On 1 April 2018, the Announcement of the State Administration of Taxation on Issues Relating to “Beneficial Owner” in Tax Treaties, (“Announcement 9”) came into force. It applies to both foreign and resident enterprises and individuals of Hong Kong and Macau who obtain dividends, interest or royalties from China. They can apply for a beneficial owner (“BO”) status, which will allow them to enjoy tax treaty and arrangement benefits.
BO is an important issue in relation to dividends, interest and royalties under tax treaties and arrangements. It aims to prevent treaty abuse. The China State Administration of Taxation (SAT) has released the following regulations around BO:
- SAT Circular on How to Understand and Identify the BO in Tax Treaties (“Circular 601”);
- SAT Announcement on the Determination BO in Tax Treaties (“Announcement 30” );
- SAT Opinions on Hubei State Tax Bureau and other State Tax Bureau’s Dealing with Cases Relating to Implementation of BO in Dividend Clause of Double Tax Arrangement between the Mainland China and Hong Kong; and
- SAT Announcement on Issues Relating to Identification of BO under Entrusted Investment Arrangement.
Announcement 9 combines years of practical experience of Chinese tax authorities with the latest developments in the international taxation field. It replaces both Circular 601 and Announcement 30. Major amendments have been made to the criteria and assessment of BO status.
Update 1: Expansion of the “safe harbor” for dividends
A dividends recipient may qualify for a “safe harbor” which makes them eligible for BO without undergoing a comprehensive assessment.
Previously, in Announcement 30, a dividends recipient could qualify for a safe harbor and obtain BO status automatically if they were a company listed in the other contracting state or were directly or indirectly wholly owned by a company that is a resident of and listed in the other contracting state (excluding the situation wherein its shares were indirectly held through a company that was a resident of a third jurisdiction) and its dividends were derived from shares held by the listed company. Safe harbors were allowed under these circumstances because the dividends recipient had a strong connection with its residence jurisdiction. Therefore risk of treaty abuse was low.
Announcement 9 has broadened the “safe harbor” rule to include governments and individuals as well as listed companies. The dividends recipient can automatically obtain BO status if they are:
- the other contracting state government
- a company that is a resident of and listed in the other contracting state
- an individual resident of the other contracting state; or
- directly or indirectly wholly owned by one or more aforesaid parties during 12 consecutive months before obtaining dividends.
In cases of indirect shareholding, the “safe harbor” rule requires intermediary shareholders to be either Chinese residents or residents of the other contracting states.
The following table illustrates the application of the “safe harbor” rule.
Update 2: Increased opportunities for dividends recipients to enjoy tax treaty benefits
In Circular 601 and Announcement 30, applicants were not entitled to tax treaty benefits, unless they qualified as a BO or fell within the scope of a “safe harbor”. Announcement 9 allows more dividends recipients to enjoy tax treaty benefits. It provides two situations where applicants can be deemed as a BO even though they fail to qualify as one:
- Same jurisdiction rule
If a shareholder who has directly or indirectly held 100% of the shares of the recipient for 12 consecutive months before obtaining dividends qualifies as a BO and is a resident of the same jurisdiction as the recipient, the dividends recipient can be deemed as a BO. Intermediary shareholders are not taken into account.
- Same treaty benefits rule
Even though the dividends recipient may not itself qualify as a BO, if a shareholder who has directly or indirectly held 100% of the shares of the recipient for 12 consecutive months before obtaining dividends qualifies as a BO and the shareholder and all intermediary shareholders are entitled to tax treaty benefits identical to or more favorable than what the dividends recipient would be entitled to, then the dividends recipient can be deemed to be a BO.
BO status is extended to dividends recipients because the ultimate shareholder has no incentive to establish an intermediary shareholding structure for treaty abuse purposes as the ultimate shareholder can itself be entitled to identical or more favorable treaty benefits than what the dividends recipient would be entitled to.
Update 3: Amendment of unfavorable factors for assessment of BO
Announcement 9 updates the unfavorable factors in Circular 601 for assessing whether an applicant qualifies as a BO. In its official interpretation of Announcement 9, the SAT uses positive and negative abstract cases to explain how to understand and apply the unfavorable factors listed in the Announcement.
The steps for assessing whether applicants with dividends will have the opportunity to enjoy the tax treaty benefits are summarized in the diagram below.
Other updates in Announcement 9:
- The general anti-avoidance rules (“GAAR”) override BO. If there is a need, the Chinese tax authorities can use GAAR to deny treaty benefits by applying the principal purpose test or domestic GAAR, even if the dividends/interest/royalties recipient qualifies as a BO.
- Where recipients provide backlog tax filing to Chinese tax authorities due to lack of BO status, the tax authority in charge must file records of the case with the relevant provincial tax authority. The provincial tax authority must consent before a recipient’s BO status can be revoked.
- Shareholders obtaining dividends from shares, creditors deriving interest based on creditor’s rights, and licensors collecting royalties based on licenses cannot claim they are “receiving income on behalf of others”.
- When filing records for treaty benefit entitlements, recipients must provide their tax resident certificate and those of all other involved parties. The tax resident certificates must show that each party has been a tax resident in the year or in the preceding year relating to the income.
- Compared to interest and royalties, Announcement 9 provides more opportunities for dividends recipients to enjoy treaty benefits. These include broadening the scope of the “safe harbor” and the creation of the same jurisdiction and same treaty benefits rules. Entities should reassess their shareholding structures to see whether they satisfy these new rules. If not, entities should then assess whether related party transactions are favorable or unfavorable factors. Also, records of daily business activities must be maintained to support the assessment of BO status.
- Announcement 9 has stricter requirements for unfavorable factors. For example, decreasing percentage of income to be paid to residents of a third jurisdiction from 60% to 50%, broadening the term “obligated” to refer to contractually obligated or de facto payments without contractual obligation, and changing the statement “the applicant has little or no other business activities” to “the applicant’s business activities do not constitute substantive business activities”. It is noteworthy that, the official interpretation of Announcement 9 gives multiple examples of how the tax authorities actually apply the BO rules and unfavorable factors. Companies are advised to study the sample cases carefully, and adjust their investment structures and substantiate business activities accordingly.
- Announcement 9 clearly distinguishes the relationship between the BO concept and GAAR. This clarifies for tax authorities the BO criteria and procedures, which are only applicable to dividends, interest and royalties, and the GAAR criteria and procedures which are applicable to cases such as indirect share transfer. However, a recipient qualifying as BO will not always be exempted from GAAR adjustment.
- There is still room for improvement. First, Announcement 9 continues to define BO as “one who has ownership and control over the income or the rights and property from which the income is derived”. However, this may lead to dispute over the determination of “dividends recipient” when “one who has ownership and control over the income” and “one who has ownership and control over the rights and property from which the income is derived” are not the same party. Second, Announcement 9 still applies the criterion of “substantive business activities” to unfavorable factors. Collective investment vehicles including fund management plans, investment trusts, and contractual private equity, which have been gaining momentum recently, are mainly engaged in passive investment activities. Whether they will satisfy the standard of “substantive business activities” to qualify as BO remains unclear.