A Primer of China's Anti-treaty Shopping Regime

Tax treaties are often abused by way of setting up shell companies in a treaty state in order to enjoy the tax benefits under the tax treaty between that treaty state and the source state. This is neatly named “treaty shopping”.

Some anti-treaty shopping provisions are embedded in tax treaties. The requirement of being a “beneficial owner”, for example, the fulfillment of which entitles foreign investors to preferential withholding tax rates, is prevalent in most modern tax treaties in force. How such a “beneficial owner” is determined, on the other hand, is subject to domestic laws and the discretion of tax authorities of each tax jurisdiction, which plays a much larger part in cracking down on treaty shopping, or to invoke a trendy term, “BEPS” (Base Erosion and Profit Shifting).

This article serves as a primer of the legislative development of China's anti-treaty shopping regime over the past 5 years.

Circular 601

In 2009, the State Administration of Taxation (“SAT”) of China issued Circular on How to Determine the “Beneficial Owner” in Tax Treaties (Guoshuihan [2009] No.601 or “Circular 601”), and thereby brought the concept of “beneficial ownership” into China’s domestic law. As one of China’s earliest attempts to cramp down on treaty shopping, Circular 601 provided the legal authority and rules of thumb for China's local tax authorities in determining whether a tax treaty applicant qualifies as beneficial owner so as to grant preferential withholding tax rates on royalties, interest or dividends paid or payable to that applicant.

Endorsing the “substance over form” principle, Circular 601 defined “beneficial owner” (“BO”) in the following terms:

1. It owns or controls the income or the rights or assets from which the income is derived;
2. It must also be engaged in substantial business activities; and
3. It does not include an agent or a “conduit company”, incorporated for the purpose of avoiding or reducing taxation, transferring or accumulating profit without any substantial business activities.

It also identified 6 “adverse factors”, the presence of which should negatively affect the application for beneficial ownership:

1. The applicant has an obligation 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. The applicant’s 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 risk;
5. The applicant has non-taxable income or 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 are similar or close to those of the loan contract under which the interest income is received; and
   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.

Announcement 30

Three years after the issuance of Circular 601, the SAT sought to clarify what it meant therein by releasing “Announcement Regarding Determination of Beneficial Ownership under Tax Treaties” (SAT Announcement [2012] No.30, or “Announcement 30”) . The following constitute the gist of this announcement.

Article 1 - “Totality of factors” approach

Article 1 emphasized a “totality of factors” approach in determining beneficial ownership. That is, regards should be had to all 6 “adverse factors” listed in Circular 601. And none of the 6 factors has the status of a “super factor”, the existence of which supposedly leads to an automatic denial of the beneficial ownership status. Neither is a strong case for a lack of “the objective to avoid or diminish tax revenue, shift or accumulate profits” (the very words that Circular 601 used to define a “conduit company”) per se sufficient for an applicant to put forth in order to qualify as a beneficial owner.

Article 3 - “Safe harbour” Rule

Article 3 is in effect a “safe harbour” provision regarding dividend payments, the fulfillment of which shall be followed by a “reflex action” of granting the beneficial owner status, without the pain of having to go through the 6 “adverse factors”.

Article 3 describes two scenarios which will comply with the “safe harbour” rule.

Scenario 1:

In Scenario 1, the applicant company will be granted the beneficial owner status if it is a listed company and tax resident in the contracting jurisdiction.

Scenario 2:

In spite of the lengthy drafting which renders the second limb of Article 3 somewhat baffling, Scenario 2 appears to be the case where the applicant company, being a tax resident of and listed in the contracting jurisdiction, holds 100% of the shares of the Chinese company, either directly or indirectly. And in the case of indirect shareholding, the intermediary holding entities (between the applicant and the Chinese company) are subject to the additional condition that they shall be tax residents of either China or the contracting state.

Article 4 - “Look-through” treatment for agency arrangement

Article 4 provides that where an “agent or designated payee” receives income, in an agency or nominee capacity for the applicant company (the principal), this should not affect the identification of the true beneficial owner. And whether the agent or designated payee is a tax resident of the contracting jurisdiction is irrelevant. However, the “agent or designated payee” shall disclaim its beneficial ownership local tax authorities in writing. A sample form to make such a disclaimer is also attached to Announcement 30.

Circular 165

Less than a year later, in 2013 the SAT issued Opinion Letter on the Determination of Beneficial Ownership Cases under the Dividend Article of the PRC-HK Double Taxation Arrangement (Shuizonghan [2013] No.165, or “Circular 165”) in response to several provincial and municipal state tax bureaus' requests to ascertain the BO statuses of a handful of Hong Kong applicants. Circular 165 re-affirmed the “totality of factors” approach and shed more light on how the 6 “adverse factors” should be assessed.

Article 1 - profits retention

Article 1 clarified that, the beneficial owner status of the applicant should not be adversely affected where the applicant does not make any distribution to a non-HK tax resident.

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Article 2 – Business activities

A single-investment holding company should not be denied its beneficial owner status solely based on this adverse factor that it was set up for only one project. The presence of other factors, or the lack thereof, should be taken into account as well.

Article 3 – Assets

Tax authorities should not equate “assets” with the registered capital of the applicant. They should consider other sources of funding of, and risks born by, the applicant.

Also tax authorities should not only consider the number of staff and the size of staff costs of the applicant in assessing whether its staffing level is commensurate with its income. They should also take into account the responsibilities and nature of the work of the staff.

Article 4 - Rights of control and disposal

The mere fact that the applicant’s shares are controlled by a higher-level corporation should not negate the existence of rights of control or disposal of the applicant.

Article 5 – Home jurisdiction taxation

The fact that offshore income of a HK applicant company is exempt from HK Profits Tax under HK's territorial tax system should not have a negative implication for determining the beneficial ownership of the income. The applicant's actual tax filing in HK of its income other than that paid by the Chinese company should be taken into account.

Article 6 – clarification of the “safe harbour” rule

Also, Article 6 of Circular 165 served to correct the misinterpretation (and, in some unfortunate cases, misapplication) on the part of some local tax authorities of the “safe harbour” rule introduced in Announcement 30. Since the legislative intent behind the “safe harbor” rule was to provide relief, instead of imposing more restrictions, a failure to comply with the “safe harbor” rule does not in itself means a denial of the beneficial owner status altogether. Article 6(1) provides that there shall not be a “ reflex action” of denying its beneficial ownership if the applicant is directly or indirectly 100% owned by a non-listed HK Company, or that intermediate offshore companies were incorporated in jurisdictions other than Hong Kong and China.

Announcement 53

The SAT issued Announcement on Determining Tax Residency Status under the PRC-HK DTA (SAT Announcement [2013] No.53, or “Announcement 53”) to streamline the procedures when HK applicants are trying to apply for tax benefits under the PRC-HK DTA.

Announcement 53 freed HK applicants of the burden of producing Certificates of Resident Status if they were incorporated or registered in HK. Instead, incorporation or Business Registration Certificates should suffice, unless, inter alia:

1. the PRC tax authorities are suspicions of, and deem its submitted information insufficient to prove, an applicant’s claimed resident status, including the case where the applicant company was incorporated outside of HK but claims to have its management and control in HK; or
2. the applicant intending to apply for its beneficial owner status under the “safe harbour” rule pursuant to Announcement 30.

Announcement 53 also clarified the application procedure for a HK Certificates of Resident Status in which an applicant would need a referral letter issued by the PRC tax authorities to apply for the certificate from the HK Inland Revenue Department.

A word of caution: Announcement 53 is only applicable to tax treaty relief claims by HK residents under the PRC-HK DTA, and should not be taken as binding on claims under China's tax treaties with other jurisdictions. This is but one legislative manifestation of the central government's preferential treatment towards Hong Kong, its long estranged, unruly son.

Announcement 24

The latest piece of legislation is a further supplementary clarification on the issue of determining beneficial owners. Announcement on Determining Beneficial Ownership for Entrusted Investments (SAT Announcement [2014] No.24, or “Announcement 24”) was released for “entrusted investments” arrangements where applicants entrust their investment funds with “Overseas Professional Institutions” which charge commissions or service fees from the former. Investment income and risks rest sole with applicant companies.

The rules for determining beneficial ownership for entrusted investments are as follows:

1. If the nature of the investment income is dividend or interest, and that nature does not change when remitted layer by layer to the non-resident applicant, as proved by documentary evidence, then the applicant shall be deemed the beneficial owner;
2. If any entity (other than the applicant) on the chain of investment charges any expenses and remuneration related to the dividend or interest, then the applicant shall not be deemed the beneficial owner;
3. If the nature of the investment income is capital gain, or other income to which the beneficial ownership rules do not apply, then the income shall be treated according to the relevant provisions in the DTA.

Conclusion

By trial and error, public consultations and public outcries, China gradually fine-tuned its approach to tackling anti-treaty shopping and anti-avoidance, enhancing legal certainties and raising cross-border investors' confidence along the way. Rest assured that more “announcements” are down the road, clearing the anti-avoidance regime for the pros, while muddying the water for the laymen.