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New Restrictions to Enjoy Tax Treaty Benefits

20 February 2011

Under Chinese law, a foreign company or individual doing business in China as a non-resident is subject to taxation in China on the income derived from China. Non-residents may, however, be entitled to preferential tax treatment if its home jurisdiction (referred to as the contracting state) has entered into a double taxation treaty with China.

The Administration Measures for Non-resident to Enjoy Treatments on Income under Double Tax Treaties (Trial) (Guoshuifa [2009] No. 124, “Measures”) issued by the State Administration of Taxation (“SAT’) on 24 August 2009 (effective 1 October 2009) now subjects beneficial treatment of passive income such as dividends, interest, royalties and property income to approval procedures.

In accordance with Article 7 of the Measures, the non-resident should submit an application for treaty treatment of passive with the taxpayer’s in-charge tax bureau or another authorized tax bureau. After obtaining approval, the non-resident or its withholding agent may declare and pay taxes on the income in accordance with the approved preferential treatment, before remitting the remainder to the non-resident abroad.

Application materials include:

  • Application for Treatment under Double Taxation Agreement;
  • Information Form of Non-resident, which includes particulars such as its shareholders, its business in China and in its home jurisdiction, related-party transactions in third counties, etc.
  • Certificate of Tax Residency issued by the competent authorities of the home jurisdiction after the beginning of the last calendar year;
  • Title Certificate related to the income, such as the property deed, contract, agreement , payment order or a certificate issued by an agent or a public notary;
  • Other documents as required by the tax bureau.

Upon acceptance of the application materials, the competent tax bureau will decide on approval, rejection, temporary un-entitlement or un-entitlement of the treaty treatment within 20, 30 or 40 working days depending on the level of the tax bureau handling the application (which can be further extended with 10 working days). Once approval for certain income is obtained, it will remain valid for the same income for three years, which means that the non-resident is not required to re-apply for treaty treatment of the same income within this period. Same income refers to dividends paid by the same subsidiary for the same investment, interest paid by the same debtor for the same credit right, and royalties paid by the same licensee for the same licensed right.

Where a non-resident is entitled to treaty treatment but has failed to apply and therefore has paid too much tax, it is permitted to file for treaty benefits within three years from the date the tax was paid, and upon approval of the filing, to obtain a refund. Although the Measures are effective from 1 October 2009, non-residents may also submit a filing for treaty treatment on the income derived before 1 October 2009, provided that the three-year threshold is satisfied.

Special Provisions on Dividend Remitted Abroad

The SAT has separately released a circular on the criteria and conditions for treaty treatment of dividends. In accordance with the Notice for Implementation of the “Dividends” Article under Double Tax Treaties – Guoshuihan [2009] No. 81 (“Circular 81”) issued by the SAT on 20 February 2009, the preferential treaty rate shall apply where the Chinese resident company pays dividends to its foreign shareholder, which is a tax resident of the contracting state and the beneficial owner of the dividends (see below).

In some tax treaties, beneficial treatment is conditional upon the non-resident holding at least a certain percentage (usually 10% or 25%) of the equity of the Chinese subsidiary, in which case beneficial treatment of dividends is subject to the following conditions:

  1. The shareholder must be a company (dividends paid to
    foreign individuals are currently exempt from individual
    income tax);
  2. The non-tax resident’s beneficial interests and voting
    rights in the subsidiary shall meet the required minimum
    shareholding percentage;
  3. The minimum shareholding percentage requirement
    shall have been met during the 12-months period before
    the dividends are paid.

Circular 81 specifies the documents and information to be submitted to the competent tax bureau for approval purposes. This includes a number of documents not mentioned in the Measures, such as the tax profile of the non-tax resident in the contracting state, whether the nontax resident is a tax resident in a third jurisdiction, and whether the non-tax resident is a tax resident in China. The Measures should prevail over Circular 81 in case of conflicts, and so logically the application documents for dividends treaty treatment should be prepared as per the requirements of the Measures instead of Circular 81. In practice however, the competent tax bureau may require the documents specified in Circular 81 to be submitted as well, especially if the tax bureau aims to challenge the non-tax resident’s qualification for treaty treatment. Furthermore, the competent tax bureau has the authority to deny granting of the treaty treatment and make adjustment to the taxation on dividends, if it believes the foreign investor abuses the tax treaty, and the main purpose of the transaction or arrangement is to obtain preferential treatment, for example by using an intermediary company (which is entitled to beneficial treaty treatment, i.e. a Hong Kong company) between the actual foreign investor and the Chinese subsidiary.

Special Provisions on Beneficial Ownership

One of the conditions for preferential treatment under a tax treaty is beneficial ownership, a concept which was not been defined under Chinese law until 27 October 2009, when the SAT issued Guo Shui Han [2009] No. 601 (“Notice 601”). Notice 601 provides guidance to Chinese tax bureau’s on how to determine who is the beneficial owner under China’s tax treaties with other jurisdictions. The beneficial owner of certain income is the individual, corporation or other organization that owns or controls the income, or the rights or assets that generate such income. Generally, it should engage in substantive operational activities such as manufacturing, trading or management activities; the definition specifically excludes agents and conduit companies. When determining whether an applicant for treaty benefits is the beneficial owner of the income, the competent tax bureau should make its decision based on the actual circumstances in the specific case under review, focusing on the purposes of the tax treaty (namely avoiding double taxation and preventing evasion of taxes) as per the principle of substance over form. The following circumstances can adversely affect a decision on whether a treaty is applied:

  1. The applicant is obliged to pay or distribute to residents of a third country all or most of the income (e.g. 60% or more) within a prescribed time limit (e.g. within 12 months after the income is received);
  2. Except for holding properties or rights generated from the incomes, the applicant does not have or hardly carries out other business operations;
  3. The applicant is a company or other entity but it has very few assets, is small in scale or the number of employees makes it disproportional to the amount of income;
  4. The applicant does not have or has very limited rights to control or dispose the income or the assets or rights generated from the income, and it bears little or no risk;
  5. The contracting state does not impose any tax on or exempts tax from the relevant income, or imposes tax on the relevant income but at a very low rate;
  6. There is another loan or deposit contract between the creditor and a third party, of which the amount, interest rate or contract conclusion time are nearly the same as those of the loan contract, from which the interest is generated and under which the said interest is paid; and
  7. There is another contract between the applicant and the third party on the right to use or own a copyright, patent or technology apart from the contract on the transfer of the right to use or own a copyright or technology, from which the royalty is generated and under which the said royalty is paid.

It is obvious that for many foreign companies that have structured their investments into China through Hong Kong or another offshore jurisdiction, it will become much more difficult to enjoy the tax treaty benefits under these stricter rules. It should also be noted that the taxpayer will bear the burden to prove that it is indeed the beneficial owner of the said income.

Practical Consequences

While the new rules took effect immediately, there has been relatively little information available in public on how they are applied. It generally takes time for tax bureau’s across the country to first understand and then begin implementation. The new rules on beneficial ownership in particular have been applied inconsistently.

In some cases, applications for tax treaty benefits have been granted despite there being no or little substance in the operations of the non-resident beneficiary, in other instances the competent tax bureau’s have denied applications for treaty benefits on the same ground. At present, where the substantive requirements of beneficial ownership are in doubt, the ruling seems to depend very much on the tax bureau that is handling the application.

On the other hand, the general consensus is that it is only a matter of time before all tax bureau’s will start strictly applying the new rules. As such, holding companies in tax treaty jurisdictions such as Hong Kong that presently do not meet the requirements of beneficial ownership should consider how easy and convenient it would be to increase the degree of substance. Now that Notice 601 has specifically recognized management as a substantive operational activity, one option for investors could be to move certain supervisory and coordinating functions involving operations, personnel, financing and property of Chinese subsidiaries to the holding company.

When structuring or adjusting their business models, foreign companies should also consider the adverse conditions specifically listed in Notice 601. Avoiding these conditions will make it easier to preserve the benefits that are available under tax treaties. However, the cost of establishing substance should not become too high. Passive income of a non-resident that does not meet the requirements of beneficial ownership will be taxed at 10%, the rate available to companies from other jurisdictions. Thus the question becomes whether the savings benefits of tax treaty application weigh up against the additional costs of creating substance and avoiding the above adverse conditions.