New Tax Arrangement between the Mainland and Hong Kong

Dividends

Under the New Arrangement, dividends paid by a Chinese company to its Hong Kong shareholders will be subject to a Chinese withholding tax rate of 5%, provided that the Hong Kong shareholder owns more than 25% of the equity interest of the Chinese company. Although dividends paid by a foreign investment enterprise to their foreign investors are currently exempt from the 10% Chinese withholding tax, it is unclear whether this exemption will survive the Mainland's ongoing tax law reforms. If the current full exemption is withdrawn, the New Arrangement will at least provide some protection to qualified Hong Kong investors.

Interests and royalties

The New Arrangement lowers the Chinese withholding tax rate to 7% for interests and royalties paid by Chinese companies to Hong Kong creditors or royalty owners. Under the current tax treaties between the Mainland and a majority of other countries, the Chinese withholding tax rate is 10% for interests and royalties.

Capital gains

In addition, provided that the shares disposed of are less than 25% of the total shares of the Chinese company (that is not a real estate holding company under a 50% value test), the New Arrangement provides a Chinese withholding tax exemption for capital gains generated by Hong Kong investors from disposing shares in Chinese companies. Under current Chinese law and tax treaties with a majority of other countries, gains derived by foreign investors from disposal of shares in Chinese companies are generally subject to a 10% withholding tax.

Exchange of information

The New Arrangement contains an exchange-of-information provision (Article 24) that was not included in the Old Arrangement. This provision states that both the Mainland and Hong Kong taxation authorities must exchange such information as is necessary for implementing the provisions of the New Arrangement or relevant taxation laws concerning the taxes covered by the New Arrangement (to the extent that the existing tax laws do not conflict with the New Arrangement). The New Arrangement emphasizes that both sides should exchange information to prevent illegal tax evasion. Any information received for these purposes must be treated as confidential information.

It should be noted that Article 24 applies only to information relating to those taxes covered by the New Arrangement. Accordingly, taxes not covered by the New Arrangement (such as the value-added tax) are not subject to this information exchange requirement.

Employment income

Under the Old Arrangement, if a Hong Kong employee stays for more than 183 days (in a calendar year) in the Mainland, the salary derived from his or her activities within may be taxed by the Chinese taxation authority. The New Arrangement amends the base period during which the number of days spent in the Mainland is counted from a calendar year to any 12-month period. Consequently, the New Arrangement will make it harder for Hong Kong employees frequently visiting the Mainland to ensure that they do not breach the 183-day threshold.

Incentives for investing in HK

The New Arrangement has significantly extended the scope of the Old Arrangement. The New Arrangement now covers direct income earned by businesses and individuals, such as operating profits and employment income, as well as indirect income, such as dividends, interests, royalties, and capital gains. The New Arrangement also ensures that the same income will not be taxed twice in the two jurisdictions.

Overall, the New Arrangement provides more incentives for international investors to enter the Mainland market through Hong Kong. The lowered withholding tax rate on dividends provides more certainty to foreign investors who fear that the Mainland will completely withdraw the withholding tax exemption on dividends in its tax reforms. Moreover, the New Arrangement may prove to be especially beneficial for investors intending to hold their Chinese investment on a long term basis. In fact, the withholding tax rates contained in the New Arrangement are possibly the lowest, when compared with the treaties entered into between the Mainland and other countries.

Furthermore, the preferential withholding rates on interest and royalties will promote financing investments and licensing of intellectual properties between the Mainland and Hong Kong.