China Tightens Royalty Payments via Double Tax Treaty Residency

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BEIJING, Sept. 30 – The State Administration of Tax moved last week to clarify the treatment of royalties under the nation’s double tax treaties.

Guo Shui Han (2009) No. 507, published on September 23 and taking effect October 1, sets out the scope of permitted royalties under double tax treaties (DTAs) as well as what should not be treated as royalties. It also clarifies the application of royalty clauses of a DTA to resident beneficiaries only.

The scope of royalties as determined in most DTAs signed between China and other jurisdictions typically include payments of any kind being received as a consideration for the use of or right to use copyrights, artistic or scientific work, films or tapes used for broadcasting, patents, technical know-how, trademarks, design or model, plan, secret formulas and processes. The circular clarifies that if a DTA defines payments associated with right to use for industrial, commercial or scientific equipment as royalties, beneficial treaty withholding taxes will apply despite any provision of receipts being categorized as rental income under China’s corporate income tax law.

The circular also defines determinants as to whether payments related to proprietary technologies should be defined as royalties or a service fee as follows:

  • The payment is related to a licensor licensing proprietary technology for the use of the licensee and is not involved in implementation of licensed technology and does no guarantee a result
  • The licensed technology is normally existing technology however may also be used as a technology developed on licensees needs with confidentiality restrictions

Additional stipulations address circumstances when royalty clauses of a DTA may apply to service income if the following conditions are satisfied:

  • The results fall within the scope of royalties provided by a DTA
  • The service provider is the owner of the work provided
  • The service recipient only has the usage rights to the work results

The circular also determines that royalty clauses under a DTA shall only apply if the beneficial owner is a resident of the contracting party:

  • For a permanent establishment by a third party jurisdiction in the contracting party, the DTAs signed between the third jurisdiction and China shall apply to royalties generated from China
  • If a China registered company has a permanent establishment in the contracting party, the PE shall not be treated as a resident of the contracting party to apply royalty provisions of the DTA
  • For royalty payments from foreign companies permanent situated in China to a resident of a contracting party, if the royalties are borne by and remitted by the permanent establishment in China, the royalty clauses under the DTAs between China and the contracting party shall apply

Companies should note that the SAT determines differences between service receipts and royalties. For royalties, withholding tax (normally 10 percent) will apply to the gross receipt. However, service receipts do not attract withholding tax unless there is a PE in China. If so, income tax at 25 percent will be levied to profits attributable to the permanent establishment. Companies with contracts in place for royalty agreements or service contracts should have these reviewed to determine whether royalty or service definitions apply.

For advice on this matter please contact Sabrina Zhang, national tax partner for Dezan Shira & Associates, and Richard Hoffmann, senior business advisory associate, Dezan Shira & Associates, at tax@dezshira.com.