Editor's Note: In venture capital practice, discrepancies in the tax and accounting treatment of equity transfers by partnerships represent a high-risk area for tax audits and a focal point of disputes between taxpayers and tax authorities. This article analyzes a case in which a partnership, following an equity transfer, directly offset the transfer proceeds against the book value of its long-term equity investment rather than recognizing taxable income and filing the corresponding tax returns, thereby triggering a tax audit. Based on this case, the article examines three core disputed issues, analyzes the underlying legal logic, and offers compliance recommendations, with the aim of providing practical guidance and risk alerts for relevant partnerships and their investors.

01 Case Introduction

Partnership A (a limited partnership) was established in 2013 and primarily engages in venture capital investment. In 2017, through a combined investment involving subscription for new shares and convertible preferred shares, it invested a total of RMB 120 million to acquire 100 million shares of an unlisted target company in the high-end equipment manufacturing sector, representing a blended cost of approximately RMB 1.2 per share. In March 2021, Partnership A assessed that the target company was experiencing sustained losses and that the risk of investment failure was escalating. To preserve part of its investment capital, it decided to transfer approximately 50 million shares at RMB 2 per share, receiving total proceeds of approximately RMB 100 million. The equity transfer agreement was formally executed and became effective in March 2021, and the corresponding change in equity registration with the company registry was completed in August 2021. For accounting purposes, Partnership A, based on its understanding of the cost method of accounting, treated the transfer as a “recovery of investment.” Pursuant to Accounting Standards for Business Enterprises No. 2 — Long-term Equity Investments, it offset the full transfer proceeds against the book value of its long-term equity investment and neither recognized investment income in its financial statements for that period nor filed and paid individual income tax on behalf of its partners in respect of the equity transfer gain.

The target company subsequently reversed its business trajectory and successfully listed on the ChiNext board in June 2023, with its market value appreciating substantially. Partnership A completed its registration as a venture capital enterprise in 2023 and elected to apply the single-fund accounting method. In 2024, Partnership A disposed of its remaining 50 million shares in full, generating divestment proceeds of approximately RMB 450 million. In March 2025, it proactively filed its tax returns and paid individual income tax of approximately RMB 78 million at the preferential rate of 20%, with the taxable base calculated as the divestment proceeds less the corresponding initial investment cost. On the same day that Partnership A completed its tax filing and payment, the competent tax authority verbally notified it that the equity transfer transaction of March 2021 appeared to present tax compliance concerns, indicating that tax had not been fully declared and paid in respect of that transaction. In September 2025, the tax authority formally issued a written notice, officially commencing a tax investigation and requiring the enterprise to conduct a self-examination and pay the shortfall in tax calculated at the 35% progressive rate applicable to “business income” under the individual income tax regime, together with the corresponding late payment surcharge.

This case spans a multi-year investment cycle. The core disputed issues center on three points: First, does the enterprise’s act of offsetting investment costs without filing a tax declaration constitute a good-faith error arising from a difference in tax and accounting interpretation, or deliberate tax evasion? Second, in which tax year should the equity transfer income be recognized, and has the five-year statute of limitations for tax recovery expired? Third, can the single-fund accounting policy adopted upon subsequent registration be applied retroactively to earlier equity transactions? Each of these issues is analyzed in turn below.

02 Offsetting Investment Costs Based on a Reasonable Understanding of Tax Policy Should Not Be Characterized as Tax Evasion

In this case, whether tax evasion has occurred is the foundational dispute governing which limitation period applies to tax recovery, and it also directly affects the determination of subsequent administrative penalties and liability. Under Article 52 of the Law on the Administration of Tax Collection (the “Tax Administration Law”), where a taxpayer or withholding agent underpays or fails to pay tax as a result of calculation errors or other mistakes, the tax authority may recover the tax and late payment surcharge within three years; under special circumstances, this recovery period may be extended to five years. For acts of tax evasion, resistance to tax collection, or tax fraud, however, the tax authority has an unlimited right of recovery, unconstrained by the foregoing limitation periods. Under Article 63 of the Tax Administration Law, a finding of tax evasion requires the simultaneous satisfaction of four elements: a subject element, a fault element, a conduct element, and a consequence element. The fault element requires that the taxpayer acted with subjective intent, and the burden of proving this intent rests with the tax authority. In practice, cases where the taxpayer and the tax authority hold different understandings of a particular tax matter should not be summarily characterized as tax evasion — such an approach helps ensure that the determination and punishment of tax evasion are commensurate with the gravity of the violation, in accordance with the principle of proportionality between violation and penalty.

Analyzing the facts of this case from the perspective of the transaction background and subjective intent: at the time of the equity transfer in 2021, Partnership A assessed that the target company was in a phase of sustained losses and that the investment carried significant risk. The core purpose of the transfer was to cut losses and preserve capital, not to realize a profit. Although subsequent objective data show that the transfer price exceeded the initial investment cost, indicating an accounting gain, the assessment of subjective intent must be based on the operating conditions as they existed at the time of the transaction. At that time, the enterprise’s characterization of the transaction as a defensive divestment to recover invested capital was consistent with the commercial logic applicable at the time. Furthermore, the local industrial park authority had previously provided guidance on the accounting treatment and tax position for stop-loss equity transactions of this type, which further shaped the enterprise’s understanding of the relevant tax and accounting treatment, demonstrating that it did not fabricate false accounts with the deliberate intent of evading tax.

From the perspective of the differing standards applied at the audit stage versus in judicial proceedings: the standard for finding tax evasion varies across different procedural phases. At the audit stage, tax authorities routinely apply a logical framework of inferring subjective intent from objective conduct — where the objective fact of non-declaration or underpayment is established, the inspection bureau tends to infer that the enterprise acted with subjective intent, frequently placing the enterprise in a reactive position. However, once the case enters the administrative reconsideration or administrative litigation phase, the determining body shifts to the superior tax authority or the People’s Court, and the focus of scrutiny also shifts — the inquiry centers on whether the inspection bureau has discharged its burden of proof, whether there is direct evidence of subjective intent on the part of the enterprise, and whether the enterprise can adduce evidence demonstrating that its conduct reflected a good-faith difference in interpretation. At that stage, if the enterprise can produce records of the guidance provided by the industrial park authority on tax matters, such evidence can support an affirmative defense negating subjective intent for tax evasion purposes, and there is a reasonable probability of overturning a finding of tax evasion at the reconsideration or litigation stage.

03 Equity Transfer Income Should Be Recognized in Tax Year 2021; the Audit Falls Within the Five-Year Recovery Period

Assuming that a finding of tax evasion is excluded, this case still requires an assessment of whether the tax authority’s recovery action falls within the statutory five-year recovery period — the limitations issue is equally material to the enterprise’s available defenses.

With respect to the production and business income of individual partners of a partnership, Article 6 of the Regulations on the Imposition of Individual Income Tax on Investors of Sole Proprietorships and Partnerships issued by the Ministry of Finance and the State Administration of Taxation (Caishui [2000] No. 91) provides that, for enterprises subject to audit-based collection, business income shall be determined by reference to the Individual Income Tax Calculation Method for Self-Employed Industrial and Commercial Households (Trial) (Guoshuifa [1997] No. 43), which expressly provides that business income is to be accounted for on the accrual basis. As to the specific timing of recognition of equity transfer income under the accrual basis, reference may be made to Article 3 of the Notice of the State Administration of Taxation on Several Tax Issues Concerning the Implementation of the Enterprise Income Tax Law (Guoshuihan [2010] No. 79), which states: “Income from an enterprise’s transfer of equity interests shall be recognized as realized upon the effective date of the transfer agreement and the completion of the equity change registration.” Although this document is a normative instrument issued in the context of enterprise income tax, the analytical framework it embodies is equally instructive for the recognition of equity transfer income by partnerships.

In this case, the equity transfer agreement was executed and became effective in March 2021, while the change in equity registration with the company registry was not completed until August 2021. Applying the foregoing rules, the equity transfer income should be recognized in tax year 2021. Accordingly, the statutory deadline for the annual tax reconciliation filing for Partnership A’s business income for the 2021 tax year was 31 March 2022. The five-year recovery period runs from the day after the expiry of the tax filing deadline — that is, the recovery period in this case commenced on 1 April 2022 and expires on 31 March 2027. The tax authority’s verbal risk alert in March 2025 and the formal service of its written notice commencing the investigation in September 2025 both occurred before the expiry of the recovery period. Accordingly, the tax authority’s recovery action in this case has a lawful basis in terms of limitations, and the enterprise will find it difficult to halt the audit proceedings by invoking the expiry of the recovery period.

04 The 20% Preferential Rate for Single-Fund Accounting Has No Retroactive Effect and Does Not Apply to the 2021 Transaction

In the venture capital sector, income derived by individual partners of a partnership from equity transfers is generally taxed as “business income” under the individual income tax regime, subject to the five-bracket progressive rates ranging from 5% to 35%. This tax burden is relatively high for the venture capital industry. To improve the tax environment and reduce the burden on investors, in 2019 the Ministry of Finance, the State Administration of Taxation, the National Development and Reform Commission, and the China Securities Regulatory Commission jointly issued the Notice on Individual Income Tax Policy Issues Concerning Individual Partners of Venture Capital Enterprises (Caishui [2019] No. 8), allowing qualifying venture capital enterprises to elect the single-fund accounting method, under which individual partners’ equity investment income from that fund is subject to individual income tax at the flat rate of 20%. This policy attracted widespread attention in the private equity sector and prompted many partnerships to actively pursue registration and compliance.

However, the application of the preferential rate is subject to a prerequisite that cannot be overlooked. Article 1 of Caishui [2019] No. 8 expressly provides: “The term ‘venture capital enterprise’ as used in this Notice refers to a partnership-type venture capital enterprise (fund) that satisfies the relevant provisions on venture capital enterprises (funds) under the Interim Measures for the Administration of Venture Capital Enterprises or the Interim Measures for the Supervision and Administration of Private Investment Funds, has completed registration pursuant to the foregoing regulations, and operates in compliance therewith.” Accordingly, a partnership must complete the single-fund tax registration before generating taxable income — the registration must pre-date the relevant transaction and the corresponding tax filing. In this case, Partnership A completed its single-fund registration in 2023, which was clearly later than the date of the equity transfer in question in March 2021. It therefore cannot claim the 20% preferential rate in respect of the gain on that transfer and must instead pay the tax shortfall at the progressive rates of 5% to 35%.

From a tax fairness perspective, the application of different tax rates to similar investment transactions by the same enterprise — solely by reason of the timing of registration — may appear inequitable. However, from the standpoint of the internal logic of the tax law system, tax incentives are inherently permissive, conditional policy arrangements: an enterprise that fails to fulfill its prior compliance obligation to register as required by the applicable policy cannot circumvent the rules to seek retroactive application. An argument to the contrary is unlikely to succeed before the tax authority or in subsequent judicial review. Notably, the tax authority has not yet raised any objection to Partnership A’s tax filing for tax year 2024 at the 20% rate, and it is unlikely to challenge the validity of that filing going forward. For partnerships that have not yet completed their registration and are still in the investment holding phase, it is advisable to assess at the earliest opportunity whether they satisfy the registration conditions for single-fund accounting, complete the necessary formalities promptly, and ensure that future equity exit transactions can properly benefit from the applicable tax incentive.

Conclusion: Beyond the three disputed issues addressed above, particular attention should also be paid in practice to audit response strategy and day-to-day compliance. In terms of audit response, the enterprise’s attitude and conduct during the investigation are an important factor in the tax authority’s exercise of its discretionary power in imposing penalties. Proactive cooperation and candid disclosure will generally improve the prospects of obtaining lenient treatment. However, particular caution is warranted with respect to written statements and submissions made to the inspection bureau on disputed matters — if poorly worded, they may constitute admissions of fact adverse to the enterprise. It is advisable for enterprises to work with qualified tax counsel in reviewing the facts and drafting their submissions, so as to cooperate fully with the audit while avoiding missteps that could aggravate their liability. In terms of day-to-day compliance, enterprises should work to establish a routine mechanism for identifying and adjusting tax-accounting differences and to complete all required compliance registrations on a prospective basis.