Analysis and Handling of Tax Issues for Partners in a Partnership Enterprise

Author: Zhang Guodong

[ Raising the Question

As a non-legal entity structure, partnerships feature flexible governance mechanisms and tax transparency, and in recent years have been widely adopted as platforms for employee stock ownership or for business operations and investments. However, given the unique characteristics of partnerships, tax-related issues involving partnership partners exhibit certain specific features. This article provides a brief analysis of tax treatment issues relevant to partnership partners, based on current operational practices of general partnerships. Note: For tax treatment issues pertaining to limited partnership venture capital firms and special partnerships such as law firms—where separate policy provisions apply—this article does not address these matters at this time.

[   Partnership Tax Policy

(1) The “tax first, then allocate” principle

On September 19, 2000, the Ministry of Finance and the State Administration of Taxation issued the "Regulations on the Collection of Individual Income Tax from Investors in Sole Proprietorships and Partnership Enterprises" (Cai Shui [2000] No. 91), which stipulated that partnership enterprises would no longer be subject to corporate income tax, and individual investors would pay taxes in accordance with the Individual Income Tax Law.

On March 16, 2007, the National People's Congress formally adopted the Corporate Income Tax Law, legally establishing that partnership enterprises would not be subject to corporate income tax.

On December 23, 2008, the Ministry of Finance and the State Administration of Taxation issued the “Notice on Income Tax Issues for Partners in Partnership Enterprises” (Cai Shui [2008] No. 159), which stipulates that individual partners shall pay individual income tax, while corporate partners shall pay enterprise income tax. At the same time, the notice adopts the “allocate first, then tax” principle for the business operating income and other income generated by partnership enterprises. To date, this policy remains in effect.

As can be seen from the historical evolution of the above-mentioned fiscal and tax policies, partnership enterprises are not subject to corporate income tax; however, they adopt the “distribution first, tax later” principle, under which partners are taxed on a “look-through” basis, thereby achieving certain tax-saving effects. In general terms, the “distribution first, tax later” principle refers to the allocation of tax obligations among the partners of a partnership enterprise.

According to Document No. [2008]159 issued by the Ministry of Finance and State Administration of Taxation, for the income derived from the production and operation activities as well as other income of a partnership enterprise, each partner’s taxable income shall be determined in accordance with the distribution ratio stipulated in the partnership agreement. If no such agreement exists, the distribution ratio shall be determined through mutual consultation. In the event that no agreement can be reached through consultation, the distribution ratio shall be based on the actual contribution ratio. If the ratio still cannot be determined, the income shall be allocated equally.

This is essentially the same as the method for profit distribution and loss sharing stipulated in Article 32, Paragraph 1 of the Partnership Enterprise Law. However, Paragraph 2 of that article explicitly provides that the partnership agreement may not stipulate that all profits be distributed to only some partners, nor may it stipulate that only some partners bear all losses. Nevertheless, for limited partnerships, in accordance with Article 69 of the Partnership Enterprise Law, the partnership agreement may indeed provide for the distribution of all profits to only some partners.

(2) The Termination of the Determined Collection of Individual Income Tax

For a long time, since fiscal and tax policies have allowed individual partners in partnerships to opt for assessed collection of personal income tax (Cai Shui [2000] No. 91), "assessed collection" has often been used as a tax-planning tool by individual partners in partnerships. Under the conditions of assessed collection, many individual partners with relatively high personal incomes have an actual personal income tax burden that is even below 3%, which has inadvertently led to substantial losses in state tax revenue.

On December 30, 2021, the Ministry of Finance and the State Administration of Taxation issued the “Announcement on the Collection and Administration of Individual Income Tax on Business Income from Equity Investments” (Ministry of Finance and SAT Announcement No. 41 of 2021), which stipulates that partnership enterprises holding equity or other equity investments externally shall, without exception, be subject to individual income tax under the bookkeeping-based collection method. As a result, individual partners in partnership enterprises holding equity or other equity investments externally may no longer adopt the “determined-collection” method for calculating their individual income tax.

However, it should be noted that individual partners in partnerships that do not hold equity investments can still be subject to the assessed collection of individual income tax. At the same time, this policy does not apply to corporate partners.

[Contribution to Partnership]

According to the Partnership Enterprise Law, partners may contribute capital in the form of currency, non-monetary assets, or labor services. Generally, partners are not required to bear relevant taxes and fees on contributions made in the form of currency; however, when contributing non-monetary assets, partners do face related tax obligations.

(1) Capital contribution by individual partners

If a natural person partner contributes non-monetary assets, the contribution shall be governed by the "Notice of the Ministry of Finance and the State Administration of Taxation on Policies Relating to Individual Income Tax on Investments in Non-Monetary Assets by Individuals" (Cai Shui [2015] No. 41). When an individual invests with non-monetary assets, it is considered both a transfer of non-monetary assets and an investment simultaneously. The income derived from the transfer of such non-monetary assets shall be subject to individual income tax according to the provisions applicable to property transfer income. However, if an individual invests immovable properties such as land and real estate owned by him or her into the partnership, depending on the nature and type of these immovable properties, value-added tax, land value-added tax, and other related taxes and fees must also be taken into account. For those investments that qualify for preferential tax policies, procedures may be carried out in accordance with relevant regulations.

(2) Capital contribution by corporate partners

If a corporate partner contributes non-monetary assets, there is currently no explicit tax policy regulating this situation. The "Notice from the Ministry of Finance and the State Administration of Taxation on Issues Relating to the Corporate Income Tax Policy for Investments in Non-Monetary Assets" (Cai Shui [2014] No. 116) applies only to cases where non-monetary assets are used to establish new resident enterprises or to contribute to existing resident enterprises. Moreover, according to the "Corporate Income Tax Law," partnership enterprises are not considered resident enterprises and are thus not subject to the corporate income tax law. However, when a corporate partner contributes non-monetary assets to a partnership enterprise, such contribution simultaneously involves both the transfer of non-monetary assets and investment activities. Although partnership enterprises do not have legal person status and are not themselves taxpayers under the corporate income tax law, tax authorities may nonetheless, by analogy with documents such as Cai Shui [2014] No. 116, impose corporate income tax on the corporate partner based on the gains derived from the transfer of non-monetary assets. In addition, depending on the nature and type of the non-monetary assets, the partnership may also be required to pay value-added tax, land value-added tax, and other related taxes. For those partnerships eligible for tax preferential policies, they may proceed in accordance with the relevant regulations.

[   Partnership Income and Taxation】

According to the current tax policies, the income earned by partnership enterprises mainly falls into two categories: interest, dividends, and bonus income, as well as income from production and operations. Both types of income are subject to the “distribution first, then tax” principle. Individual partners pay individual income tax, while corporate partners pay corporate income tax.

(1) Income from interest, dividends, and bonuses

With regard to individual partners, in accordance with the Notice issued by the State Administration of Taxation on the Implementation Guidelines for the “Regulations on the Collection of Individual Income Tax from Investors in Sole Proprietorships and Partnership Enterprises” (Guo Shui Han [2001] No. 84), interest, dividends, and bonuses distributed by a partnership enterprise from its external investments shall not be included in the total income. Instead, they shall be subject to individual income tax under the taxable item “Income from Interest, Dividends, and Bonuses.” Specifically, the “Income from Interest, Dividends, and Bonuses” received by individual partners is subject to a flat tax rate of 20%.

As for corporate partners, dividend income under these circumstances does not qualify as “tax-exempt income” within the meaning of the Corporate Income Tax Law. Therefore, dividends should be combined with interest income and included in the corporate partner’s taxable income for the current period, upon which corporate income tax shall be calculated and paid.

(2) Income from production and business operations

With regard to individual partners, according to Document No. [2000]91 issued by the Ministry of Finance and State Administration of Taxation, the business income generated by a partnership enterprise—the balance remaining after deducting costs, expenses, and losses from the total revenue—is subject to personal income tax at progressive tax rates ranging from 5% to 35%, in five brackets. The aforementioned total revenue includes sales revenue from products, operating revenue, revenue from project contracts, income from leasing or transferring property, and non-operating income, among others.

As for corporate partners, the business income they derive from the partnership enterprise is included in their current taxable income as a corporate partner and is subject to corporate income tax.

[   Tax Implications of Equity Disposal

(1) Liquidation and Exit

According to the Partnership Enterprise Law, when a partnership enterprise encounters any statutory or contractual grounds for dissolution, it must undergo liquidation. As stipulated in Document No. [2000]91 issued by the Ministry of Finance and State Administration of Taxation, upon liquidation of an enterprise, the fair value of all assets or properties, after deducting various liquidation expenses, losses, liabilities, and retained profits from previous years, shall be treated as liquidation income. This liquidation income, exceeding the paid-up capital, shall be subject to individual income tax under the category of annual business operating income. For corporate partners, the portion of the liquidation income exceeding the paid-up capital may be included in the current period’s taxable income of the corporate partner and used to calculate and pay corporate income tax.

(2) Settlement and Withdrawal from the Partnership

According to the Partnership Enterprise Law, when a statutory or agreed-upon reason for withdrawal arises, a partner may withdraw from the partnership after settlement. For individual partners, the business income attributable to the current period that has not yet been taxed shall be subject to individual income tax under the category of annual production and operating income. As for the settlement of the partnership enterprise’s property, the income remaining after deducting the original investment amount and the portion already taxed may be subject to individual income tax under the category of property transfer income.

For corporate partners, the business income attributable to the current period that is not yet taxed, as well as the net income after deducting the original investment amount and the portion already taxed, may be included in the corporate partner’s taxable income for the current period and used to calculate and pay enterprise income tax.

(3) Transfer of Partnership Interest

If a natural person partner transfers his or her partnership interest, the current-period income from production and operation settled at the partnership enterprise level shall be subject to individual income tax under the “income from production and operation” item. As for the income derived from the transfer of the partner’s interest—specifically, the amount received minus the original investment amount and the portion already taxed—the resulting gain shall be subject to individual income tax under the “income from property transfer” item.

If a corporate partner transfers its partnership interest, the current-period operating income settled at the partnership enterprise level, as well as the income received from the transfer of the partnership interest less the original investment amount and the portion already taxed, shall be included in the corporate partner’s taxable income for the current period and used to calculate and pay enterprise income tax.

[Summary]

Due to differences in nature and legal status, tax-related matters involving partnerships as general employee stock ownership or operating platforms differ significantly from those handled by corporations. While partnership governance models are relatively flexible, given the current imperfections in existing laws, when implementing these models in practice, in addition to complying with the basic provisions of the Partnership Law, it is also essential to comprehensively consider tax implications related to partners’ entry, withdrawal, and transfer of partnership interests, so as to achieve an optimal governance solution.

About the Author:

Zhang Guodong, Attorney at Liaoning Tongfang Law Firm

Professional Expertise: Dedicated to the company’s comprehensive business services, including corporate governance and compliance management, equity and capital transactions, tax-related handling and planning for investments, equity incentives, and partnership programs for business associates. In the administrative field, we are well-versed in government regulatory procedures and measures, and capable of representing companies effectively in responding to inappropriate government oversight. In litigation, we excel at handling complex and challenging cases; in recent years, we have represented numerous cases that have had significant national impact or contributed to advancements in the rule of law.