tax shall be levied on the two business operations through dividing the repayment into two processes, the process of assigning a non-cash asset at sound value and the process of making repayment of the debt at the value to the equivalent of the sound value of the non-cash asset, and the debtor (enerprise) should recognize the gain (or loss) arising from the assignment of the said property and the creditor (enterprise) in obtaining the non-cash asset should determine the taxable costs of the transferred asset (including the tax payments involved in the transfer) at sound value whereby the creditor should determine the costs of depreciation of the fixed asset, the allowance for the amortization of intangible asset or the cost of the marketing of commodities as a basis for the pre-tax deduction for income tax of the enterprise.

Article 5 In reorganizing a debt in the manner of transferring it into capital, unless otherwise provided for the reorganization or liquidation of an enterprise, the debtor (enterprise) should confirm its gain from the reorganization of the debt based on the difference between the book value of the reorganized debt and the sound value of the equity of the creditor resulting from giving up its claim of debt and include it as income taxable, and the creditor (enterprise) should count in the sound value of the equities as the taxable costs of its investment thereof.

Article 6 In the event the creditor makes compromise in the reorganization of a debt such as agreeing to repayment of the debt by cash or cash asset that is lower than the taxable cost of the debt, the debtor should confirm the gain from the difference between the taxable cost of the reorganized debt and the cash or the sound value of the non-cash asset (including the taxes related to the transfer of non-cash asset) and count it into the current taxable income of the enterprise; the creditor should recognize the difference between the taxable cost of the reorganized debt and the cash or the sound value of the non-cash asset received as the current loss arising from the reorganization of the debt to offset part of the income tax it should pay.

Article 7 In the case of reorganizing a debt by changing the other liability conditions, the debtor should enter the taxable cost of the reorganized debt as reduced value into the future account payable and the reduced value thereof shall be recognized as gains from the current reorganization of the debt; the creditor should enter the taxable cost of the debt as reduced value into the future account receivable and the reduced value thereof shall be recognized as loss resulting from the reorganization of the debt.

Article 8 If the gain of an enterprise from the reorganization of a debt by repayment with non-cash asset or from compromise by the creditor in the transfer of asset is very large and the enterprise finds it difficult to pay income tax all at once, the income tax may be spread out evently into no more than five taxation years with the approval of the tax authorities.

Article 9 In case the agreement on reorganization of a debt involves a compromise clause on the assignment of profit from one party to the other between the parties concerned, there is a proper reason needed for business operation and the clause complies with one of the following conditions, payment of income tax may be handled in accordance with the provisons of Article 4 ~ Article 8 of this Procedure with the approval of the tax authorities.

(1) With approval by a court ruling;

(2) With the concensus of all of the creditors in an agreement;

(3) It being a reorganization of debt into shares on the part of a state-owned enterprise with the offical approval.

Article 10 In case the agreement on reorganization of a debt involves a compromise clause on the reorganization of a debt from one party to the other between the parties concerned which is at variance with the provisions of Article 9 of this Procedure, the creditor in principle shall not recognize the loss from the reorganization of the debt but may treat it as a donation and the debtor should recognize the income of the donation; should the debtor be a shareholder of the creditor, the compromise made by the creditor shall be deemed as a distribution by the enterprise to the shareholder and the case shall be handled in accordance with the provisions of Clause 2, Article 1 of the "Circular of the State Administration of Taxation on Issues in Connection with Equity Investment in an Enterprise" (GSF [2000] No.118).

Article 11 The term "sound value" used in this Procedure refers to fair price in dealings between independent enterprises.

Article 12 This Procedure shall enter into effect as of March 1, 2003.