The Articles of the Organization for Economic Co-operation and Development Model Tax Convention (“OECD Articles”) address the taxation of prescribed passive income (i.e., dividends, interest and royalties). Under the OECD Articles, the recipient of an item of such passive income must be the Beneficial Owner (“BO”) of that income in order to enjoy the benefits available under the relevant treaty. However, neither the OECD Articles nor their commentary have provided a clear definition of the term. Consequently, the lack of a universal and precise meaning of the term BO in a treaty context has given rise to inconsistent interpretation and application of the term.

According to Guoshuifa [2009] No.124 (“Circular 124”), for the purpose of claiming treaty benefits, an approval-based application procedure is used for passive income (namely dividends, interest and royalties). In addition, the China State Administration of Taxation (the “SAT”) issued Guoshuihan [2009] No. 601 (“Circular 601”) and SAT Announcement [2012] No. 30 (“Announcement 30”), which establish the SAT’s interpretation of the term BO for the purpose of granting treaty benefits under Sino-foreign tax treaties.

Circular 601

The term BO refers to a person who has the right of ownership and control over an item of income, or the right or property from which that item of income is derived. A BO generally must be engaged in substantive business activities and may be an individual, a corporation or any other group.

Agent or conduit companies

An agent or conduit company is not regarded as a BO if the entity is considered a “conduit company”(and therefore does not qualify for treaty benefits). A conduit company normally refers to a company that is set up for the purpose of avoiding or reducing tax or transferring or accumulating profits. Additionally, conduit companies are generally those that are registered in their country of residence merely to satisfy the legal requirements of tax residence and are not companies that engage in substantive activities such as manufacturing, sales and management.

Specific factors to assist in determining BO status

The presence of the following factors could negatively affect an applicant’s status as a BO:

  1. The applicant is obliged to distribute most of its income (e.g., more than 60%) to a resident of a third country within a prescribed time period (e.g., within 12 months from the date of receipt);
  2. The applicant has no or minimal business activities;
  3. Where the applicant is an entity such as a corporation, its assets, scale of operations and deployment of personnel are not commensurate with its income;
  4. The applicant has no or minimal control and decision-making rights, and does not bear any risks;
  5. The income of the applicant is nontaxable or, if subject to tax, is subject to a low effective tax rate;
  6. In the case of interest income, there is a loan or deposit contract between the applicant and a third party, the terms of which (i.e., the amount, interest rate, signing dates) are similar or close to those of the loan contract under which the interest income is received; and
  7. In the case of royalty income, there is a license or transfer agreement between the applicant and a third party, the terms of which are similar to the terms under which the royalty income is received.

When a taxpayer applies for treaty benefits, it will need to provide documentation to the local tax authority to support its claim as being the BO of the relevant income.

Announcement 30

With regards to assessing the BO status of treaty resident applicants that have passive income derived from China, Announcement 30 emphasizes that each of the seven factors listed above should be comprehensively considered when assessing BO status. BO status should not be denied simply because one of the seven unfavorable factors exists. However, BO status also should not be granted simply because an applicant has not demonstrated any motivation to avoid or reduce their tax burden.

Documents and evidence

Tax authorities consider a wide range of key documents and evidence in analyzing the factors under Circular 601. Such evidence includes articles of association, financial statements, board minutes and resolutions, functional analyses, legal contracts, asset ownership certificates and invoice registers.

Safe-harbor rule

In the case of dividend income, Announcement 30 provides a safe-harbor rule allowing those qualified listed companies with Chinese subsidiaries to be directly or indirectly accepted as a BO without the need to go through the vetting process. The safe-harbor rule requires that the immediate recipient of the China-sourced dividend, the listed company and the intermediate holding companies, if any, must be 100% related and tax resident enterprises of the same treaty jurisdiction.

Tentative denial

In situations where the Chinese tax authority receiving the application for the treaty benefit is not able to accurately determine the BO status of the applicant within the prescribed timeframe, it may tentatively deny the treaty benefit application and collect the China tax in full. However, if the applicant is eventually assessed and granted BO status and, thus, becomes entitled to the treaty benefit, the Chinese tax authority should refund the overpaid tax.

Authority to deny BO status

Only provincial-level tax bureaus have the authority to deny BO status.