China double tax arrangements: New paths emerge
The past year has seen a further evolution in China’s tax treaties, in particular in integrating impactful BEPS permanent establishment (PE) changes. The maturity of work on global tax reforms hints at more profound changes ahead, write Chris Xing and Conrad Turley.
Over recent years there had been something of a lull in the signing of significant tax treaties by China. This situation shifted in 2018 and 2019, with China signing new treaties, and entering protocols to existing treaties, with a number of jurisdictions. These included India, New Zealand, Italy, Spain, Angola, Argentina, Congo and Gabon, as well as a substantial new fifth protocol to the Hong Kong SAR double tax agreement (DTA).
A number of key developments are in evidence, and these are best understood in tandem with the accompanying article: The age of reason(ableness): Economic shifts impact China's cross-border tax enforcement.
BEPS PE updates
As noted in last year's publication, while China did sign the BEPS multilateral instrument (MLI) in 2017, it opted to make the minimum updates possible: namely, the principal purpose test (PPT) and associated new DTA preamble. Notably, China did not opt for the BEPS PE updates. However, in the new treaties and protocols entered into recently, many of the BEPS PE changes have been adopted, though in a fairly hotchpotch manner.
Examples of this mixed approach are much in evidence:
Take the BEPS PE provision requiring case-by-case substantive evaluation of whether activities conducted are truly preparatory and auxiliary in nature. This analysis overrides the 'specific exclusions' in Article 5(4). It has been adopted in the new China treaties with Congo, Gabon, Spain, Argentina, and New Zealand, but not for the other new agreements.
The treaties with India and New Zealand adopted the contract-splitting rule for construction PE, while the preparatory and auxiliary activity anti-fragmentation rule was adopted solely in the treaty with Spain.
Meanwhile, the BEPS dependent agent PE (DAPE) rule appeared in treaties with Spain, Argentina, India and New Zealand, and the arrangement with Hong Kong SAR. However, the updated independent agent concept, associated with the new DAPE rule, has only been adopted in the arrangements with Italy and Hong Kong SAR.
The PE provisions in Chinese treaties are already quite diverse, and these changes add yet another layer of complexity. It further raises the question of how Chinese treaty policy on PE will develop going forward, both in terms of inclusion of BEPS PE changes in future bilateral treaty changes and in terms of China's position, going forward, on its reservations on the MLI PE provisions.
Of the PE provisions above, by far the most interesting is the new DAPE wording, particularly as adopted in the arrangement with Hong Kong SAR. As is well known, Hong Kong SAR is the portal through which much of mainland China's overseas direct investment (ODI) flows, and through which much of the country's foreign direct investment (FDI) enters. Ministry of Commerce of the People's Republic of China (MOFCOM) data to the end of 2018 indicates that 54% of mainland China's FDI stock, $1.1 trillion, comes through Hong Kong SAR. At the same time, the stock volume of mainland China's non-financial ODI in Hong Kong SAR reached $622 billion, making it the principal channel for outbound investment.
The BEPS DAPE rule is explained in the updated OECD model tax commentary as focusing on whether a local representative of a foreign enterprise "convinced" local market customers to enter into contracts with the enterprise. This is clearly a lower threshold than the existing rule, which focuses on whether the foreign enterprise "authorised" the local representative to enter into contracts binding on it. In light of this, existing Hong Kong SAR-based arrangements for marketing support and distribution into mainland China may need to be re-examined.
The new definition of "independent agent" also requires refreshed consideration on whether local China marketing support subsidiaries may be excluded from its scope. It should be noted that China typically applies deemed profit approaches for the calculation of PE profits, which in the case of selling agents may be calculated as a percentage of sales. As such it cannot be assumed that, if a local marketing support subsidiary receives an arm's-length consideration, that there will be no further profit to tax. The STA is yet to provide guidance on the application of the new PE rules in the Hong Kong SAR arrangement and the other treaties mentioned above, and this will be highly anticipated.
By the same token, Chinese enterprises operating in/through Hong Kong SAR will also need to consider any additional exposures under the new PE threshold. New Hong Kong SAR tax guidance on PE profit allocation principles was set out in Departmental Interpretation Practice Notes (DIPN) 60, issued in July 2019, which will be relevant in this regard.
A final notable trend in the PE space, emerging in the new treaties, is the inclusion of special PE profit allocation clarifications. The protocols to the Italy, Gabon, Congo and Argentina treaties provide that where a construction/installation PE arises, only profits attributable to the activities conducted by the PE will be attributed to it, not the total value of the construction/installation contract. The Argentina protocol further elaborates, for the specific case of EPC contracts, that revenue from cross-border sales of equipment, which occur parallel to but separate from the services rendered via the construction/installation PE, will not automatically be attributed to the PE.
The increased use of such clauses reflects the challenges that Chinese EPC projects were facing in many countries; with the planned refresh of many treaties with Belt and Road Initiative (BRI) countries, it is to be expected that these clauses will be drawn into further treaties.
Transparency and SWF treaty provisions
A key feature of the new/updated treaties is that most of them include provisions dealing with transparent entities. This is the case for the agreements with India, New Zealand, Italy, Spain, Argentina, and Congo. These provide that to the extent that the country of establishment of the relevant entity (for example, the partnership) allows for transparent treatment (attributes income of the partnership through to the underlying partners), then the country of source, including China, will adopt the same treatment. These treaties join the China-France treaty of 2015, which up to now was the only China treaty to provide for such transparency.
These provisions start to address an issue that was heightened last year by STA Announcement  11 (Announcement 11). The latter provided that unless there are specific provisions in a given treaty dealing with partnership transparency, then foreign partnerships themselves must qualify for the treaty benefits in their own right. However, most foreign partnerships will not be registered overseas as tax residents, and will not be in a position to claim relief. As Announcement 11 otherwise blocks any look-through to the underlying partners to allow them to claim treaty benefits in their own right, this has become a major issue.
However, welcome as these changes are, the lack of inclusion of such provisions in the new protocol with Hong Kong SAR, as the major channel for investment in mainland China, is unfortunate. It might also be noted that much investment in China comes via the Cayman Islands and British Virgin Islands (BVI) partnerships. As these jurisdictions have no tax treaties with China, there is no foreseeable resolution to this issue for partnerships in these jurisdictions.
Another notable area relates is sovereign-related treaty benefits. Earlier in the 2010s a number of treaties (for example with France, the Netherlands, Switzerland and the UK) were updated to include various tax rate reductions and exclusions for sovereign-controlled entities. These joined earlier treaties (with Saudi Arabia, UAE and Kuwait) with similar exclusions. This trend continues with the latest treaties, reflecting the importance of Chinese sovereign wealth funds (SWFs) and state-owned entities (SOEs), and the emergence of new bodies linked to the BRI, such as the Silk Road Fund.
In addition to an exemption from withholding tax (WHT) in most of the treaties for interest paid to state-owned banks, including the national pension fund (NSSF), China Investment Corporation (CIC) and the Silk Road Fund, many of the treaties offer lower/zero WHT for dividends paid to state controlled entities (Argentina, New Zealand, Congo). In the case of Argentina, this goes further to also cover capital gains. Given how important Chinese state-controlled entities are to BRI investment, the BRI treaty refresh is likely to work in many more such provisions.
Beyond the matters outlined above, the new and updated treaties include various BEPS provisions, including: the PPT; the new BEPS treaty preamble; the residence tie-breaker on the basis of mutual agreement; and the modernised exchange of information and MAP articles. These are in line with the changes that are set to be made across Chinese treaties via the MLI. The latter is set to update 63 Chinese tax treaties and rising, with the adherence of further China treaty parties to the MLI. However, it is still not clear when China will have completed domestic procedures to ratify the MLI.
The treaties also tweak WHT rates for various types of income and the timeframes for construction PEs. Interestingly, the Argentina treaty incorporates a 'most-favoured nation' (MFN) clause, which will 'automatically' alter WHT rates in the treaty where Argentina signs a more favourable treaty with another country. This is the second Chinese treaty that includes such a clause, after the China-Chile DTA of 2015.
Treaty relief administration updated
In October 2019, new treaty relief administration guidance was set out in STA Announcement  No. 35 (Announcement 35). This will take effect from January 2020 and replaces the existing guidance in Announcement  No. 60 (Announcement 60). The guidance is in line with a broader government programme to reduce regulatory burdens and red tape for businesses, and moves China further in the direction of a full self-assessment-based tax system. There are two main changes:
Announcement 60 required treaty relief claimants or WHT agents, when notifying the tax authorities of a relief claim, to submit upfront extensive supporting documents. This could be highly burdensome. Announcement 35 now simply requires that supporting documents are kept by the relief claimants on their files for review. Solely a short notification form is sent to the authorities, either directly from the relief claimant or via the WHT agent.
A further change alters WHT agent tax exposures. The Announcement 60 system obliged the WHT agent to ensure that the materials (relief form and supporting documents) are complete. The WHT agent also had to ensure that the assertions made by the relief claimant in the form (as supported by the documents) corresponded to the qualifying conditions for treaty relief. This could lead to liabilities for WHT agents for underpaid tax or penalties, where it was later determined by the authorities that relief was not merited. This naturally made many WHT agents quite cautious when it came to applying reduced treaty WHT rates upfront, and pushed relief claimants into making cumbersome refund applications instead. Announcement 35 makes clear that the WHT agent's responsibility is just to check that the claimant has fully filled out the form, and should facilitate upfront grant of relief.
While these clarifications are welcome, many deficiencies and uncertainties remain for China treaty relief administration. For example, WHT refund processes should in principle take 30 days, but local tax authorities can spin these out for a long period by making repeated requests for additional supporting documentation and explanations; there is no hard 'stop the clock' rule. There is a lack of clarity on the extent of WHT agent obligations to the tax authorities in relation to obtaining supporting documents from the relief claimant.
Relief claimants continue to face a lack of clarity on the precise documentation needed to support their DTA positions, and this is compounded by the continued absence of a tax rulings system in China. It remains to be seen in 2020 how effective this new guidance will be in practice, and whether the STA can make any positive moves to address these other issues.
The calm before the storm?
As covered in greater detail in BEPS 2.0: What will it mean for China?, China has been heavily engaged in the G20/OECD project on overhauling international tax rules through the Inclusive Framework (IF) on BEPS. As a steering group (SG) member, and as home to many of the world's largest companies in the digital space, China has a key role in the process. The IF is striving to agree on a new architecture for international tax rules by January 2020, with work on detailed rule design to follow.
The work is based on two pillars. Pillar 1 aims to change the fundamental building blocks of international tax by introducing a non-physical remote taxable presence threshold (alongside traditional physical presence PE) and formulary rules for profit allocation, which would operate at an MNE group level in conjunction with traditional entity-to-entity transactional arm's-length principle-based TP rules.
At present it is understood that a wide range of large MNEs could fall under this scope, especially those which rely heavily on marketing intangibles for their business operations. This could capture highly-digitalised businesses as well as leading branded goods firms. MNEs, inbound and outbound from China, could face new tax exposures across their market jurisdictions, and would require significantly overhauled tax accounting and compliance systems to calculate and allocate profits.
Pillar 2 aims to introduce a global minimum tax, relying on an income inclusion rule and an undertaxed payments rule. This would call into question the use of low-taxed intermediaries in distribution, finance and IP structures, as well as impact the value of tax incentives obtained in countries of operation.
The expectation is that, if the IF project succeeds in achieving consensus, the Pillar 1 rules could become a global minimum standard (adopted widely across countries), while the Pillar 2 rules might become best practice (perhaps adopted by a smaller number of countries).
At a policy level, China has seen few new CIT rules of significance this year, just minor measures such as the exemption for China depositary receipts and clarified tax treatment for perpetual debt. However, in view of the magnitude of the changes that could come with Pillar 1 and 2, this could be taken as a temporary lull before significant changes set in. Chinese tax policymakers and businesses operating in China are conscious that the new international tax rules would be coming into effect in parallel with a rapidly changing global trade environment, meaning that tax and tariff changes would need to be considered in parallel for structuring of global supply and value chains.
Tel: +86 (10) 8508 7072
Chris Xing is the KPMG Asia Pacific regional leader for international tax. He has assisted numerous international and domestic Chinese private equity funds and corporations on tax due diligence, as well as a wide range of tax issues concerning cross-border transactions, corporate establishment, mergers and acquisitions (M&A) and other corporate transactions in mainland China and Hong Kong SAR.
Chris has also assisted multinational enterprises with undertaking investments in China, restructuring their business operations and devising tax efficient strategies for implementing China business operations and profit repatriation strategies.
Chris is a member of the mainland taxation sub-committee of the Hong Kong SAR Institute of Certified Public Accountants and is an editor of the Asia-Pacific Journal of Taxation. He is also a regular speaker and writer on tax matters, and has published numerous articles on Chinese taxation in various journals. He has also been interviewed and quoted in the New York Times, Wall Street Journal and BBC World News.
Tel: +86 10 8508 7513
Fax: +86 10 8518 5111
Conrad Turley is a tax partner with KPMG China and heads up the firm's national tax policy and technical centre. Now based in Beijing, Conrad previously worked for the European Commission Tax Directorate in Brussels, as well as for KPMG in Ireland, the Netherlands and Hong Kong SAR.
Conrad has worked with a wide range of companies on the establishment of cross-border operating and investment structures, restructurings and M&A transactions, both into and out of China. He is a frequent contributor to international tax and finance journals including ITR, Tax Notes International, Bloomberg BNA and Thomson Reuters, and was principal author of the 2017 IBFD book, 'A new dawn for the international tax system: evolution from past to future and what role will China play?'. He is also a frequent public speaker on topical China and international tax matters.
Conrad received a bachelor's degree in economics and a master's degree in accounting from Trinity College Dublin and University College Dublin, respectively. He is a qualified chartered accountant and a registered tax consultant with the Irish Taxation Institute.