Nonresident enterprises have long invested in outstanding shares issued by Chinese listed companies, which are Chinese resident companies listed on domestic and overseas stock exchanges. Those shares generally are classified into different types, including but not limited to A shares, B shares, H shares, N shares and so on, although only the qualified foreign institutional investors (“QFIIs”) among nonresident enterprises have been granted access to the investment in A shares. Nonresident enterprises are expected to receive dividends and capital gains on the equity investment. Nevertheless, the tax treatment of those dividends and capital gains has remained murky to nonresident enterprises for many years.
Initially, nonresident enterprises were exempted from the withholding tax (“WHT”) with respect to dividends and capital gains derived from B shares and overseas-listed shares under Guoshuifa  No. 45. In practice, such exemption applied to dividends and capital gains derived from A shares as well. The Enterprise Income Tax Law (“EITL”), which became effective on January 1, 2008, has largely changed the landscape. Although the EITL does not directly address the WHT on dividends and capital gains received by nonresident enterprises from the publicly listed shares, several tax circulars issued afterwards have provided muchneeded clarity. In less than two years, the State Administration of Taxation (“SAT”) issued the following:
- Guoshuihan  No. 897 (“Circular 897”) issued on November 6, 2008 dealing with the WHT on dividends from H shares (please refer to our China Tax Bulletin December 2008);
- Guoshuihan  No. 47 (“Circular 47”) released on January 23, 2009 addressing the WHT on dividends paid to the QFIIs (please refer to our China Tax Bulletin February 2009); and
- Guoshuihan  No. 394 (“Circular 394”) issued on July 24, 2009 responding to a question raised by the Shanghai State Taxation Bureau regarding the WHT on dividends from A shares, B shares and overseas-listed shares.
The three circulars have made it clear that nonresident enterprises are subject to a 10 percent WHT on “dividends for 2008 and beyond” received in respect of A shares, B shares and overseaslisted shares issued by Chinese resident companies. The WHT rate could be reduced by an applicable tax treaty. It is worth noting that the tax treatment of capital gains on those shares is left unaddressed by Circulars 897, 47 and 394. The issuance of the three circulars, however, did not bring about the broad compliance of the tax withholding. On May 6, 2010, the SAT released Guoshuihan  No. 183 (“Circular 183”) to strengthen the tax compliance in this area.
Examination on the WHT Registration
Prior to the issuance of Circular 183, Guoshuifa  No. 3 (“Circular 3”) was adopted by the SAT on January 9, 2009 to provide for the requirements on the WHT registration (please refer to our China Tax Bulletin February 2009). Under Circular 3, a Chinese listed company is required to act as a withholding agent for nonresident enterprises upon the distribution of dividends. The Chinese listed company must file a WHT registration and maintain the detailed record for the WHT payment. Circular 183 essentially requires the local tax authorities to make a comprehensive examination on the fulfillment of the tax withholding obligations on the part of Chinese listed companies.
Failure to Discharge the WHT Obligations
Before nonresident enterprises even receive the dividends, a Chinese listed company can easily withhold the amount of tax and remit it to the local tax authorities. Since nonresident enterprises do not necessarily have any other nexus with China, it is imperative for the Chinese listed company to properly discharge its WHT obligations. Otherwise, it would likely lead to a permanent loss of tax revenue to China.
If a Chinese listed company fails to fulfill its WHT obligations, the relevant enforcement procedures would become applicable. Under Circular 3, a nonresident enterprise will be required to settle the WHT on its own within seven days of receiving the dividends, given its withholding agent’s failure to do so. Circular 183 clearly points to a different direction. Pursuant to Circular 183, a Chinese listed company would not only need to correct its withholding failure within the designated time frame, but also face potential penalties and late payment interest. The question is which one will be the easier target for the local tax authorities. Without a clear legal mandate, the local tax authorities are more likely to go after a Chinese listed company.
Term of “Dividends for 2008 and Beyond”
This particular term is subject to two interpretations. The term could only refer to the dividends distributed out of profits earned in 2008 and beyond. According to Caishui  No. 1, for a foreigninvested enterprise, dividends distributed out of profits earned in 2008 and beyond will be subject to a 10 percent WHT, while dividends distributed out of pre-2008 profits are exempt from the WHT. It is unclear whether the same tax treatment would stand with respect to dividends distributed to nonresident enterprises by a Chinese listed company.
Alternatively, the term could mean the dividends actually decided and distributed in 2008 and beyond, regardless of whether they come from pre-2008 profits or not. This interpretation is consistent with the term’s plain meaning and the EITL Implementation Rules. Unfortunately, the SAT has not yet come up with a definitive explanation on this term.
Clarity Still Missing on Capital Gains
The EITL threw the uncertainty into the tax treatment of capital gains derived by nonresident enterprises on shares issued by a Chinese resident company. Theoretically, those capital gains should be subject to a 10 percent WHT upon the disposition of the shares. In practice, capital gains derived by nonresident enterprises would be treated differently, depending on whether the shares are publicly listed or not.
If the shares are not publicly listed anywhere, capital gains derived from the disposition are indeed subject to a 10 percent WHT. On December 10, 2009, the SAT specifically released Guoshuihan  No. 698 (“Circular 698”) to address the tax treatment of capital gains derived by nonresident enterprises on direct and indirect transfers of the non-listed shares issued by a Chinese resident company (please refer to our China Tax Bulletin February 2010). Under Circular 698, nonresident enterprises are taxed on any direct transfer of the non-listed shares, while an indirect transfer of the non-listed shares must be reported to the local tax authorities.
If the shares are publicly listed, nonresident enterprises are de facto exempt from the WHT on capital gains derived from the dispositions. Circular 698 does not apply to capital gains derived by nonresident enterprises on the transfer of the publicly listed shares issued by a Chinese resident company. Neither previous tax circulars on dividends nor Circular 183 provides any guidance on the tax treatment of capital gains on the disposition of the publicly listed shares by nonresident enterprises.
Such bifurcation of the tax treatment on capital gains has caused some concerns among nonresident enterprises, including the QFIIs. The SAT is expected to issue new tax circulars to provide for some guidelines, although there is no indication on when and how it would make such a move. Some outstanding issues are as follows:
- Whether capital gains derived from the disposition of the publicly listed shares issued by a Chinese resident company will be exempt from the WHT on the part of nonresident enterprises?
- If there is no exemption of the WHT, what will be the required compliance measures?
- Will there be any withholding agent? If so, who should act as the withholding agent? Since the dispositions of the overseas-listed shares take place outside China, there is virtually no way to designate any withholding agent.
- How to enforce the WHT compliance, especially because some nonresident enterprises might have no tax registration or presence in China?
Enforcement in Action
Circular 183 requires the local tax authorities to report on the examination results to the SAT before June 30, 2010. In particular, the report on the WHT over dividends from B shares is due before June 10, 2010. Chinese resident companies must make up past withholding deficiencies, plus some potential penalties as well as late payment interest assessed at 0.05 percent of the underpayment per day from the supposed WHT payment date.