China-Hong Kong DTA: Tax Residency, Permanent Establishment Requirements Amended
- China and Hong Kong have signed the Fifth Protocol to their longstanding double tax avoidance agreement (DTA).
- Business entities as well as individuals holding dual residency should note that the Fifth Protocol revises several aspects of the DTA’s tax residency and permanent establishment provisions.
- The Fifth Protocol came into effect starting January 1, 2020 in mainland China and will be in effect from April 1, 2020 in Hong Kong.
- Companies and individuals must review their tax position in both jurisdictions to avoid being challenged by tax authorities.
On December 6, 2019, the Fifth Protocol of the Double Taxation Avoidance Arrangement between the Mainland China and Hong Kong (Fifth Protocol) entered into force after the completion of approval procedures on both sides. The agreement, signed in July, made changes to the original double tax avoidance agreement (DTA) signed in August 2006. The DTA was previously supplemented by protocols in 2008, 2010, and 2015.
On paper, the Fifth Protocol has now taken effect. However, the adoption of these provisions at a local level will follow the respective tax calendar year for each jurisdiction. This means it came into effect January 1, 2020 in China and will come into effect from April 1, 2020 in Hong Kong SAR. The Fifth Protocol introduces a number of revisions to the DTA’s tax residency and permanent establishment provisions.
It also makes changes to the calculation of capital gains and the individual income tax payable by teachers and researchers when in the other respective jurisdiction. Companies and individuals are suggested to review their tax position in both jurisdictions for potential tax implications and restructure their operations to avoid being challenged by tax authorities on both sides.
Here we look at three significant changes introduced by the Fifth Protocol that will affect an entity’s residency and permanent establishment status.
Changes made to determining tax residency
The Fifth Protocol introduces a new tiebreaker rule for dual residency of a Person (defined by the DTA as an individual, company, trust, partnership or other groups). Where a Person other than an individual is a resident of both jurisdictions, the local authority on both sides (China State Taxation Administration and Hong Kong Inland Revenue Department) must come to a mutual agreement on the place of residence, taking into account the following: the place of effective management, the place of incorporation, and other relevant factors.
If a mutual agreement cannot be reached, such Persons will not be entitled to any tax benefits provided under the DTA. This expands the criterion of determining a Person’s tax residency, which previously only considered the place of effective management.
According to observers, the amendments made to the Resident Article may cause the application for the Certificate of Resident (COR) to become more complicated and time-consuming, as an entity considered to be a residence in both China and Hong Kong will need to undergo review from tax authorities in both jurisdictions before any decision is made.
For example, a Hong Kong company that has employees or directors based in mainland China will need to undergo the usual process of submitting information regarding the number of employees based in and outside Hong Kong, as well as the location of the central management (where the directors and managers are based) to the Inland Revenue Department in Hong Kong as part of their COR application process. In addition to this, they must also be reviewed by tax authorities on both sides to determine the Person’s state of residency before the COR is approved.
Definition of agency under the permanent establishment article revised
The Fifth Protocol also revises the definition of agency under the permanent establishment (PE) article to include those Persons who “habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise,” thereby expanding the definition beyond situations where a Persons “habitually concludes contracts” as was the previous definition. The contracts mentioned above include those:
- in the name of the enterprise, or
- for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use, or
- for the provision of services by that enterprise.
According to these changes, if a Hong Kong company has a sales team operating in its mainland China office, and the manager in this sales team habitually plays the principal role to conclude the sales contract under the Hong Kong company, the Hong Kong company is then deemed to have a PE in mainland China under the Protocol.
Concept of independent agent under permanent establishment article is clarified
Under the revisions of the Fifth Protocol, a Person is explicitly excluded from being an independent agent where they act exclusively or almost exclusively on behalf of one or more enterprises to which that person is closely related. The Protocol clarifies the definition of ‘closely related’ to an enterprise, by defining it as:
- A Persons that has the control of the other or both are under the control of the same persons or enterprises;
- A Persons that directly or indirectly possesses more than 50 percent of the beneficial interest or voting rights of the other, or;
- Another Person possesses directly or indirectly more than 50 percent of the beneficial interest or voting rights in the Person and the enterprise.
In this case, if a mainland Chinese company acts exclusively or almost exclusively in negotiating and concluding a Chinese contract, on behalf of its Hong Kong parent company in Hong Kong, such a mainland China company will be considered to be the Agency PE of the Hong Kong company instead of an independent agent.
How to read the changes introduced by the Fifth Protocol
The Fifth Protocol makes this DTA the most amended among all such arrangements signed by Hong Kong, demonstrating the determination on both sides to strengthen economic and business activities between the two jurisdictions.
As stated in the revised Preamble, the DTA aims to further develop their bilateral economic relationship and to enhance cooperation on tax matters. The DTA intends to eliminate double taxation without creating new opportunities for non-taxation through tax evasion or avoidance. The changes also help to shift the arrangement to be more in line with international tax standards, with the amendments to Article 4 (Resident) and Article 5 (Permanent Establishment) adopting many of the recommendations made to the latest OECD’s BEPS Action Plan.
Businesses should pay close attention to the local tax authorities on both sides as they release more details on the application of these rules. It is prudent for investors to seek professional advice on identifying potential risks and undergo any corporate restructuring that is necessary.
China Briefing is written and produced by Dezan Shira & Associates. The practice assists foreign investors into China and has done since 1992 through offices in Beijing, Tianjin, Dalian, Qingdao, Shanghai, Hangzhou, Ningbo, Suzhou, Guangzhou, Dongguan, Zhongshan, Shenzhen, and Hong Kong. Please contact the firm for assistance in China at email@example.com. We also maintain offices assisting foreign investors in Vietnam, Indonesia, Singapore, The Philippines, Malaysia, and Thailand in addition to our practices in India and Russia and our trade research facilities along the Belt & Road Initiative.