PRC Issues Partnership Tax Circular - Paves the Way for Pass-through Tax Treatment of Onshore Partnerships and Certain RMB Funds

January 1, 0001

The Ministry of Finance ("MOF") and the State Administration of Taxation ("SAT") jointly issued a crucial tax circular addressing the unified tax treatment of partnership enterprises on December 23, 2008. Following discussion by authorities and various commentators for some time with regard to the revised Partnership Enterprise Law (revised as of June 1, 2007), the circular represents an important step towards the further development of partnership tax law in China. The new circular is entitled Notice on Issues Concerning Income Tax for Partners in Partnership Enterprises, Caishui [2008] No. 159 and is effective retroactively to January 1, 2008.

The most significant aspect of this circular is that it confirms partnership enterprises are entitled to pass-through tax treatment, irrespective of whether the partners are natural persons or legal persons (incorporated entities). A partnership enterprise (as defined) will not be subject to tax and, instead, each of the partners will be liable for tax only in their separate and individual capacities. Natural person partners will be liable for individual income tax and legal person partners will be liable for enterprise income tax on the income they recognize from the “production, business operations and other activities” of such partnership enterprise.

These pass-through principles are articulated by adopting the expression “allocate first, then tax,” as is found in a flurry of local tax guidance issued by many localities that are promoting the formation of RMB funds in their jurisdictions. This circular also clarifies that partners will recognize income from partnership enterprises on an annual basis irrespective of whether they receive an actual distribution.

Taxable income will be calculated in accordance with existing tax circulars governing certain sole proprietorships, industrial and commercial households, and partnership enterprises in existence before the Partnership Enterprise Law was revised in 2007. Citation to those circulars is curious since they only addressed individual income tax matters and are not compatible for legal person partners.

In addition, the following rules of priority will be applied to determine the appropriate allocation of income to partners:

(i)  allocated according to the written partnership agreement;

(ii)  allocated according to a subsequent agreement among the partners in the event the partnership agreement is silent or unclear;

(iii)  allocated based on partners’ capital contributions; and

(iv)  allocated based on the number of partners pro rata.

Interestingly, provisions of a partnership agreement that operate to shift income entirely to or away from any specific partner(s) (this was purposely added out of concerns for abuse) are prohibited according to the circular and, furthermore, losses generated by the partnership enterprise will not be recognized by partners to offset their income from other sources.

While the circular leaves many issues of partnership tax mechanics unaddressed, it represents a very significant step forward.

A bi-lingual OMM version of the circular can be accessed here.

Should you have any questions about this alert, please contact its authors:

Lawrence Sussman

Min Huang

O'Melveny & Myers LLP
Beijing Office
Yin Tai Centre, Office Tower, 37th Floor
No. 2 Jianguomenwai Ave.
Chao Yang District
Beijing 100022
People's Republic of China