The People’s Republic of China (PRC) State Administration of Taxation (SAT) recently issued two interpretive tax circulars which are likely to have an impact on international tax planning by foreign investors for their China-related investments.
- State Administration of Taxation Defines Beneficial Owner
The SAT set forth guidelines for determining beneficial owner status under tax treaties in its Circular on How to Interpret and Recognize the “Beneficial Owner” in Tax Agreements (Guo Shui Han  No. 601) (“Circular 601”) issued on October 27, 2009.
Tax treaties between China and foreign countries (including the tax arrangements entered into by Mainland China with Hong Kong and Macao; hereinafter collectively referred to as Tax Agreements) have long contained the concept of a “beneficial owner.” For example, in the Agreement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, (which is the Tax Agreement between Mainland China and Hong Kong), the Chinese withholding tax rate on the payment of dividends may be reduced to a 5 percent rate from the statutory 20 percent rate if the “beneficial owner” of the PRC payor is a Hong Kong company which owns at least 25 percent of the payor. Chinese withholding taxes on interest and royalty payments are similarly entitled to a reduced withholding rate of 7 percent if the “beneficial owner” is resident in Hong Kong. However, the Mainland-Hong Kong Tax Agreement and other Tax Agreements do not contain a definition of “beneficial owner.”
Circular 601 generally defines the term “beneficial owner” to be a person who has ownership or control over income or the rights or property from which income is derived. The Circular states that beneficial owners, in general, engage in substantive business activities and may be individuals, companies or other entities.
However, agents and “conduit companies” are not beneficial owners. Circular 601 identifies a “conduit company” as being a company that is established for the purpose of avoiding or reducing taxes, or diverting or aggregating profits. According to the Circular such companies are only registered in their jurisdiction of incorporation to satisfy the organizational form required by law and do not engage in manufacturing, distribution, management or other substantive business activities in this jurisdiction.
Circular 601 indicates that the determination of a person’s status as a beneficial owner cannot be determined solely from the technical aspects or from the perspective of domestic laws, but also should be considered from the objectives of the Tax Agreements (namely the avoidance of double taxation and prevention of fiscal evasion). In determining beneficial owner status the Circular provides that an analysis should be conducted and a determination reached based on the principle of “substance over form” while taking into account the actual circumstances of the specific case.
The Seven Factors Not Supporting Recognition as a Beneficial Owner
In addition to providing a general description of the type of person who would be entitled to recognition as a beneficial owner Circular 601 identifies the following seven factors as not supporting recognition of an applicant’s status as a beneficial owner.
- The applicant is obliged to pay or distribute all or the great majority (e.g., at least 60 percent) of the income to residents of a third country (or region) during a specified period of time (e.g., within 12 months of receipt of the income).
- The applicant has no or almost no business activities other than holding the property or rights from which the income is derived.
- Where the applicant is a company or other such entity, its assets, scale and staffing are small (or few) and are out of proportion to the amount of income.
- The applicant has no or almost no control over, or right to dispose of, the income or the property or rights from which the income is derived, and bears no risk thereof or rarely bears risk.
- The contracting state (region) does not tax or exempts tax on income or, although it does levy tax, the actual tax rate is very low.
- In addition to the loan contract on the basis of which interest is generated and paid, there is another loan contract or deposit contract between the creditor and a third party that is similar in amount, interest rate and time of execution.
- In addition to the contract for the transfer of the right to use a copyright, patent, technology, etc. on the basis of which royalties arise and are paid, there is another contract concerning the transfer of the right to use, or the ownership of, the relevant copyright, patent, technology, etc. between the applicant and a third party.
The Circular provides that a taxpayer applying for beneficial treatment under a Tax Agreement must submit documentation evidencing its status as a beneficial owner with reference to the factors set forth above.
Further Clarification of the Seven Factors
While Circular 601 provides some useful guidance on beneficial owner status it is likely that a number of criteria specified by the Circular to determine beneficial owner status will themselves need further clarification. Among others, what constitutes a “very low actual tax rate”? (See item 5 above.) Secondly, how does one determine that “a company’s assets, scale and staffing are small (or few) and are out of proportion to the amount of its income”? (See item 3 above.) Finally, must the income recipient avoid meeting all seven factors to be considered a beneficial owner? If the presence of less than all factors will disqualify a recipient from beneficial owner status how much relative weight will be given to the different factor?
Circular 601 may eliminate the withholding tax advantages of using a Hong Kong holding company to operate businesses in the PRC. Under the Hong Kong-Mainland China Tax Agreement, withholding taxes payable on dividend, interest and royalty payments to eligible Hong Kong persons are reduced to 5 percent, 7 percent and 7 percent, respectively. Most Tax Agreements between China and other countries (including the United States) reduce such withholding rates to 10 percent from the PRC statutory rate of 20 percent. So, structuring an investment in China through Hong Kong in theory could, in many instances, offer the advantage of lower withholding tax rates. However, in light of Circular 601 it now appears that this benefit may no longer be available if a Hong Kong company holding China investments is not otherwise engaged in significant business activity in Hong Kong.
- Tax Imposed on a Foreign Company From Sale of Investments in China
The SAT addressed the issue of taxes payable by a nonresident owner in connection with the transfer or sale of an equity interest in an unlisted Chinese company in its Circular Concerning Strengthening the Enterprise Income Tax Administration of Income from the Transfer of Shares by Nonresident Enterprises (Guo Shui Han  No. 698) (“Circular 698”) issued on December 15, 2009. The Circular applies retroactively to January 1, 2008. Circular 698 may have a significant impact on companies that use intermediate offshore holding companies to invest in China because it contemplates the possible taxation of gains derived by a foreign company from the indirect sale of Chinese assets.
Main Points of Circular 698
Circular 698 provides for the taxation of income derived by a nonresident company from the transfer of an equity interest in a PRC resident enterprise (a direct transfer). It specifically excludes from its scope of application any gain from the purchase and sale of listed Chinese stocks.
If the withholding agent (generally the payor) fails to fulfill its withholding obligations with respect to the equity transfer, the nonresident company must file and remit enterprise income tax within seven days after the date of the equity transfer specified in the equity transfer contract or agreement.
Taxable gain on the equity transfer will be determined based on the difference between the consideration paid for the equity interest transferred and the cost of the equity interest, without taking into account any undistributed profits and reserves of the Chinese resident enterprise being transferred.
Circular 698 also imposes a filing obligation on a nonresident investor when transferring its indirect equity interest in a PRC resident enterprise if the actual tax burden in the jurisdiction of the direct owner of the equity interest being transferred is less than 12.5 percent, or if the jurisdiction in which the owner is resident provides an income tax exemption for foreign-source income. The indirect nonresident investor must submit the following documentation to the Chinese tax authorities within 30 days after the equity transfer agreement is concluded:
- the equity transfer agreement
- the relationship between the nonresident investor and the offshore intermediary holding company being transferred in connection with fund, operation and sale
- production and operation, staff, finance and assets of the offshore intermediary holding company being transferred
- the relationship between the offshore intermediary holding company being transferred and Chinese residents in connection with fund, operation and sale
- a statement that establishment of the offshore intermediary holding company being transferred has a reasonable commercial purpose
- other relevant documents that may be required by the tax authority
For example, if a U.S. investor holds its interest in a PRC business through an intermediate holding company and subsequently sells its interest in the intermediate holding company to a third party, it may have an obligation to comply with the documentation requirements if the tax criteria of the holding company’s jurisdiction of incorporation are met. It would appear on its face to impose a filing obligation on companies organized in many tax havens, but also for example, Hong Kong, which does not tax foreign-source income.
Circular 698 does not provide any guidance as to how one determines the actual tax burden in the jurisdiction of the offshore intermediary holding company.
In addition to providing for a filing obligation, the Circular also provides that the Chinese tax authorities may disregard the existence of the direct owner, the intermediate holding company, if it lacks a valid business purpose and was established to avoid tax.
It is unclear what criteria the tax authorities will use to determine that an offshore holding structure lacks proper business purpose and was established to avoid tax. It also remains to be seen how the tax authorities will be able to enforce Circular 698 when a foreign company is involved and what will happen if the nonresident seller fails to make the filing required by Circular 698. Unless these issues are clarified, it will likely add an additional layer of tax exposure uncertainty in acquisitions involving China businesses. An aquiror of an offshore company that has a China business may well end up finding its newly acquired offshore or PRC subsidiary being held liable for taxes in respect of the offshore seller’s gain on the disposition of its interest in an offshore intermediate holding company.