China’s economy is gradually recovering from COVID-19. As in other countries, COVID-19 disruption has accelerated certain longer-term economic shifts, giving further momentum to emerging industries, such as e-commerce, fintech, educational technology (edtech), and medical technology (medtech).
These sectors and others are naturally very attractive to foreign investors and China is enabling this through reductions in the investment restrictions ‘negative list’. The recently-released 2020 nationwide negative list (effective July 23) reduces the number of sectors restricted to foreign investment to 33 from 40 (in 2019), and further to 30 in the free trade zones (FTZs). Financial sector restrictions had already been reduced over a number of years and the 2020 list eliminates the final remaining restrictions. Restrictions for the infrastructure and transport sectors are also reduced.
While foreign investment restrictions are being reduced, a number of tax issues still present themselves. A recurring issue, particularly for funds, is that investments structured via foreign partnerships into China can struggle to access relief under Chinese double tax agreements (DTAs), due to peculiarities of China’s tax law.
A recently published State Taxation Administration (STA) case book clarifies and reinforces the strict Chinese approach in this space, and investors should be aware of the investment structuring implications.
Evaluating barriers to treaty relief access
The basic issue is that China lacks comprehensive tax rules to deal with partnerships and other tax transparent entities, and this subsequently leads to several issues.
The default position under Chinese law is that foreign partnerships are treated as opaque entities for tax purposes. This means that a foreign partnership will be treated, for Chinese tax purposes, as the ‘taxpayer’ and therefore as the only ‘person’ eligible to apply for DTA benefits, for any Chinese-sourced income paid to them.
However, this does not mean that it will be considered a ‘tax resident’ of its country of establishment for DTA relief purposes. If the partnership is not subject to local tax in that country, in its own name, then it cannot qualify as a ‘tax resident’. Consequently, it will not be permitted access to DTA relief.
Furthermore, China has demanding commercial substance requirements for foreign entities to enjoy DTA reductions in withholding tax (WHT). STA guidance treats these conditions as part of the DTA beneficial ownership test. An investment partnership will typically be structured as a flow-through entity and is unlikely to have significant substance in terms of staff, assets and operations. As such, even if the tax residence issue could be addressed, relief could be lost even though the underlying investors have substantial commercial substance.
What is more, the partnership may be in an offshore jurisdiction (e.g. Cayman Islands), which has no DTA with China, even if the fund investors are in a country that has a DTA with China. As Chinese tax law does not allow for look-through to the underlying investors, DTA relief can readily be lost.
While the law has lacked clarity for many years, up to 2018 it was sometimes possible to get concessional look-through treatment from local tax authorities, on a case-by-case basis.
However, the STA Announcement 11 (2018) set out a strict position, saying that look-through would not be permitted unless a Chinese DTA specifically allowed for this. Until recently this was just the case for the Chinese DTA with France – though since, DTAs with India, New Zealand, Italy, Spain, Argentina, and the Congo also allow for some measure of look-through.
Neither the Mainland China DTA with Hong Kong SAR, nor the DTA with the US, two of the main jurisdictions for investment into China, have been updated for this issue. This, together with the fact that many of the investment partnerships are in non-DTA jurisdictions such as Cayman Islands and British Virgin Islands means that this remains largely an unresolved issue.
Many taxpayers have continued to argue their cases with the authorities. However, the recent STA book reinforces this strict position in three cases drawn from local tax authority enforcement experience:
A tax transparent US S corporation (S-Corp) claimed China-US DTA relief on its disposal of a minority interest in a Chinese company. While the S-Corp’s US shareholders paid US tax on the gain, the Chinese tax authorities refused DTA relief in the shareholders’ names, as Announcement 11 forbids look-through. The S-Corp, not being taxed in its own name, could not be recognised as a tax resident to access DTA relief.
A US partnership, with a Luxembourg partner, indirectly disposed of equity in a Chinese company. The Luxembourg partner claimed use of the Announcement 7 indirect disposal rules ‘safe harbour’. This provides relief from indirect disposal tax in cases where the disposer ‘could have’ accessed DTA relief on a direct disposal of the Chinese company. The partner sought to leverage the China-Luxembourg DTA for this. The authorities, however, read the Announcement 11 restrictions into Announcement 7 and denied DTA relief.
A French SCS received dividends from a Chinese company. The SCS is a ‘semi-transparent’ entity deemed by French tax law to realise income at an entity level which is then assessed to tax at the level of its members. Pursuant to the special provisions of the China-France DTA the SCS was treated as a tax resident. It was further determined to meet the beneficial ownership substance requirements and DTA relief was granted.
Looking ahead, it is expected that the STA will continue to update DTAs to deal with this issue. However, in the context of the COVID-19 disruption, the process may be delayed. In the medium-term, this will remain an ongoing issue and investors need to be cognizant of it in planning their China investments.
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