Over the last year, positive developments have included circulars issued by the Chinese tax authorities clarifying uncertainties over issues relating to cross-border secondment arrangements and the determination of the beneficial ownership of dividend income. At the same time, China is also imposing a more restrictive tax treaty interpretation to combat arrangements that are perceived to be an abuse of double tax treaties.
These themes and some of the recent developments in China's expansion of its double tax treaty network as well as outcomes of renegotiated tax treaties with some of its most prominent trading partners are discussed here and illustrations highlight the Chinese and Hong Kong SAR tax authorities' recent interpretive approaches applied in tax issues relating to cross-border transactions and likely future trends.
China's efforts to unify Chinese double tax agreements and the emphasis on general anti-avoidance rules
As of June 2013, China has entered into 101 double tax agreements (DTAs) with other jurisdictions and regions, including Hong Kong and Macau SAR. Information from the State Administration of Taxation of China (SAT) shows that Botswana, Ecuador and Uganda were among the latest countries to sign a DTA with China in 2012 and 2013.
In addition to the expansion of its treaty network, Chinese tax authorities have also renegotiated a number of existing DTAs. Most notably, the older agreements with Belgium, Denmark, Netherlands and the UK have been modified to encompass anti-avoidance measures so they are in closer alignment with standards set out in the OECD's Model Tax Convention on Income and on Capital (OECD Model). As of the publication date, the DTAs with Belgium, Netherlands and the UK have yet to be enforced. For instance, under the modified DTAs for each of the articles pertaining to passive income such as dividends, interest and royalties, an additional limitation of benefits (LOB) paragraph has been added to deny preferential treaty rates if the main or one of the main purposes of the claimant is to take advantage of the treaty benefits.
An additional article has been added to these new Chinese DTAs to give China or the DTA country rights to apply its domestic general anti-avoidance rules (GAAR) when needed. This is in line with the international practice that such a LOB paragraph/article is commonly seen in other countries' DTAs (for example, Singapore, UK and Japan).
In other aspects, the revised DTAs have also seen some relaxation. In some cases, the permanent establishment (PE) clauses under certain DTAs have been loosened in two aspects:
- The period for a construction PE (that is, an enterprise which carries on a business through "a building site, a construction, assembly or installation project, or supervisory activities" in the other country) has been extended from six months to 12 months. This is a more relaxed clause compared to the same PE clause under older treaties; and
- The time threshold for furnishing services to create a PE (service PE) has been amended from six months to 183 days, which unifies it with the service PE threshold under other more recently concluded Chinese DTAs. As such, the unified treaty articles interpretation under Guoshuifa  No 75 (Circular 75) issued by the SAT will be also applicable to these revised Chinese DTAs.
The dividends and royalties articles for the above DTAs have also been revised. The withholding tax (WHT) rates for dividends and royalties have been cut from 10% to 5% and 6%/7% respectively, subject to specific conditions being met. The specific conditions are drafted in line with similar articles under other more recent DTAs concluded by China.
Another focal point is the revisions to the article on capital gains – the renegotiated Chinese DTAs have adopted the standard capital gains clauses in DTAs which China has recently concluded. The revisions limit China's taxing rights on capital gains from the disposal of shares of a Chinese company, under which China only has taxing rights on (i) gains from a disposal of shares of a land-rich company and/or (ii) gains from a disposal of shares of a company in which the recipient directly or indirectly owns at least 25% of the shares of that company. A land-rich company refers to a company deriving 50% of its value, directly or indirectly from the value of immovable property situated in China. Given this trend, the older DTAs (for example, those with Ireland and Switzerland) with the relaxed capital gains tax clause that does not impose a 25% threshold may eventually be revised to be consistent with the above.
The new Chinese DTAs with Belgium and Netherlands also include a new article to exempt capital gains tax from the disposal of quoted shares where specific conditions are satisfied. Such added treaty protection is welcome news for foreign investors.
Common cross-border transactions and related tax law development
Secondment arrangements and safe harbour from PE assessment
In April 2013, the SAT issued Announcement  No 19 (Announcement 19) to provide further guidance on when the cross-border secondment arrangements of expatriates (secondee) by a foreign enterprise (home entity) to an enterprise in China (host entity) may give rise to a taxable presence under Chinese domestic law or a PE under a Chinese DTA where the home entity does not directly or indirectly own the host entity.
Announcement 19 states that the "fundamental criterion" is whether the home entity bears all or part of the responsibilities and risks in relation to the work products of the secondees, and whether it is the home entity that normally reviews and appraises the job performance of the secondees. Announcement 19 also prescribes five "reference factors" in deciding whether the secondees are in substance the employees of the home entity.
The five reference factors prescribed in Announcement 19 to decide whether the Secondees are in substance employees of the home entity are:
- The host entity pays the home entity management fees or makes payments in the nature of service fees;
- The payment to the home entity from the host entity is more than the secondees' wages, salaries, social security contributions and other expenses borne by the home entity;
- The home entity does not pass on all the related payments made by the host entity to the secondees; instead, the home entity retains a certain amount of such payments;
- PRC individual income tax (IIT) is not paid on the full amount of the secondees' wages and salaries borne by the home entity;
- The home entity decides the number, the qualification, the remuneration and the working locations of the secondees in China.
If the fundamental criterion is met and at least one of the reference factors is satisfied, the secondees will generally be considered employees of the home entity rendering services in China and thus the home entity may be regarded as having a taxable establishment or place of business in China. In the DTA context, if the secondees who are viewed as employees of the home entity render services in China for longer than six months, a service PE is normally created.
Announcement 19 also requires the tax authority in charge to focus on reviewing the execution documentations/information (for example, secondment contracts, protocols set for the secondees and information on the secondment arrangement payments) and related economic substance in assessing whether the home entity has any corporate income tax (CIT liability) for the secondment arrangement.
In a DTA context, if the establishment or place of business through which the services are provided by a foreign tax resident – applying the Announcement 19 criteria – is of a relatively fixed and permanent nature, it will be regarded as a PE of the home entity in China. However, Announcement 19 also contains a "stewardship exception" that the home entity would not have a taxable establishment or PE in China merely because its employees perform stewardship functions (for example, exercises the home entity's shareholder rights and safeguards its shareholder interest) at the host entity's place of business.
Announcement 19 represents a measure by Chinese tax authorities to tighten tax enforcement against non-residents on their taxable presence in China (whether in the domestic law or the DTA context), but where the assessment of which is now guided by clear principles that should be respected by the local tax administration authorities. As such, this provides more certainty to foreign companies deploying staff to China and is another welcome development.
Further clarifications on beneficial ownership requirements for granting tax treaty benefits for dividends under Circular 165
The assessment of beneficial ownership over passive income derived by foreign residents from China through Guoshuihan  No 601 (Circular 601) remains a real challenge for foreign enterprises when they apply for tax treaty relief on passive income derived from China. Though the SAT has issued SAT Announcement  No 30 (Announcement 30) to clarify a few important matters of application of Circular 601, significant interpretational issues with the circular remain unclear. A positive development is that the Chinese tax authorities issued Circular 165 in April 2013 to provide clarifications about the assessment of the beneficial ownership of dividends under the PRC-Hong Kong DTA for the purposes of WHT on dividends received by Hong Kong dividend recipients. Circular 165 reduces interpretational uncertainties where the holding company is in Hong Kong and concrete action by foreign enterprises to secure their beneficial ownership positions can consequently be taken.
Circular 601 provides various factors that are considered to be unfavourable to treaty applicants to be regarded as a beneficial owner. Circular 601 has not further elaborated on how the adverse factors are to be considered and weighed (that is, collectively or individually) when determining the beneficial ownership.
In this regard, Announcement 30 clarified that, when determining beneficial ownership, these factors should be collectively considered and weighted against the substance of the overall commercial arrangement based on the substance-over-form principle. This "totality of factors" approach in assessing who is the beneficial owner of a non-resident enterprise in relation to dividends derived from China is further confirmed under Circular 165.
Another favourable aspect of Circular 165 is that it also makes clear that 'investment activities' will be considered to be a type of 'business activities'. Thus, the tax authorities may not deny DTA relief solely on the basis that the claimant only holds one investment and that the holding of multiple investments would in principle be a favourable factor to establish the existence of 'substantive business operations'. Similarly, Circular 165 also prescribes that the tax authorities should go beyond considering only the number of staff and the magnitude of staff costs of the claimant when assessing whether the claimant's staffing level is commensurate with its income; they also need to take into account the responsibilities and nature of the work of the staff, considering the fact that, for instance, a small number of experienced and competent staff may be sufficient for the needs of the business.
Circular 165 also clarifies that the tax authorities should not draw a negative conclusion based on the fact that the claimant is 'lowly' capitalised. This effectively removes the negative implications of having the claimant being thinly capitalised so long as it is commercially justifiable and the interest payments on the claimant's debt do not result in a failure of the income retention test under the first adverse factor under Circular 601.
Circular 165 pinpoints the importance of examining the applicant's legal capacity and rights to control and dispose of investments, as supplemented by information on the actual exercise of those rights, in determining whether the claimant is the beneficial owner of the income. It specifically directs the tax authorities' attention to the claimant company's articles of association, as well as other documents demonstrating the degree of the claimant's freedom of action in relation to its deposition and use of its investments.
Such changes will obviously place stronger emphasis on the claimant's adherence to corporate governance formalities such as board meetings' minutes as the key in finding evidence of the beneficial ownership of the income derived.
Under the safe habour provision under Announcement 30, if any of the subsidiaries which are directly/indirectly held by the listed parent that is not a tax resident of the same DTA partner state of the listed parent, this safe harbour provision will not be available.
Although Circular 165 provides further interpretation of the safe harbour rules contained in Announcement 30 such that the safe harbour provision should still be available in situations where the applicant is held by a non-listed HK resident company and where there is a third jurisdiction entity between the applicant and the ultimate HK holding company, it does not explicitly lessen the above-mentioned requirement where all intermediate holding companies (between HK Listed Parent and the applicant) should be HK tax residents to enjoy the safe harbour provision.
The upshot of Circular 165 for Hong Kong holding companies is quite positive. Where commercially feasible, foreign investors should consider leveraging the potential benefits of using a Hong Kong holding company as a gateway to investing in China.
New developments on Hong Kong tax residency certificates application
On the administrative side, in seeking treaty protection, Guoshuifa  No 124 (Circular 124) set out administrative procedures which need to be followed. In this regard, one of the specified documents to be submitted to the PRC tax authorities is a tax residency certificate issued by the tax authority from the foreign investor's country of residence.
The issuance of Circular 165 for Hong Kong holding companies should be positive news. However, it is worth noting that Hong Kong tax authorities have tightened up the issuance of HK tax residency certificates to applicants incorporated/constituted outside Hong Kong. In particular, with effect from April 1 2013, different application forms have to be completed and filed by applicants incorporated/constituted in and outside Hong Kong (HK and non-HK applicants). While it is relatively simple for Hong Kong applicants to obtain HK Tax Residency Certificates, non-HK applicants are required to provide information regarding their business activities and establishments, staffing, nationality, residency and responsibilities of each director in and outside Hong Kong. This information was only required to be submitted upon request in the past.
Typical examples of non-HK applicants are overseas incorporated intermediate holding companies. Companies (either incorporated in or outside Hong Kong) listed on the Hong Kong Stock Exchange, normally hold their equity investments in China through overseas incorporated intermediate holding companies. To claim treaty benefits under the PRC-HK DTA, Hong Kong listed companies as well as the intermediate holding companies have to be Hong Kong tax residents and present their HK tax residency certificates to the PRC tax authorities under the safe harbour provision under Announcement 30. However, in reality, management and control of a listed group are normally exercised at the level of the listed company. As special purpose vehicles, it may not be common for the intermediate holding companies to prepare and maintain their own documentation (for example, board minutes) to substantiate that their management and control are exercised in Hong Kong. Even though in practice the HK tax authorities may still consider their applications favourably upon submission of documentary evidence on a group basis, the processing time for these applications will be significantly longer.
International tax law developments on cross-border transactions
Increasing globalisation and the growth of e-commerce means it has become easier for MNCs to locate business functions away from where their customers are. Consequently, it is easier for such companies to shift functions, risks and the ensuing profits across borders to jurisdictions that provide greater efficiencies, and sometimes, greater tax advantages.
In response to safeguarding each country's own tax base, the OECD was tasked by the G20 at its meeting in 2012 to develop a policy framework to address the erosion of domestic tax bases due to the shifting of corporate profits to other jurisdictions.
On July 19 2013, the OECD released its action plan for multilateral cooperation to address tax base erosion and profit shifting (BEPS). What the BEPS action plan sets forth is an ambitious to-do list, consisting of 15 action items to be completed by 2015. The action plan demonstrates a fierce determination against international tax avoidance and has ramifications for the modernisation of international tax system.
As a result of the BEPS action plan, there will be significant revisions and additions to the OECD Transfer Pricing Guidelines and other OECD transfer pricing-related documents. As China has been an observer at the OECD and a strong advocate of anti-avoidance, the PRC tax authorities will definitely monitor the execution of the action plan and propose corresponding changes under the domestic law to align with it.
Proposed changes will likely focus on clarifying, strengthening and developing guidance in areas such as the digital economy, hybrid instruments, treaty abuse, dependence on specific PE exceptions and commissionaire, significant interest deductions, intangibles, and transfer pricing policies.
Clear strategies must be set forth and articulated across departments for MNCs which want to stay on top of the tremendous changes occurring in the international tax system. Multinational companies should perform immediate tax health checks to identify potential weaknesses in their tax positions. This will involve several rounds of review of existing operational structures to see if they derive disproportionate income from underlying economic activities. Additional attention should be placed on the use and exploitation of intangibles, which has already been hinted at in the BEPS report and the action plan.
An internal transfer pricing policy review should also be carried out simultaneously. In light of the increasing uncertainty, advance pricing arrangements (APA) and other forms of early engagement with the tax authorities could again be sought to avoid operational disruptions for the company due to TP disputes with tax authorities.
At the group level, MNCs should review their existing international financing and organisational structure. It is imperative that MNCs should be ready to make proper disclosure of their international profit allocation, with sufficient and concrete documentation, for possible challenges raised by the tax authority.
Last but not least, businesses should take into account the potential impacts of any changes on planning arrangements being contemplated now or the planning arrangements may be at risk.
Prepare for the future
The closer alignment of Chinese DTAs with the OECD Model demonstrates PRC tax authorities' increasing efforts to make China a more favourable jurisdiction for foreign investment and to achieve more uniformity in tax treaty interpretation in China. Nonetheless, given there is more emphasis on GAAR under these newly renegotiated DTAs, existing equity holdings, profit repatriation and exit strategies should be revisited and assessed as to whether the intended treaty benefits could be secured in the long run.
With the globalisation and cross-border cooperation between tax authorities becoming more extensive, China's treaty network and its enforcement of tax collection in relation to cross-border transactions will probably continue to evolve over time to reflect international tax developments and economic realities. Offshore investors that have cross-border transactions with China enterprises would be advised to stay ahead of these changes and undertake appropriate s to retain their competitive advantage in the future.
Chris Xing has assisted numerous international and domestic Chinese private equity funds and corporations on tax due diligence, and a wide range of tax issues concerning cross-border transactions, corporate establishment, M&A and other corporate transactions in the People's Republic of China (PRC) and Hong Kong.
Chris has also assisted multinational corporations with undertaking investments in the PRC, restructuring of business operations and devising tax efficient strategies for implementing PRC business operations and profit repatriation strategies.
Chris is a member of the Mainland Taxation sub-committee of the Hong Kong 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.
Curtis Ng is well versed in the complexities of delivering compliance and advisory services to multinational clients in various sectors. His experience includes a depth of experience in cross-border business activities and coordination and liaison with specialists to provide the most efficient and effective services.
Curtis received his BSSc degree in Economics. He is an associate member of the Hong Kong Institute of Certified Public Accountants, an associate member of the Taxation Institute of Hong Kong and a certified tax adviser in Hong Kong.
Vincent Pang is a specialist in the industrial and consumer market sectors and has extensive experience in serving many companies in these sectors.
Vincent started his career with professional accounting firms in Canada in 1991 and has experience in various disciplines including tax, auditing and consulting. He arrived in Beijing in 1998 and started to focus on providing PRC tax services to foreign investors in the areas of tax structuring, tax planning, general tax advice as well as tax compliance services.
Vincent has also been active in assisting many foreign companies in designing their corporate and operational structures in China to meet their business objectives. He has been focused on providing M&A tax services to both foreign and domestic companies and assisting in tax due diligence, transaction structuring, post-acquisition structuring and contract negotiation from a Chinese tax perspective as well as setting up various forms of legal entities for acquisition or operational purposes.