The State Administration of Taxation of the PRC (SAT) issued a circular on July 19, 2008 to clarify three issues concerned in the implementation of Protocol II of the arrangement between the mainland and Hong Kong regarding the avoidance of double taxation. These three issues relate to the determination of what constitutes a permanent service establishment, whether a company’s properties mainly consist of real property, and the tax treatment of the transfers of a company’s equity or other interest.
The circular is called the Circular on Certain Issues Relating to the Implementation of Protocol II to the Arrangement between Mainland China and the Hong Kong Special Administrative Region on Avoidance of Double Taxation and Prevention of Tax Evasion Regarding Income Taxes (the Agreement), Guo Shui Han  No.685, Circular 685). In January 2008, China’s central government and the government of the Hong Kong Special Administrative Region signed Protocol II to the Agreement (Protocol II) to revise several provisions of the Agreement. Circular 685 clarifies certain issues that have surfaced since Protocol II took effect on June 11, 2008.
Applicability of the 183-Day Rule
Mainland China and Hong Kong are the two different tax jurisdictions concerned in the Agreement. Under the Agreement, when an enterprise incorporated in one jurisdiction provides services on a project (including consulting services) in the other jurisdiction directly or through its employees, and if the services last for a consecutive six months out of any consecutive 12 months, the enterprise will be deemed to have a permanent establishment in the other jurisdiction. In this case, the enterprise may pay taxes in the other jurisdiction on the permanent establishment’s profits. Protocol II changed the abovementioned six months stipulation to 183 days, and Circular 685 clarifies that for service activities of Hong Kong persons in the mainland, this 183-day rule only applies to service activities that start after the effective date of Protocol II. The six-month rule still applies to service activities that started before Protocol II took effect.
Calculation of the Percentage of Real Properties
The Agreement provides that the mainland may collect taxes on Hong Kong residents when these persons receive certain income on properties, and vice versa. Revised by Protocol II, the Agreement provides that one jurisdiction may collect the income tax for gains obtained from the transfer of a company’s equity, if within the three years before the equity transfer over 50 percent of the company’s properties have been composed of real properties located in the collecting jurisdiction. Circular 685 clarifies that relevant book values at the end of each tax year will be used to ascertain the relevant percentage of real properties.
Gain on Equity Transfer
Consistent with Protocol II, Circular 685 provides that a Hong Kong resident’s gain from the transfer of equity interest or other interest in a mainland company is subject to tax in the mainland if the resident directly or indirectly owned more than 25% of the equity in the mainland company at any time during the 12-month period preceding the transfer. The previous rule did not stipulate the 12- month timeframe for review of the ownership.
Circular 685 overrides any inconsistent previous interpretations on the relevant issues made by the state tax authorities.