Gambling agreements are also known as valuation adjustment agreements. "An agreement designed by investors and financiers to address the uncertainty of the future development of the target company when they reach an investment and financing agreement, which includes equity buybacks, monetary compensation, and other adjustments to the valuation of the future target company.". However, when equity buybacks and monetary compensation occur, there is currently no legal document specifying how to make tax treatment, and in practice, the treatment methods of local tax authorities vary.

1、 Treatment by different tax authorities varies

Based on the announcements of a listed company, published cases, and responses from tax service centers around the country, we will learn about the handling of different tax authorities.

（1） Dongguan Tax: Tax refund allowed

Dongguan Taxation: Tax refund granted (slide down to view)

In June 2016, Guangdong Yinxi Technology Co., Ltd. (hereinafter referred to as "Yinxi Technology") and the original shareholders of Xingke Electronic Technology Co., Ltd. (hereinafter referred to as "Xingke Electronics"), Hu Enci, Chen Zhiyong, Xu Liming, and Gao Bingyi, signed the Performance Commitment Compensation Agreement between Guangdong Yinxi Technology Co., Ltd. and the Subscriber (hereinafter referred to as "Performance Commitment Compensation Agreement"). According to the Performance Commitment Compensation Agreement, Hu Enci, Chen Zhiyong, Xu Liming, and Gao Bingyi, as performance compensation obligors, promise that the net profit of Xingke Electronics in 2016-2018 (after deducting non recurring profits and losses) will not be less than 200 million yuan, 240 million yuan, and 290 million yuan, and agree to compensate for the portion of Xingke Electronics' actual net profit that is less than the promised net profit. Due to Xingke Electronics' cumulative net profit after deducting non recurring profit and loss from 2016 to 2018 was -56.09 million yuan, while Xingke Electronics' cumulative committed performance from 2016 to 2018 was 730 million yuan, and the completion rate of Xingke Electronics' performance commitment was 0%.
According to the Performance Commitment Compensation Agreement, Hu Enci, Chen Zhiyong, Xu Liming, and Gao Bingyi need to compensate the company for their performance (i.e., compensate the company for their shares and cash, and return the dividends received from the company). In July 2019, Yinxi Technology submitted an application for personal income tax refund to the Dongguan Municipal Taxation Bureau. Based on the compensation shares of Hu Enci, Xu Liming, and Gao Bingyi, the former shareholders of Xingke Electronics, it applied for a tax refund of 112550463.36 yuan.

After receiving the tax refund application, the Dongguan Tax Bureau will refund the tax.

（2） Guangzhou Tax: Allow adjustment of transaction consideration

Guangzhou Tax: Allow adjustment of transaction consideration (slide down to view)

According to the Announcement on the Delivery of Tax Documents (Li Julian's Tax Treatment Decision) (No. 91, 2020) issued by the Third Inspection Bureau of Guangzhou Municipal Taxation Bureau

In May 2014, Huawen Media acquired 100% of the equity of Guangzhou Bangfu Software held by Li Julian and other three people, with a total transaction price including cash of 20.1 million yuan and stock of 518.4 million yuan. At the same time, performance compensation provisions have been agreed. Due to the failure of Guangzhou Bangfu Software to fulfill its performance commitments, Li Julian and other three people need to make performance compensation, including 1038644.00 shares of Li Julian Compensation Company.

Due to Li Julian's failure to declare and pay personal income tax in full on the above-mentioned equity transfer matters, the Inspection Bureau requested Li Julian to make up for personal income tax. When calculating the tax payable by Li Julian, the Inspection Bureau deducted the corresponding value of 1038644.00 shares of shares it compensated for Huawen Media (calculated based on the original additional issue price).

（3） Hainan Tax: The profit compensation obtained can be regarded as an adjustment to the pricing of the transferred equity

Hainan Tax: The profit compensation obtained can be regarded as an adjustment to the pricing of the transferred equity (slide down to view)

Reply on Issues Related to Profit Compensation for Corporate Income Tax in Gambling Agreements (Qiongdi Shui Han (2014) No. 198)

Hainan Airlines Co., Ltd.:

We have received your company's Request for Instructions on Issues Related to Profit Compensation for Corporate Income Tax in Gambling Agreements (Qionghangcai [2014] No. 237). After research, we hereby reply as follows:
According to the relevant provisions of the "Enterprise Income Tax Law of the People's Republic of China" and the "Regulations for the Implementation of the" Enterprise Income Tax Law of the People's Republic of China "on investment assets, the profit compensation obtained by your company in this gaming agreement can be considered as a pricing adjustment to the initially transferred equity, that is, adjusting the initial investment cost of the corresponding long-term equity investment in the year in which the profit compensation is received.

In reply to this letter.

Hainan Provincial Local Taxation Bureau

May 5, 2014

（4） Sichuan Taxation: Promoting the Implementation of Relevant Policies

Sichuan Taxation: Promoting the implementation of relevant policies (slide down to view)

Letter from Sichuan Provincial Taxation Bureau of the State Administration of Taxation on Reply to Proposal No. 0427 of the Third Meeting of the 12th Sichuan Provincial Committee of the Chinese People's Political Consultative Conference
We have received your Proposal on the Tax Confirmation of Pairing Agreement in Equity Transfer, and hereby reply as follows:

In recent years, the frequent restructuring of China's capital market has boosted the widespread application of the Pai Bet Protocol, which in turn has promoted the prosperity and development of the capital market. The treatment of income tax on gambling agreements has always been a theoretical and practical challenge in the field of tax law. Even in countries with relatively complete income tax systems such as Europe and the United States, due to the complexity of transactions and the diversity of consideration methods, they have been continuously developing. Currently, there is no direct and clear document specification for the tax treatment of gambling agreements in China's corporate income tax; The current policy basis for individual income tax is the "Administrative Measures for Individual Income Tax on Equity Transfer Income (Trial Implementation)" (Announcement No. 67 of the State Administration of Taxation in 2014), which clarifies the basic policy in principle, but the specific operation still needs to be further detailed.
In 2019, our bureau has conducted research and discussion on relevant issues, formed views and suggestions on handling this issue, and made a special report to the Income Tax Department of the State Administration of Taxation. After receiving your proposal and suggestion, due to the lack of policy interpretation power of the provincial tax bureau, our bureau conducted a special study on this issue and again reported it in writing to the State Administration of Taxation, requesting the State Administration of Taxation and the Ministry of Finance to study and issue policy documents. In the next step, our bureau will adhere to the principle of no heavy or omitted tax collection, and consistent tax treatment. We will continue to follow up and implement the work requirements related to the proposal, and promote the early resolution of the tax difficulties involved in the gambling agreement.

Thank you sincerely for your valuable comments on tax work. Please continue to care about and support tax work.

State Administration of Taxation Sichuan Provincial Taxation Bureau

July 27, 2020

（5） Fujian tax: No tax refund

Fujian Tax: No Refund (slide down to view)

Message content: In January 2020, Zhang San purchased 100% of the equity held in Company A from Li Si. The investment cost of Li Si in Company A was 1 million yuan. The price for Zhang San to purchase Company A was 2 million yuan, with a premium of 1 million yuan. Li Si has already paid 200000 yuan of personal income tax on the income from this equity transfer. In the transfer agreement, Li Si promised that if the net profit of Company A in 2020 was less than 500000 yuan, Li Si would compensate Zhang San with 500000 yuan. In April 2020, the audited net profit of Company A was 350000 yuan, which did not meet the promised profit target. Therefore, Li Si needed to compensate Zhang San for 500000 yuan.
May I ask: 1. After Li Si has paid 500000 yuan of compensation, can I apply to the tax authorities for a refund of 100000 yuan of personal income tax on equity transfer? 2. Does Zhang San need to pay personal income tax after receiving the 500000 yuan compensation? Is it necessary to pay 20% personal income tax on incidental income?

Reply department: Fujian Provincial Taxation Bureau Tax Service Center

Response time: 2021.6.7

Reply: According to Article 6 of the Individual Income Tax Law of the People's Republic of China, income from the transfer of property shall be taxable income based on the balance of the income from the transfer of property minus the original value of the property and reasonable expenses. There is no relevant policy for refunding individual income tax in the situation you described. "Accidental income" refers to income of an individual's winning a prize, winning a lottery, or other incidental nature. As you mentioned, "Zhang San received this 500000 yuan compensation" is not incidental income and does not pay personal income tax.

（6） Ningbo Tax: The profit compensation obtained cannot be regarded as adjusting the pricing of the transferred equity

Ningbo Tax: The profit compensation obtained cannot be regarded as adjusting the pricing of the transferred equity (slide down to view)

Message content: Company A has purchased 100% of the equity of the target company from the counterparty, and has signed a gambling agreement, agreeing that the target company should achieve a certain profit operation goal within three years, otherwise the counterparty should pay compensation to Company A. Due to the fact that the target company has not achieved its profit operation goal, the counterparty has actually paid compensation to Company A. How can I confirm this portion of compensation and adjust the initial investment cost of the corresponding long-term equity investment? The Reply of Hainan Provincial Local Taxation Bureau on Issues Related to Profit Compensation for Corporate Income Tax in Gambling Agreements (Qiongdi Shui Han [2014] No. 198) issued by the Hainan tax authority on May 5, 2014 clearly states that:, "According to the relevant provisions on investment assets in the Enterprise Income Tax Law and its Implementation Regulations, the profit compensation obtained in the gambling agreement can be considered as a pricing adjustment to the initially transferred equity, that is, the initial investment cost of the corresponding long-term equity investment in the year in which the profit compensation is received is adjusted." Can this provision be applied mutatis mutandis?

Reply department: Ningbo Municipal Taxation Bureau

Response time: March 16, 2020

Reply content: Article 56 of the "Regulations for the Implementation of the Enterprise Income Tax Law of the People's Republic of China" stipulates that all assets of an enterprise, including fixed assets, biological assets, intangible assets, long-term unamortized expenses, investment assets, inventory, etc., are taxable on the basis of historical cost.

The term "historical cost" as mentioned in the preceding paragraph refers to the actual expenses incurred by an enterprise when acquiring the asset.

Ningbo does not implement it.

（7） Xiamen Tax: The profit compensation obtained cannot be regarded as adjusting the pricing of the transferred equity

Xiamen Tax: The profit compensation obtained cannot be regarded as adjusting the pricing of the transferred equity (slide down to view)

Question content:

Hello, our company is a venture capital partnership, investing in Company B and signing a gambling agreement with the company. If the profits fail to meet the agreed period, Company B will provide performance compensation (cash compensation) to our company. Can the cash compensation agreed in the gambling agreement be considered as a pricing adjustment to the originally transferred equity, that is, adjusting the initial investment cost of the corresponding long-term equity investment in the year in which the cash compensation is received and not included in the current year's investment income? The Reply of Hainan Provincial Local Taxation Bureau on Issues Related to Profit Compensation for Corporate Income Tax in Gambling Agreements (Qiongdi Shui Han [2014] No. 198) issued by the Hainan tax authority on May 5, 2014 clearly states that:, "According to the relevant provisions on investment assets in the Enterprise Income Tax Law and its Implementation Regulations, the profit compensation obtained in the gambling agreement can be regarded as a pricing adjustment to the initially transferred equity, that is, the initial investment cost of the corresponding long-term equity investment in the year in which the profit compensation is received can be adjusted." Can this provision be implemented mutatis mutandis? thank you

Reply department: Xiamen Municipal Taxation Bureau

Response time: March 8th, 2022

Response content: Dear taxpayer (withholding agent, payer), hello! "We have received your online message consultation and have replied as follows: According to Article 56 of the Regulations for the Implementation of the Enterprise Income Tax Law of the People's Republic of China, various assets of an enterprise, including fixed assets, biological assets, intangible assets, long-term unamortized expenses, investment assets, inventory, etc., are taxed based on historical cost.". The term "historical cost" as mentioned in the preceding paragraph refers to the actual expenses incurred by an enterprise when acquiring the asset. During the period when an enterprise holds various assets, unless the financial and tax authorities under the State Council stipulate that profits and losses can be recognized, the tax basis of the assets may not be adjusted. Please comply.

2、 Analysis of the reasons why tax authorities refuse to refund taxes and adjust costs

（1） Without legal provisions, the transfer price can be adjusted or other special treatment can be made if the gambling fails

As the "gambling agreement" is an adjustment to the valuation of the target company. The final consideration will only be generated when the gambling conditions are triggered, and then the equity transaction consideration can be finally determined. According to current legal regulations, upon completion of the equity change procedures, the initial consideration must be fully recognized as income realization and taxes must be paid. Therefore, in the case of a failure to adjust the consideration for equity transfer due to gambling, the tax authorities refused to make an adjustment to the equity transfer price based on the lack of a clear legal basis.

（2） Equity transfer and compensation belong to two independent transactions

Some tax authorities believe that equity transfer and compensation belong to two independent transactions and do not belong to the same legal relationship. It is believed that the transaction has ended after the completion of the first equity change procedures. If compensation occurs, it is a second transaction, and the tax payable is calculated based on the equity transfer price agreed in the equity transfer agreement as the equity transfer income. It is not recognized that the compensation returned after meeting the conditions is an adjustment to the previous equity transfer price.

3、 Legal Analysis of Tax Refunds Should be Granted by Tax Authorities

（1） The application of Article 9 of Announcement 67 should be interpreted in favor of taxpayers

Article 9 of the Announcement of the State Administration of Taxation on the Issuance of the "Administrative Measures for Individual Income Tax on Income from Equity Transfer (for Trial Implementation)" (Announcement No. 67 of the State Administration of Taxation 2014, hereinafter referred to as "Announcement No. 67") stipulates: "The subsequent income obtained by taxpayers in accordance with the contract after meeting the agreed conditions shall be recognized as equity transfer income." Article 9 of the Announcement No. 67 stipulates that subsequent income shall be included in equity transfer income, The subsequent losses incurred after meeting the agreed conditions should also be reduced in equity transfer income. This interpretation is in line with the principle of capacity based taxation and fairness in the tax law.

（2） The equity transfer agreement and the gambling agreement should be recognized as the same legal relationship

In practice, both investment and financing parties usually agree on the bet arrangement in addition to the main equity transfer agreement through supplementary agreements or other forms, that is, equity transfer agreements are used for the needs of industrial and commercial registration and changes, while valuation adjustment agreements may be signed separately. The main agreement for equity transfer and supplementary agreements such as the gaming agreement correspond to the same legal relationship for equity transfer. The equity transfer price can only be confirmed after the implementation of the main agreement and supplementary agreement, and the overall equity transfer transaction can be truly completed. The compensation triggered by the terms of the equity transfer agreement and the gambling agreement should not be considered as two transactions. The compensation incurred after the punishment of the terms of the gambling agreement should be considered as an adjustment to the equity transfer price.
Counsel's advice

Due to the triggering of the monetary compensation clause in the gambling agreement, there is no legal requirement as to whether to grant a tax refund. In view of the different handling methods of local tax authorities, taxpayers should promptly consult local tax authorities. If there is a dispute, they can seek the assistance of a professional tax lawyer to handle it.