NEWS
Jan-04-2010 Chinese State Administration of Taxation Issues New Guidelines About Passive Income
By Debby Davidson, AFP Group
In a previous client briefing note, we advised that from 1 October 2009, any claim of double tax treaty benefits by tax residents of tax treaty countries/regions (collectively called “treaty residents”) in respect of passive income (namely dividends, royalties, interest and capital gains) derived from China is subject to approval by the authorised Chinese tax authorities, pursuant to tax circular Guoshuifa [2009] No.124 (“Circular 124”) from the Chinese State Administration of Taxation (“SAT”).
While Circular 124 focuses mainly on the procedural requirements, the PRC State Administration of Taxation has issued another tax circular, Guoshuihan [2009] No. 601 (“Circular 601”), relating to the substantive requirements for the determination of "beneficial ownership" for the purpose of claiming DTA benefits by Treaty Residents in respect of Articles of Dividends, Royalties, and Interest under the DTAs (collectively called “DTA Passive Incomes”).
Definition of “Beneficial Owner”
According to a previous circular, in order to enjoy double tax treaty benefits on dividends, the Treaty Resident had to be the beneficial owner of the dividends. Prior to Circular 601, however, there was no explanation as to the circumstances in which a Treaty Resident would be regarded as a beneficial owner. Circular 601 provides for the following:
1. Extension of “Beneficial Owner” - The previous circular about the concept of “beneficial owner” only uses the concept in relation to dividends. Circular 601 confirms that the concept of Beneficial Owner is crucial whenever a Treaty Resident applies for treaty benefits in respect of dividends, interests, royalties etc.
2. Control - A “Beneficial Owner” is an individual, company or other organisation that has the ownership and control over the relevant income in question (e.g. dividends, interests, royalties etc.), or has the ownership and control over the assets or rights employed for the purpose of generating the relevant income.
3. Genuine Business Operations - As a “Beneficial Owner” will generally conduct genuine business operations, agents and conduit companies are not regarded as “beneficial owners”. Conduit companies are referred to in Circular 601 as companies that are established for the purpose of avoiding tax, reducing tax, transferring profits or accumulating profits. Such companies are only established in the corresponding jurisdictions to fulfill the legal requirements as a formality, but they do not conduct actual business operations such as manufacturing, sales, management, etc. It would seem that an “intermediate holding company” established for pure investment holding purposes would be seen as a conduit.
Factors that may jeopardise the recognition of a Treaty Resident as a Beneficial Owner
Circular 601 takes a “substance over form” approach when determining whether a Treaty Resident is seen as a “beneficial owner”.
The following factors could prevent a Treaty Resident from being recognised as a beneficial owner:
1. The Treaty Resident applying for treaty benefits (“the applicant”) is obligated to remit most of the relevant income (say, above 60% of the income) to the third country/jurisdiction residents within an agreed timeframe (for example, within 12 months of the receipt of the particular income).
2. Apart from owning and controlling the assets or rights employed to generate China-sourced income, the applicant conducts no other (or almost no other) business operations.
3. In case the applicant is an entity (such as a company), the entity only has a limited amount of assets, a limited operating scale and a small number of employees, and the above do not match with the income generated.
4. The applicant does not have control over the assets or rights employed to generate the relevant income, and it bears no or almost no risks associated with the assets or rights.
5. The relevant income from China received by the applicant is either exempt from tax in the jurisdiction where it is located, or the effective tax rate is very low.
6. In case the China-sourced income is interest income generated from a loan agreement, the applicant (as a lender) has entered into other loan agreements or deposit agreements with another party with a similar amount, interest rate and signing date.
7. In case the China-sourced income is royalty income generated from a contract granting a Chinese entity the right to use the copyright, patent, technology etc., the applicant (as the granting party) has entered into other contracts with another party for the purpose of acquiring the ownership or the right to use the relevant intangible assets.
Our Observations
The SAT has delegated the assessment and determination of whether the Treaty Resident is a “beneficial owner” to the local-level tax bureaus, which may refer more complicated cases to the International Tax Department of the SAT.
The determination of “beneficial ownership” is not straightforward and demands extensive knowledge about DTAs and international tax practice. Whilst the local-level tax bureaus should assess a structure based on a totality of facts, it may be that in practice, local-level tax bureaus may not observe the totality of the facts and may raise challenges based on just one or two of the seven factors listed above.
Unfortunately, Circular 601 does not provide sufficient guidelines as to what types of documentation the Treaty Residents should submit to prove their beneficial ownership. The SAT has left the detailed administration of Circular 601 to the discretion of the local-level tax bureaus. Whilst it would be a nightmare to come up with a standardised checklist of the documentation, because each case has its own unique facts and circumstances, we are concerned that the absence of any direction could give rise to clumsy administration as well as disputes between local-level tax bureaus and Treaty Residents.