Authored by Clara Yang

The case Wang v. Shanghai Municipal Tax Service and Others, heard at first instance by the Shanghai Railway Transport Court and ultimately decided on appeal by the Shanghai No. 3 Intermediate People’s Court (Final Administrative Judgment No. 133 [2024], Case No. (2024) Hu 03 Xing Zhong 133), was selected as one of the “Top Ten Influential Tax Judicial Cases of 2024” in the 2025 evaluation organized by several institutions. Following its release, the judgment immediately attracted significant attention and active discussion among scholars and practitioners in the field.

At the heart of the dispute is a question frequently encountered in contemporary investment and financing transactions in China: how individual income tax should be imposed and administered on equity transfers involving performance-based compensation mechanisms, and, in particular, whether tax should be refunded after such mechanisms are subsequently triggered.

The core controversy is whether the equity transfer at the investment stage and the subsequent compensation obligations triggered under the performance-based compensation mechanism constitute a single taxable fact or two separate taxable facts under Chinese tax law—specifically, whether these two stages should be treated independently for purposes of determining tax liability.

Both the first-instance and second-instance courts held that the equity transfer at the investment stage constituted a complete taxable fact under Chinese tax law and independently gave rise to tax liability. The appellate court also called for policy adjustments based on the economic substance of investment and financing transactions and considerations of fairness under the rule of law, so as to provide more reasonable and precise tax rules for emerging business models. This reflects the application of the substance-over-form principle of taxation.

This article analyzes the dispute and judicial reasoning through the lens of the principle of statutory taxation—in particular, the requirement that taxable elements be clearly and expressly defined—and the principle of substantive taxation.

I. Factual Background

Between December 2015 and June 2016, Mr. Wang (the transferor), the acquiring company (the transferee), and a third-party shareholder executed a series of agreements. The parties agreed that Wang and the third party would each transfer 50% equity of the target company, with a combined transaction consideration of RMB 1.15 billion to be paid in cash and shares issued by the transferee.

Under the accompanying performance commitment and compensation agreement between Wang and the transferee, if the target company failed to meet agreed profit targets, the transferee would repurchase the compensatory shares from Wang at a nominal aggregate price of RMB 1 and cancel them in accordance with applicable laws.

On 8 September 2016, Wang received RMB 250 million in cash. The acquiring company also issued 16,598,569 shares to him, which were registered on 26 September 2016. 

In March 2017, Wang paid RMB 50 million in individual income tax on the cash consideration. Following a tax audit conducted by the Qingpu Tax Bureau, Wang remitted an additional RMB 64 million in individual income tax on 15 November 2017 for the share consideration.

Because the target company failed to meet its profit targets in 2018 and 2019, Wang returned 20,730,949 shares for 2018 and 6,717,799 shares for 2019 as compensation.

In October 2022, Wang applied to the Qingpu District Tax Bureau for a tax refund, claiming that he had overreported and overpaid individual income tax on the equity transfer. He argued that the equity transfer agreement had not been fully performed until the occurrence of the compensation obligations, that income had not yet been realized, and that the tax paid constituted a prepayment. He contended that the returned shares should be deducted from the previously reported equity transfer income and the corresponding tax should be refunded.

Both the trial and appellate courts rejected his claims.

II. Analysis of Taxable Elements for Individual Income Tax on Equity Transfers

The courts held that the taxable fact related to Wang’s equity transfer was complete upon the receipt of cash and registration of the shares. The subsequent return of shares constituted a new administrative legal relationship and did not alter the taxable fact of the original equity transfer. Wang, however, argued that the entire arrangement should constitute a single taxable fact.

The term “taxable fact” referred to in this view is a type of “legal fact” under Chinese tax law. Unlike legal facts that give rise to civil-law relationships, a taxable fact is generally defined in Chinese tax-law theory as the legal fact that triggers a specific tax obligation. In other words, once a legal fact occurs that satisfies the statutory taxable elements set out in tax law, the taxpayer becomes obligated to pay tax. Whether a tax obligation arises depends on whether a legally relevant taxable fact has occurred. A taxable fact is composed of “statutory taxable elements” (also referred to as the constituent elements of a tax). With reference to the statutory taxable elements applicable to individual income tax on property transfer gains, the following analysis of this case applies:

1. Forms of income under individual income tax on property transfer gains includes cash, physical assets and securities. Income realized through the receipt of shares likewise constitutes taxable income.

Both the 2011 amendment and the 2018 version of the Implementation Regulations for the Individual Income Tax Law of the People’s Republic of China expressly define the forms of individual income to include cash, physical assets, securities, and other forms of economic gain. Article 7 of the Administrative Measures for Individual Income Tax on Equity Transfer Income (Trial) (State Administration of Taxation Announcement No. 67 [2014]) contains similar provisions.

In this case, the consideration agreed upon between Wang and the transferee consisted of two components: cash and shares issued by the transferee. Together, these two components constituted Wang’s property transfer income and were both subject to individual income tax. Accordingly, Wang was required to pay tax on the income realized in the form of shares.

2.Timing of Tax Liability for Property Transfer Income

(a) Court’s Reasoning

The appellate court held:

• Under Article 2 of Circular [2015] No. 41, when an individual contributes non-monetary assets as investment, the realization of income from the transfer of such non-monetary assets occurs at the time the assets are transferred and the individual obtains equity in the investee enterprise.

• Under article 20 of SAT Announcement No. 67 (2014), the withholding agent and the taxpayer must declare and pay tax to the competent tax authority within fifteen days of the following month if any of the following circumstances arise:

(1)the transferee has paid or partially paid the equity transfer consideration;(2)the equity transfer agreement has been executed and has entered into effect;

(3)the transferee has already performed shareholder duties or enjoyed shareholder rights;

(4)a judgment, registration, or announcement issued by a competent governmental authority has taken effect;

(5)any of the circumstances listed in Items (4) to (7) of Article 3 of this Announcement has been completed; or

(6)any other circumstance recognized by the tax authority as evidence that the equity transfer has occurred.

In this case, with respect to the share consideration portion, the taxpayer’s tax liability arose on 26 September 2016, when the shares of the transferee company were registered under his name. Prior to that, the cash consideration received by the taxpayer had already been subject to withholding, and RMB 50 million in individual income tax had been withheld and remitted by the transferee. Therefore, from the perspective of Individual Income Tax Law, the taxpayer’s equity-transfer income and corresponding tax liability had been established by September 2016.

(b) Author’s Analysis

Based on the above judicial reasoning, the author further analyzes the tax implications as follows:

Wang received RMB 250 million in cash consideration and RMB 325 million in share consideration for the equity transfer. The portion relating to the shares was treated, for tax purposes, as income derived from a non-monetary asset investment. Under Circular [2015] No. 41, the realization of such income occurs when the non-monetary assets are transferred and the taxpayer obtains equity in the investee enterprise—namely, when the registration procedures were completed on 26 September 2016. As for the cash portion, under Article 20 of SAT Announcement No. 67 (2014), once the transferee has paid or partially paid the equity transfer consideration, or once the equity transfer agreement has entered into effect, the withholding agent is required to withhold and remit the applicable tax.

In sum, the tax liabilities for both the cash and share components were triggered in September 2016. The execution and effectiveness of the equity transfer agreements between Wang and the transferee, the receipt of the cash consideration, and the completion of share-registration procedures together constituted the taxable fact for purposes of imposing individual income tax on property transfer income under Chinese tax law.

As for the subsequent performance-compensation obligations triggered by the target company’s failure to meet its performance commitments, these constitute a new taxable fact under Chinese tax law and may give rise to a separate enterprise income tax liability on the part of the transferee. Specifically, the transferee repurchased 20,730,949 shares and 6,717,799 shares from Wang at a nominal price of RMB 1 per transaction as performance compensation. If such repurchases cannot be treated as a reduction of the transferee’s tax basis in the equity of the target company, then the transferee would be required to recognize taxable income arising from the performance compensation and pay enterprise income tax accordingly. The discussion of this issue, however, falls outside the scope of this article.

III. Divergence Between Tax-Law and Civil-Law Evaluations

Tax law, as a branch of public law, is governed by the principle of statutory taxation. It focuses primarily on whether the constituent elements of a taxable fact are satisfied and whether a tax obligation exists. Civil law, as a branch of private law, is oriented toward balancing the interests of private parties and is concerned with assessing civil legal effects and property consequences. Because the two systems are founded on different starting points and value orientations, they may reach different evaluative conclusions with respect to the same conduct.

When tax law and civil law attach different legal characterizations to the same behavior, taxpayers and tax authorities may diverge in their understanding of the criteria for tax characterization, giving rise to disputes. One view holds that civil law functions as the “preceding law” in relation to tax law; that even while emphasizing the independence of tax law, tax characterization should still be grounded in the economic substance of civil transactions as recognized under civil law, so far as possible achieving coherence between the two systems. This reflects the requirements of the tax law principle of substance-over-form.

Returning to this case, the core dispute concerning the substance-over-form principle lies in whether the equity transfer and the subsequent share repurchase triggered by the performance-based compensation mechanism should, in terms of their economic substance, be regarded as “one transaction” or “two separate transactions.”

Compared with the first-instance court—which addressed only the administrative-law characterization of the equity transfer and the compensatory share repurchase—the appellate court offered a more comprehensive analysis. It examined both the civil and commercial nature of the performance-compensation obligations and their tax-law consequences under the Individual Income Tax Law, and evaluated these issues under the respective analytical frameworks of civil law and tax law. Through this separate analysis of civil-law characterization and tax-law characterization, the appellate court aimed to reach a relatively unified conclusion. The appellate court reasoned as follows:

“From the perspective of civil and commercial transactions, the performance-compensation obligation in this case was intended to compensate for the operational risks of the target company, rather than to adjust the overall transaction consideration. The appraised value of all shareholders’ equity in the target company was RMB 1,152.95 million. Based on that valuation, the parties determined that the acquiring company would pay a total transaction consideration of RMB 1,150 million… Supplementary Agreement (III) to the Profit Forecast Compensation Agreement deleted the impairment test and corresponding compensation mechanisms after the commitment period. Therefore, after agreeing on the total consideration of RMB 1,150 million, the parties did not conduct any impairment test for the target company or make any adjustment to its valuation. The failure to meet the agreed net profit targets does not necessarily indicate any decline in the valuation of the target company.”

In other words, even under a civil-law evaluation, the performance-compensation obligation in this case was relatively independent. It was tied to whether the target company achieved the agreed performance benchmarks, rather than to any change in the valuation of the transferred equity interest in the target company. The determination of the compensation amount thus bore no direct relationship to the value of the transferred equity. Even when the conditions for triggering compensation were met, such circumstances should not lead to an adjustment of the equity transfer consideration.

In practice, however, agreements on repurchase and performance-based compensation in investment and financing transactions vary widely. These agreements are not a contract type expressly provided for in the Civil Code. Their legal characterization has long been debated. The Minutes of the National Conference on Civil and Commercial Adjudication (Fa [2019] No. 254) defines them as follows: in practice, such agreements are arrangements entered into between investors and fundraisers in equity financing transactions to address uncertainty regarding the future development of the target company, information asymmetry, and agency costs, typically involving equity repurchase or monetary compensation mechanisms designed to adjust the valuation of the target company.

However, despite this civil-law characterization provided in the Minutes, its effect remains confined to the civil-law framework. As the appellate court further explained, under the Individual Income Tax Law, income from the transfer of personal property is not subject to a system of prepayment followed by final settlement. A taxpayer’s act of compensating the transferee with shares does not alter the recognition of equity-transfer income for tax administration purposes. The appellate court thus maintained that the determination of tax liability for equity-transfer income under the Individual Income Tax Law must be made according to tax-administration rules—that is, within the administrative-law framework—and is independent of civil-law characterization standards.

IV. Considerations on Potential Solutions

Although the judgment in this case ultimately upheld the legality and compliance of the tax authority’s administrative actions, the appellate court nevertheless suggested, from the perspectives of the substance-over-form principle and the reasonableness of administrative enforcement, that Chinese tax policies could be further refined. The income tax issues arising from this case are not isolated; rather, they represent a recurring challenge in Chinese tax practice.

Under current Chinese tax-administration rules, according to the Reply of the State Administration of Taxation on Individual Income Tax Collection Issues Concerning Reacquired Equity (SAT [2005] No. 130), once an equity transfer contract has been fully performed, the change in equity registration has been completed, and the income has been realized, the transfer is deemed a separate taxable fact that gives rise to individual income tax liability on property-transfer income. Any subsequent changes—such as modification of the equity transfer or the return of the equity interest—are treated as another distinct equity transfer, unless the equity transfer contract has not been fully performed and is canceled or revoked.

Because individual income tax is levied on income, its treatment differs from that of turnover taxes—under which taxpayers may issue negative (“red-letter”) invoices to offset revenue in the event of returns—and from taxes levied on property rights, which allow taxpayers to apply for tax refunds when the relevant property rights have not been acquired or have been returned. If tax law were to allow the performance period of an equity transfer to continue until the completion of the performance-based compensation mechanism, significant uncertainties would arise: prolonged open tax years, long-term uncertainty in determining equity-transfer gains, increased administrative difficulty, and the inevitable emergence of regulatory loopholes.

Against the backdrop of China’s current tax administration regime, resolving the income-tax controversy triggered by the performance-based compensation mechanism in this case will ultimately depend on a longer-term refinement of the individual income tax system.

At present, China adopts a hybrid system combining comprehensive taxation and schedular taxation. Income from equity transfers is taxed on a schedular basis and cannot be offset by subsequent compensation obligations arising from performance-based compensation mechanisms. If China were to further enhance the comprehensive component of its mixed IIT system—such as enlarging the scope of income aggregated for annual assessment and refining the rules on how deductions may interact, the adverse impact of disputes of this kind would be alleviated to some extent.

In addition, for income arising under such special circumstances, policymakers may consider drawing on the Land Appreciation Tax (LAT) practice for real-estate developers—namely, applying a provisional levy within a prescribed period, followed by a final settlement to reconcile any over- or under-payment once the conditions for final assessment are satisfied. Such an approach may enable a more accurate implementation of the ability-to-pay principle in taxation.