China's revised Company Law: Accounting and tax implications

published on 16 April 2024 | reading time approx. 3 minutes

On 29 December 2023, China passed a reform of its Company Law, which will take effect on 1 July 2024. The reform brings with it several changes for foreign-invested enterprises in China, which we have previously covered in a separate article. In the following, we will take a closer look at the accounting and tax changes in particular.

Dividend distributions: Clarification of the legal deadline for the distribution of profits

Article 212 of the revised Company Law provides that if the general meeting of shareholders resolves on the distribution of profits, the board of directors shall distribute the profits within six months from the date of the resolution. A deadline was not specified in the previous version of the Company Law.

Pursuant to Article 210 of the revised Law, distributions shall be made in proportion to the actual shareholdings or otherwise if the shareholders have so resolved or if the articles of association so provide. There are no changes between the previous and the revised version in this respect. In the case of distributions where the dividends to be distributed differ from the actual shareholding ratio, tax implications should be considered, as the dividend income of different shareholders may be taxed differently.

Offsetting losses through capital reserves or reductions

Identical to the 2018 version of the Company Law, the 2023 revised version requires a company that distributes its after-tax profit to set aside 10 percent of the profit for the current fiscal year as the company's statutory reserve, until 50 percent of the registered capital has been reached (Article 210). After a company has allocated funds from its profit after tax to the statutory reserve, it may, subject to a resolution of the general meeting of shareholders, allocate an amount to the discretionary reserve.

Under both the original and the revised versions of the Company Law, a company's reserves are used to cover losses, expand production and business activities as well as increase its registered capital. When using reserves to cover losses, discretionary reserves and statutory reserves must be employed first (Article 214).

Example:

Company A made a profit of CNY 1,000,000 this year and wants to pay a dividend to the shareholder.

Company A: Balance sheet	CNY´000
Share capital	1,000
Statutory reserve	500
Discretionary reserve	500
Retained earnings (including current year's profit)	- 250

Company A will not be able to pay a dividend because the profit does not cover the accumulated loss to leave distributable profit. However, Company A could take advantage of Article 214 of the revised Company Law to offset the accumulated loss against the discretionary reserve.

If a deficit remains, the capital reserve (which exceeds the paid-in capital) can be used to cover losses. This is a significant change compared to the 2018 version, according to which the capital reserve could not be used to cover losses after the mandatory and voluntary revenue reserves had been used up. By using the capital reserve, the period between loss compensation and profit distribution can thus be shortened.

In case a company still has losses after covering its losses in accordance with Article 214, it may reduce its share capital to offset the losses (Article 225). In accounting terms, the share capital is offset against the accumulated loss carried forward. However, a company then may not distribute any profits to the shareholders or release the shareholders from their obligation to make contributions or payment of share capital. Profits may be distributed when the total of the statutory and discretionary reserves reaches 50 percent of the company's share capital.

Corporate restructuring: Conversion of receivables into equity permitted

Article 48 formally adds two more ways in which shareholders can contribute capital. Shareholders can now contribute capital not only in the form of cash, in kind, intellectual property rights or land use rights, but also in the form of equity or debt claims.

Although capital increase through debt-to-equity swaps has been practiced in the past, it was limited to shareholder loans and required registration with the State Administration of Foreign Exchange. The new regulation could simplify implementation, although the specific types of receivables that can be converted into equity still need to be defined by the legislator.

The new rules may prove beneficial in the event of restructuring. In an ordinary liquidation of a company, all claims and liabilities have to be be settled, which is often done by means of a debt waiver within a group of companies. The conversion of debt into equity now provides an alternative. However, the tax treatment of a debt-to-equity swap should be analyzed in a similar manner to a debt waiver.

Recommendations

The extensively revised Company Law will enter into force on 1 July 2024. We recommend that foreign investors with restructuring plans closely monitor the practical implementation of the provision on the conversion of receivables into equity and carefully analyze the tax implications of such conversions.

Regarding dividend distributions and loss compensation, we recommend that companies consider the new deadline and the possibility of covering losses through capital reserves or capital reductions in their financial strategy.