On January 23, 2009, China's State Administration of Taxation (“SAT”) issued a Notice on the Issues Concerning Withholding the Enterprise Income Tax on the Dividends and Interest Paid by Chinese Resident Enterprises to Qualified Foreign Institutional Investors (“QFIIs”) (hereinafter referred to the “Notice”). The Notice clarifies some withholding tax rules relating to QFIIs under both the Enterprise Income Tax Law of China (hereinafter referred as to the “EIT Law”) and the Regulation on the Implementation of the Income Tax Law of China (hereinafter referred to as the “EIT Regulation”).  

Background of QFIIs

QFIIs play an important role in enabling non-resident investors to access certain Chinese securities markets. The QFII regime was first introduced by the China Securities Regulatory Commission (“CSRC”) and the State Administration for Foreign Exchange in 2002, the launch of which aimed at opening China’s stock market to limited investors. Under this regime, QFIIs may invest in several reminbi-denominated financial products listed in the Shanghai as well as Shenzhen stock exchanges, including shares, bonds and other financial instruments as approved by the CSRC.

Key Points of the Notice

Pursuant to both Article 3 of the EIT Law and Article 91 of the EIT Regulation, a Chinese enterprise is required to withhold 10% of any dividends or interest paid to a non-resident enterprise where the dividend or interest payment is not attributable to an office or other establishment maintained by the non-resident enterprise in China. The Notice clarifies that this 10% withholding tax is applicable to dividends and interest paid by a Chinese enterprise to a QFII, and further provides that the QFII will be directly liable for the 10% withholding tax in the event that the Chinese enterprise fails to withhold as required.

More importantly, the Notice provides that the 10% withholding rate may be reduced in the case of payments made to QFIIs that are eligible for benefits under a tax treaty to which China is a party. This is an important clarification for QFIIs that have been established in countries that have signed tax treaties with China since significantly reduced withholding tax rates may apply. For example, under the Arrangement between the Mainland of China and Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income, QFIIs formed in Hong Kong enjoy a 5% withholding rate. In addition, it is also worth mentioning that though most QFIIs function as flow-through vehicles, the Notice does not appear to condition the application of treaty benefits on the identity of the QFII's beneficial owners – instead, the Notice treats the QFIIs themselves as the beneficial owners of the relevant Chinese dividends and interest, which may provide non-resident investors with more flexibility in structuring a investments through a QFII located in a favorable jurisdiction.

Conclusion

The Notice clarifies that the 10% withholding tax rate normally applicable to payments of dividends and interest by a Chinese enterprise to a non-resident is applicable to QFIIs. Since certain issues relating to QFIIs remain unresolved (i.e., whether gains realized by a QFII on its disposal of an investment in a Chinese enterprise are also subject to a 10% tax), further clarifications can be expected from the SAT in this area.