Chinese Tax Developments Re-draw the Map for
Canadians doing business in China may have a hard time keeping up with the country’s rapid pace of tax reform. Over the past year, China has introduced a host of changes to its tax laws and administration that aim to increase compliance and eliminate tax avoidance by non-resident investors. A new protocol to the China-Barbados tax treaty could also affect companies investing into China through Barbados by eliminating relief that was previously available to dividends and capital gains. On a brighter note, China has also announced a series of Business Tax exemptions for certain foreign business activities.
Companies with business investments or operations in China may need to review their activities and business structures in light of these reforms. The following recent Chinese tax developments of interest to Canadian investors:
- Changes to the China-Barbados tax treaty
- New anti-avoidance rules for non-residents
- Enterprise Income Tax on representative offices in China
- New exemptions from China’s Business Tax.
Protocol to the China-Barbados tax treaty
Access to reduced dividend withholding tax rate restricted
Under the protocol to amend the China-Barbados tax treaty signed on February 10, 2010, access to the reduced five-percent withholding tax rate on dividend payments between China and Barbados is only available if a beneficial owner company directly holds at least 25 percent of the dividend payer’s capital. If not, the withholding tax rate under the treaty is 10 percent.
The five-percent withholding tax rate on dividends is still competitive compared with other China treaties. Among popular holding company jurisdictions, only China’s treaties with Luxembourg, Ireland, Singapore and Hong Kong currently provide a five-percent withholding rate on dividends. Each of these treaties also includes a 25-percent ownership test as a condition for the reduced withholding tax rate.
Capital gains exemption narrowed
The China-Barbados protocol restricts the current exemption for capital gains on the disposition of shares in Chinese companies, eliminating one of the advantages of the China-Barbados treaty and bringing it in line with other Chinese treaties. Once the protocol takes effect, China’s capital gains tax will apply to gains realized on the disposition of shares deriving more than 50 percent of their value from immovable property in China. Further, if a Barbados company holds at least 25 percent of a Chinese corporation, any gains realized on the disposition of shares are also taxable in China.
The changes to the China-Barbados treaty eliminate opportunities for foreign shareholders to avoid the Chinese capital gains tax on shares in land-rich Chinese companies and significant interests in Chinese investees.
New anti-avoidance rules for non-residents
The Chinese tax authority recently issued three circulars with guidance that aims to prevent cross-border tax planning that the government perceives as abusive.
Pre-approval of treaty benefits
Starting October 1, 2009, non-residents must request pre-approval to obtain benefits under one of China’s tax treaties on Chinese-source dividends, interest, royalties and capital gains. In a circular dated August 24, 2009, China’s tax authority clarified existing procedures and documentation requirements for non-residents to apply for pre-approval. The process requires extensive disclosure of the non-resident’s operations and group structure.
Intermediate holding companies
In a circular issued on December 10, 2009, China’s tax authority announced plans to eliminate traditional tax planning approaches involving intermediate holding companies. Specifically, the circular targets the “indirect” transfer of an interest in a Chinese company through the transfer of shares in a foreign-incorporated holding company. If the transfer of the intermediate holding company has no commercial purpose, avoids tax liabilities, and is undertaken in an “abusive” manner, the tax authorities can use the substance over form principle to recharacterize the transaction as a sale of the Chinese company and levy capital gains tax accordingly. These changes are retroactive to January 1, 2008.
The December 2009 circular does not define “abusive reorganisation planning”. However, if the shares of the Chinese resident corporation are transferred indirectly and the capital gains tax paid by the ultimate transferor is less than 12.5 percent of the gain, detailed information on the transaction and the parties’ relationship must be submitted to China’s tax authority within 30 days of the transfer. The documentation requirements include questions relating to the substance of the intermediary holding company and its function within the group.
Based on these information requirements, it appears that the Chinese tax authorities may consider the transfer of an intermediate holding company to be abusive where the transfer occurs tax-free and the intermediary company has no assets or activities other than its investment in the Chinese company.
Beneficial ownership of interest, dividends, and royalties
Another new circular sets out guidance on determining whether a non-resident is eligible for beneficial owner status and thus able to claim treaty relief on dividends, interest, and royalties. This circular took effect on October 27, 2009.
The Chinese tax authorities will take a “substance over form” approach in making these determinations. The circular distinguishes a “beneficial owner”, who owns or controls property in substance and “generally” carries on business in substance, from a “conduit company”, which is only registered to satisfy legal requirements but does not manufacture, trade or manage any commercial activities in substance. The circular lists seven factors that constitute unfavourable evidence:
1. The entity applying for beneficial owner status is liable to distribute all or most (e.g., more than 60 percent) of its income to a resident of a third country within a specified time period (e.g., 12 months).
2. The entity has no commercial activities other than holding property or shares that generate dividends, interest or royalties.
3. Where the entity does carry on a business, the assets, number of employees and scale of the business are so small that the business’s size cannot match the revenues earned by the entity.
4. The entity has little or no control over the property or shares that generate the dividend, interest or royalty income.
5. The entity pays little or no tax on income earned in the treaty country.
6. Where the entity seeks treaty benefits for interest income on a loan, the entity has a third-party loan that is similar in amount, interest rate and issuance date.
7. Where the entity seeks treaty benefits for royalty income from an underlying right regarding patent, franchise or intellectual property, there is a similar underlying right with a third party.
Factors 1 to 4 focus on whether the recipient has substantial activities in its residence country to justify the revenue received. Factor 5 focuses on the amount of tax paid on income earned in the treaty company. Factors 6 and 7 address situations where the loan, patent, franchise or intellectual property is provided via a back-to-back arrangement through an intermediate holding company in a favourable treaty jurisdiction.
Previously, a non-resident of China generally only had to provide a certificate of tax residency from its state of residence to obtain benefits under one of China’s tax treaties. These new administrative measures require extensive disclosures on the holding company and related tax planning arrangement. The measures reflect the Chinese government’s intention to tighten its enforcement of the taxation of non-residents and strengthen the tax authority’s ability to scrutinize and challenge tax planning strategies that are perceived to be abusive.
If the measures are applied and interpreted strictly, many current investment structures into China may have difficulty sustaining treaty benefits. KPMG in China is aware of cases where non-residents have failed to have their previous treaty entitlements renewed under the new rules.
Canadian companies with Chinese interests should review their holding, financing and intellectual property structures in light of these rules. Structures that do not meet these substance requirements could be restructured to increase the level of activity in the intermediary company (such as by transferring additional functions, assets and resources to the relevant country). Companies intending to set up new structures should account for these substance requirements in their planning. For example, such structures could be set up in countries in which the corporate group has or plans to establish a substantial business operation with its own third-party revenue, employees and physical assets, or substantial head office management functions.
Enterprise Income Tax on representative offices
On February 20, 2010, China’s tax authority announced new rules for calculating China’s Enterprise Income Tax (EIT) and related filing requirements. The EIT applies to non-resident companies that carry on business in China through a “representative office” in China. The changes apply retroactively from January 1, 2010.
Before 2010, Chinese domestic law provided an EIT exemption for representative offices on their market research, marketing communication, and auxiliary activities in China in support of the manufacture and sale of their products. Under the new rules, the relevant tax treaty must be reviewed to determine whether the representative office has a permanent establishment in China. If it does, China has the authority to tax the activities of the representative office. Treaties based on the OECD model treaty typically exclude certain auxiliary activities from their “permanent establishment” definitions; however, the specific treaty should be consulted.
Further, unless a representative office can provide complete and accurate financial records, it must calculate its income tax liability based on the cost-plus method. The new rules raise the mark-up rate to not less than 15 percent (from 10 percent).
Representative offices in China that do not meet the new requirements for exemption should consider the potential benefits of converting the entity to a wholly-foreign-owned corporation.
New exemptions from China’s Business Tax
On September 27, 2009, the Chinese government announced that certain foreign business activities are exempt from China’s Business Tax.
China’s Business Tax is a turnover tax that applies to individuals and entities providing services, transferring intangible assets or selling immovable property in China. The tax rate on the transaction ranges from three to 20 percent depending on the type of transaction. At the end of 2008, the scope of the Business Tax was significantly broadened. Previously, the tax only applied to services that were physically carried out in China. The current regime applies to companies or individuals that either provide or receive services that are located in China
Under the recent changes, Chinese companies and individuals that render services outside China are exempt from Business Tax with respect to construction, cultural and sporting activities. Also exempt are services provided to Chinese recipients outside of China by non-resident individuals and corporations in certain areas, including cultural and sporting services, entertainment, catering, hotels and warehousing services.
Since China’s Business Tax applies to any business services provided to or received by a Chinese resident, the tax can be a significant cost for Canadian companies investing or providing services in China. For example, the tax applies not only to transfers of intangible assets from a foreign entity to a resident of China but also to any future royalties paid by the Chinese resident with respect to the intangible assets, even though the withholding tax also applies to the royalties.
China Business Tax also represents an additional cost for interest payments made by a Chinese borrower to a foreign lender as the five-percent tax is charged in addition to the 10-percent withholding tax. Further, this additional tax is beyond the scope of China’s tax treaties and no treaty protection is available. In effect, for all jurisdictions other than Hong Kong, the effective tax burden on interest payments is now 15 percent (12 percent for Hong Kong).
Further, where a Chinese resident makes service payments to a foreign entity through an intermediate Chinese resident, the Business Tax would apply to both transactions. Foreign entities investing in China should be aware of the potential adverse application of China Business Tax and structure their transactions accordingly.
Since the active business income of foreign affiliates is exempt from Canadian tax, this change does not affect income earned through Chinese subsidiaries of Canadian companies. However, if the Canadian company carries on business in China directly, the change may jeopardize the company’s ability to offset the tax by claiming foreign tax credits for Canadian purposes since the Business Tax is not a tax on income or profit. As a result, Business Tax payments only qualify for an ordinary tax deduction for Canadian purposes, instead of a foreign tax credit or grossed-up deduction under the foreign affiliate rules.
Due to the general nature of the bulletin, it should not be relied upon as legal or tax advice.