On 28 March 2014, China and Germany signed a new double tax treaty (“Treaty”) that will replace the previous treaty concluded in 1985 (“Old Treaty”). The ratification procedures are still pending, and the Treaty has not yet entered into force.
Similar to the changes in other tax treaties recently renegotiated by China (with, for example, the United Kingdom, Belgium, the Netherlands, Switzerland, and France), the Treaty makes the following favorable changes for China inbound investment coming from Germany:
Withholding taxes on dividends paid by a Chinese company to a (direct) German parent company or vice versa will be reduced from 10% to 5%.
The Chinese royalty withholding tax rate will be reduced from 7% to 6% for specific types of royalties, like the right to use industrial, commercial or scientific equipment.
China is permitted as a source state to tax capital gains on the disposal of shares, provided the German (direct or indirect) shareholder owns at least 25% of the shares in the disposed Chinese subsidiary. Nevertheless, the sale of shares in listed companies will be exempt from taxation on Chinese source state capital gains. Under the Old Treaty, there are no exceptions to the taxation of source state capital gains on the disposal of shares.
The minimum period to create a construction permanent establishment (“PE”) will be increased from 6 months to 12 months.
The resident state will have the exclusive right to tax other income. Under the Old Treaty, China reserves the right to tax other income items if they are sourced in China under Chinese domestic law.
Moreover, similar to the changes in tax treaties renegotiated by China with other nations in recent years, the Treaty also contains a provision that expressly allows the application of domestic anti-avoidance rules and a provision that addresses cross-border assistance in the collection of taxes.
In addition, the Treaty contains a general anti-avoidance rule. The general anti-avoidance rule disallows the Treaty benefits if (i) the main purpose for entering into a certain transaction or arrangement is to secure the Treaty benefits and (ii) granting those benefits would be contrary to the object and purpose of the relevant provisions of the Treaty. To date, the Treaty is only the third tax treaty signed by China to contain a general anti-avoidance rule. The other two treaties with a general anti-avoidance rule are the new China-France treaty signed on 26 November 2013 and the China- Czech treaty signed on 28 August 2009.
The following new additions in the Treaty are also worth noting:
The Treaty has a new article that expressly allows China to apply the withholding tax rate provided under its domestic law. The tax withheld in China will be refunded when the taxpayer applies to receive the treaty benefits. This change corresponds to China’s current practice, which only allows a foreign taxpayer to receive a reduced withholding tax rate on dividends, interest or royalties if approved by a PRC tax bureau.
In the protocol of the Treaty, China expresses its willingness to refer to the OECD Model Commentary (2008) in interpreting and applying Article 7 of the Treaty. This expression of reliance on the OECD Model Commentary is somewhat unusual because China is not an OECD member. China does not have domestic rules to address
profit attribution to a PE, so it usually taxes the PE of a foreign company on a deemed profit method. It remains to be seen whether the Treaty will have any impact on profit attribution to the PE of a German company in China.
By adopting the same changes found in other recently renegotiated tax treaties, the Treaty provides further evidence of the transition in China’s tax treaty regime towards a uniform withholding tax rate of 5% on cross-border dividends. And the Treaty also shows that China is committed to preventing abuses of tax treaty benefits by identifying and adjusting improper tax arrangements. These trends demonstrate that China favors direct investment from foreign companies with substantial business operations over indirect investment through the use of a special purpose vehicles located in low tax jurisdictions