On September 24, 2014, China Taxation News14 reported that Qinghai Provincial State Tax Bureau (“QPSTB”) denied beneficial owner status to a non-resident enterprise (“HoldCo.”) that was a tax resident of a low tax jurisdiction and collected approximately RMB18 million in dividend withholding tax from HoldCo.
The Holdco held a 90 percent equity interest in a Qinghai company that was a tax resident of China. The ultimate shareholder of the HoldCo was a Canadian Company. At the end of 2011, the Qinghai company distributed RMB180 million in dividends to HoldCo. The normal dividend withholding tax rate under Chinese law is 10%, but a reduced rate of 5% would apply by way of the tax treaty between the HoldCo’s jurisdiction and China if HoldCo was the beneficial owner of the dividends received. The Qinghai company applied for the 5% reduced withholding tax rate.
However, during the investigation, the QPSTB found that HoldCo had no fixed assets and had only five directors and five employees who were working for several companies at the same time. In addition, HoldCo did not conduct any substantive business activities beyond holding shares in the Qinghai company. HoldCo explained that as an investment management company, it primarily derived profits from its equity investments and therefore did not need a large number of assets or employees. The QPSTB did not accept HoldCo’s explanation and concluded that HoldCo was not a beneficial owner because its assets, business operations and personnel were too small to match its income.
In order to enjoy reduced withholding rates under tax treaties, the recipient of dividends, interest or royalties must be a beneficial owner. The Chinese tax notice Guo Shui Han  No. 601 issued in 2009 elaborates on this beneficial owner status and essentially requires the recipient of dividends, interest or royalties (i) to have economic substance and (ii) to own and control the relevant income. However, the rules are not clear how much substance is sufficient.
This case shows that Chinese tax authorities tend to require the recipient’s assets, business operations and personnel to match its income. In other words, the more income the recipient derives, the more substance the recipient should have. Moreover, this case shows that employees working for several companies at the same time (e.g., employees provided by an offshore company formation agent) will not be considered by tax authorities for substance analysis purposes. These positions taken by the Chinese tax authorities may make it more difficult for MNEs to qualify as a beneficial owner because a holding company predominantly engaging in equity investment generally does not have many assets, business operations or personnel.