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:
It owns or controls the income or
the rights or assets from which the income is derived;
It must also be engaged in
substantial business activities; and
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:
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;
The applicant has no or minimal
business activities;
The applicant’s assets, scale of
operations and deployment of personnel are not commensurate with its
income;
The applicant has no or minimal
control and decision-making rights, and does not bear any risk;
The applicant has non-taxable
income or is subject to a low effective tax rate;
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.
.
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:
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
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:
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;
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;
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.
