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Focus: China clarifies 'beneficial owner' under double taxation agreements to address 'treaty shopping'

1 February 2010

In brief: The PRC State Administration of Taxation recently released a circular clarifying when an offshore company will be considered the 'beneficial owner' of a PRC company for the purpose of obtaining relief under a double taxation agreement. Partner Campbell Davidson , Senior Associates Maggie Ma and Ross Keene, and Consultant Wen Zhang report.

How does it affect you?

  • If an offshore company that owns a PRC entity does not carry on substantial business activities, under the new circular it may not be considered the 'beneficial owner' of the PRC entity. Rather, the offshore company may be considered to be a mere 'conduit company' and will not be eligible for relief under the relevant double taxation agreement (DTA).
  • The onus of proof is placed on the taxpayer (the applicant) when applying for DTA relief to show that it is the 'beneficial owner' for the purposes of the DTA.

Background

Over the past 20 years, the PRC Government has entered into various DTAs with its foreign counterparts concerning the avoidance of double taxation in respect of dividends, interest and royalties. A 'beneficial owner' is referred to in such DTAs as a resident of another contracting state for tax purposes. Under some DTAs, the 'beneficial owner' has to own a minimum percentage (most commonly, 25 per cent) of the shares in the company paying the dividends, interest or royalties to be eligible for the relevant double taxation relief.

Applicants from different contracting states enjoy different levels of DTA relief. For example, if the 'beneficial owner' of a PRC company is a Hong Kong company, the withholding tax (WHT) payable on dividend payments from the PRC company to the Hong Kong company is 5 per cent (instead of the normal rate of 10 per cent under PRC law), while WHT of 7 per cent is payable on interest payments to the Hong Kong company (rather than the normal rate of 10 per cent).

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Circular 601

On 27 October 2009 the PRC State Administration of Taxation (SAT) issued the Circular on How to Understand and Recognise the 'Beneficial Owner' in Double Taxation Agreements (Guoshuihan [2009] No. 601) (Circular 601).

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Who is a 'beneficial owner' under Circular 601?

Circular 601 defines a 'beneficial owner' as a person who owns, or has control over, income or the rights or property from which income is derived. Under Circular 601, generally a person or company must be engaged in substantive business activities, such as manufacturing, sales, distribution or management activities, to be considered a 'beneficial owner'.

Under Circular 601, agents or conduit companies are not 'beneficial owners' and therefore not entitled to DTA relief. A 'conduit company', as defined in Circular 601, is a company established in its place of incorporation for the purpose of avoiding or reducing taxes, or diverting or aggregating profits, and that does not carry on substantial business activities.

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Factors that would adversely affect recognition as a 'beneficial owner'

Circular 601 lists the following factors that will generally have an adverse effect on an application for recognition as a 'beneficial owner':

  • if there is an obligation on the applicant to pay or distribute all, or a majority (eg more than 60 per cent), of its income to a tax resident in a third country within a specific period of time;
  • if the applicant has no, or virtually no, business activities except for holding the property or rights from which the income is derived;
  • if the applicant is a company or other entity, its assets, size of business and number of employees are relatively small when compared with its income;
  • the applicant has no, or almost no control, over, or right to dispose of, its income or the property or rights from which its income is derived, and the applicant bears no or few risks;
  • the country in which the applicant is located does not impose any tax on income or such income is tax-exempt, or tax rates in that country are relatively low;
  • where there are interest payments between the PRC company and the applicant, in addition to the contract under which those payments are made there is another loan or deposit contract between the applicant and a third party with a similar amount, interest rate and execution date; or
  • where royalties are paid under copyright, patent or technology assignment agreements, there is another agreement between the applicant and a third party concerning the assignment of the relevant copyright, patent or technology.

If an applicant intends to apply for relief under a DTA, it must provide documentation to the local SAT to prove its status as a 'beneficial owner'.

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Conclusion

By issuing Circular 601, the PRC tax authorities have made it clear that they will look at 'substance over form' when analysing offshore holding structures and applications for DTA relief, and will refuse to grant such relief to companies that do not have substantive business activities but have simply been set up for the purpose of diverting or aggregating profits, or for the purpose of 'treaty shopping' – namely, shopping around for the most tax effective jurisdiction to establish the holding company in order to avoid or reduce taxes. Foreign investors in China should keep Circular 601 in mind when considering tax structuring for their existing and proposed investments there, and should seek advice as to the documentation and processes to obtain recognition as a 'beneficial owner'.

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