Sept. 18 – Simply put, double taxation agreements (DTAs) aim to prevent the same income from being taxed by two or more states, while also eliminating tax evasion and encouraging cross-border trade efficiency.
DTAs are mostly of a bilateral nature and, while DTA-signing countries are not all members of the Organization for Economic Cooperation and Development (OECD), DTAs are generally based on model conventions developed by the OECD or (less commonly) the United Nations.
While about 75 percent of the actual words of any given DTA are identical with the words of any other DTA, the applicability and specific provisions of each treaty can vary substantially.
From an investor’s perspective, confusion about international taxation can arise when investors are subject to two different and potentially conflicting tax systems. For example, Hong Kong and Singapore adopt a “territorial source” principle of taxation, which means that only profits sourced locally are taxable.
Meanwhile, other countries like China and the United States are on the worldwide tax system, and resident enterprises are required to pay tax on income sourced both in and outside of the country. DTAs not only provide certainty to investors regarding their potential tax liabilities, but also a tool to create tax efficient international investments.
DTAs prevent double taxation by allowing the tax paid in one of the two countries to be offset against tax payable in the other country, and/or by providing exemptions or reduced tax rates for specific income types such as interest, royalties, and dividends.
DTAs apply to residents (individuals or companies) of the countries or jurisdictions who are parties to the agreement. Some DTAs are comprehensive and cover all types of income, while others are more specific. The United Nations Conference on Trade and Development divides tax treaties into categories based on their applicability, primarily:
A key concept in the applicability of DTAs is that of permanent establishments (“PE”), i.e. a fixed place at which the business of an enterprise is carried on in a country.
Where a resident of a country carries on business in another country with which the resident’s country has a DTA, the profits derived will not be subject to tax in the other country unless the business is carried on through a PE. A PE can be a place of management, a branch, an office, a factory, etc. or certain activities, such as a building site or construction project or rendering of consultancy services that last over a specified time (stipulated in the DTA).
One of the most prominent recently revised DTAs is the one between China and the United Kingdom, which was revised in June 2011, updating the definition of a PE, as well as revising withholding tax rates on dividends and royalties. It is hoped the signing of the new DTA will make the United Kingdom another attractive alternative when foreign investors choose holding jurisdictions for their China investments.
As foreign investors leverage China’s DTAs, as well as the DTAs of Hong Kong, Singapore, and other jurisdictions for their China investments, China has made significant strides in the past five years in building up regulation in the area of double taxation, as well as implementation assurance techniques.
Since the 2008 Corporate Income Tax Law, which laid the basis for anti-avoidance in China, the State Administration of Taxation has issued a flurry of related circulars stipulating reporting requirements for offshore transactions, describing qualification as a beneficial owner and dictating protocol for claiming treaty benefits. These recent circulars made qualifying under double taxation avoidance agreements (DTAs or DTAAs) more difficult.
“Prior to 2010, the Chinese regulations on DTAs were quite unclear and most companies could automatically enjoy the benefits. Beginning in 2010, stronger, more specific regulations began to come into effect, and companies began to have to apply for relief under DTAs,” explains Hannah Feng, manager of corporate accounting services at Dezan Shira & Associates’ Beijing office. “For example, in order to qualify for DTA relief from withholding tax on dividends, interest and royalties, the State Administration of Taxation needs to assess if a company in the DTA partner jurisdiction (for example, Hong Kong or Singapore) is indeed considered a ‘beneficial owner’ of the Chinese subsidiary.
“This is done by demonstrating seven factors that constitute substance over form, rather than merely testing whether the company is a tax resident in the DTA partner jurisdiction,” Feng continues. “Many companies set up in China a number of years ago with a holding company in Hong Kong and did not take into account the concepts of beneficial owners. We generally do a preliminary assessment of a company’s situation to determine the likelihood of approval before we submit an application for DTA relief.”
“The most common difficulty for our clients in Hong Kong when applying to avail of treaty benefits under DTAs between China and other countries is in obtaining the tax resident certificate for their Hong Kong entity, especially when the Hong Kong entity acts solely as a holding company,” says Jennifer Lu, manager of corporate accounting services at Dezan Shira & Associates’ Hong Kong office. “The tax resident certificate is mandatory in order for the Chinese tax authority to approve the claim for treaty benefits. A Hong Kong holding company that is set up only to function as such and without actual operations will most likely not be recognized by the China tax authority as a beneficial owner.”
In this article, we trace the development of double taxation agreements for China investment by summarizing the legal framework in four categories:
China’s general anti-avoidance rules were first introduced under the 2008 Corporate Income Tax (CIT) Law, which provides that, where an enterprise’s taxable income is reduced due to its implementation of “arrangements that do not have a reasonable business objective,” the tax authority will have the right to make adjustments.
The CIT Implementing Rules further clarify that such arrangements are those for which the main purpose is to reduce, avoid or defer the payment of taxes.
Where there is abuse of tax preferential policies, tax treaties, enterprise organizational form, tax havens, or other arrangements without reasonable business purpose, tax authorities can launch a general anti-tax avoidance investigation based on the principle of “substance over form.”
Qualifying as beneficial owner
Circular 601 states that a recipient of dividends, royalties and interest from a Chinese resident enterprise is entitled to treaty benefits if the recipient can be named “beneficial owner” of such income.
Circular 30, released in late June 2012, builds on Circular 601 to make it simpler to obtain “beneficial owner” status. This circular presents a “safe harbor” of sorts, in that listed companies are automatically considered beneficial owners of dividend income. In addition, local level tax authorizes now cannot simply reject DTA relief claims, rather, they must first receive approval from the provincial level tax authority and then report the case to the SAT for filing.
Claiming treaty benefits
In August 2009, Chinese tax authorities introduced administrative requirements for nonresidents to undertake in order to enjoy benefits under DTAs.
These requirements differ based on the type of income: benefits from passive income must receive approval (which takes 20-50 days and is valid for three calendar years), while benefits from active income should be filed before the tax obligation arises or when declaring the relevant tax obligations.
Details on this requirement are given in Circular 124 and its supplementing Circular 290, which also states that a withholding agent should complete registration procedures regardless of whether the taxpayer has provided relevant information to the tax authorities.
Reporting offshore transactions
Where an offshore investor indirectly transfers equity in a Chinese resident enterprise, and the actual tax burden in the jurisdiction of the offshore holding company is lower than 12.5 percent, or the country exempts tax on offshore income, Chinese authorities should be notified.
This requirement, which comes from Circular 698, further states that where the transfer involves abuse of organizational structure, and the arrangement (i.e. the offshore holding company) has no reasonable business purpose, or is for the main purpose of evading the obligation to pay CIT, the tax authorities can disregard the offshore holding company.
To implement the circular, tax authorities ask questions about changes in key positions of a company during the approval process to flag any circumstances in which indirect equity transfer reporting should apply. In certain circumstances, tax authorities even look at press releases abroad for changes in company ownership.
Portions of this article came from the September issue of China Briefing Magazine titled, “Double Taxation Avoidance Agreements.” In this issue, we look at the evolution of the legal framework of double taxation agreements in China, including the foundations of anti-avoidance, obligations in reporting offshore transactions, how to qualify as a beneficial owner and how to claim treaty benefits. We also outline the interpretations given in Circular 75 of the China-Singapore DTA, which was the first time that the Chinese tax authorities really opened up about DTA interpretations.
Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.
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