Circular on Issues Relevant to the Interpretation and Implementation of Relevant Articles of the «Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income»

(Issued by the State Administration of Taxation on April 4 2007.)

Guo Shui Han [2007] No.403

Offices of the State Administration of Taxation and local taxation bureaux of the provinces, autonomous regions, municipalities directly under the central government and municipalities with independent development plans:

On August 21 2006, the mainland of China and the Hong Kong Special Administrative Region formally executed the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (the Arrangement). The Arrangement was implemented in the mainland of China from January 1 2007. With a view to duly implementing the Arrangement, we hereby clarify issues, such as the interpretation of relevant articles as follows:

1. Relationship between the Arrangement and Tax Regulations

The Arrangement is a legal standard for coordinating and demarcating the tax jurisdiction of the two areas and jointly applies to taxpayers in both areas. In the event of a discrepancy between tax regulations and the Arrangement, the Arrangement shall prevail. However, if treatment specified in tax regulations is more preferential than that in the Arrangement, matters may be handled in accordance with the tax regulations.

2. Date of Implementation of the Arrangement

The Arrangement was implemented in the mainland of China from January 1 2007 and applies to income derived by taxpayers after January 1 2007. Where the Arrangement applies to a resident enterprise or individual and determination of a tax obligation is based on duration of stay, counting thereof shall commence from January 1 2007.

3. Concerning Article 4, Resident

(1) Definition and determination of resident

The definition of the term "resident" in this Article is determined based on the laws of each of the Parties. The issue of whether a person is a local resident shall be determined by either Party itself.

(2) For the purposes of Item (2) of the first paragraph of Article 4, in the Hong Kong Special Administrative Region, the term "resident" means:

(a) an individual who is normally resident in the Hong Kong Special Administrative Region, namely, an individual who has a permanent domicile in Hong Kong where he/she and his/her family live and reside;

(b) an individual who in any tax year has stayed in the Hong Kong Special Administrative Region for more than 180 days or who, in two consecutive tax years (one of which is the relevant tax year), has stayed in Hong Kong for more than 300 days, i.e. an individual who works and resides temporarily in Hong Kong; or

(c) a Hong Kong resident with legal personality, which means an incorporated company established in Hong Kong (including companies with corporate status); or an incorporated company established outside of Hong Kong but whose normal actual management or control centre is located in Hong Kong, i.e. management of its overall day-to-day business operations, or implementation of management decisions or formulation of management decisions by the Board, etc., occurs in Hong Kong (e.g. if a branch of a foreign bank in Hong Kong is not responsible for the management of, and decision making on, the entirety of the foreign bank's operations, it shall not be deemed a Hong Kong resident eligible for treatment under the Arrangement).

(3) Issue of Satisfaction of Resident Conditions and Eligibility for Treatment under the Arrangement

If a resident individual normally resident in Hong Kong as mentioned in Item (1) above relocates to another country or region to work and, although considered a tax resident of such country or region pursuant to the provisions on residence criteria of the laws of such country or region, if, pursuant to the laws of Hong Kong, he/she remains a permanent resident of Hong Kong due to his/her permanent domicile being in Hong Kong or for other such reason, he/she shall remain eligible for treatment under the Arrangement.

When an individual temporarily resident in Hong Kong as specified in Item (2) above derives income from, or incurs a tax obligation in, the mainland of China, the agreement (or arrangement) relevant to the place of which he/she is a permanent resident shall apply. Namely, if he/she is only a temporary resident of Hong Kong while being a permanent resident of another country or region, the tax agreement between China and that other country or region shall apply to him/her. If no tax agreement exists between China and that other country or region, the provisions of domestic laws shall apply.

Where a Hong Kong resident requests treatment under the Arrangement, particularly when a resident who is deemed a resident individual of another country (or region) or a resident with legal personality established in a place other than Hong Kong is involved, the provisions of the Agreement shall be applied prudently. If his/her/its residential status cannot be clearly determined, the competent tax authority at the county level or above shall issue such resident a Letter Requesting Issuance of a Proof of Residence by the Competent Tax Authority of the Hong Kong Special Administrative Region, on the strength of which the taxpayer shall apply to the Internal Revenue Department of Hong Kong to issue him/her/it a proof of residence in Hong Kong (the application form for which is attached hereto) or submit information to the State Administration of Taxation for examination.

4. Concerning Article 5, Permanent Establishment

(1) For the purposes of the first paragraph of Article 5, the term "permanent establishment" means a fixed place of business from which an enterprise carries on all or part of its business. A fixed place of business does not only mean fixed places of business, such as offices and branches of enterprises of one Party that are registered, established and engage in business activities in the territory of the other Party, but also includes offices or other similar office facilities used for the purpose of providing long-term services to enterprises in the territory of the other Party. Such provision shall not affect the implementation of the other provisions of this Article.

(2) Issue of determining the constitution of a permanent establishment by virtue of the furnishing of services by an enterprise of one Party through employees or other personnel engaged by the enterprise in the territory of the other Party, as specified in Item (2) of the third paragraph

As the provision that "an enterprise of one Party assigns employees to the territory of the other Party to engage in service activities for more than 6 more months in succession or in the aggregate in any 12 months" in this Article only mentions "months" as the unit of calculation, in the course of implementation, the specific number of days may be ignored. In order to facilitate operation, the calculation of the aforementioned months shall, for the time being, be understood as follows:

If a Hong Kong enterprise provides services (including consultancy services) for a certain project in the mainland of China, the month during which the employees assigned by the enterprise to implement the service project first arrive in the mainland of China to the month when the service project is completed and the employees finally leave the mainland of China shall be the calculation period. If, during that period, no employees are in the mainland of China engaging in service activities for 30 days in succession, a month may be subtracted from the aforementioned period. If, calculated in this manner, six months is exceeded, a permanent establishment in the mainland of China shall be deemed to be constituted. If a service project exceeds 12 months, any 12-month period calculated based on the employees' arrival month or departure month during the entire duration of the project shall be the calculation period.

(3) Tax determination in connection with the processing of supplied materials

If an enterprise in the mainland of China undertakes a processing trade arrangement for a Hong Kong enterprise and the Hong Kong enterprise participates in the production, supervision, management or sale of the processed products in the mainland of China, the Hong Kong enterprise may, pursuant to Article 5 of the Arrangement, be deemed to constitute a permanent establishment in the mainland of China, and tax shall be levied on the profits accruing to such permanent establishment. However, this provision does not modify the current actual method in the mainland of China of levying enterprise income tax based on the processing fee revenues obtained by the aforementioned mainland enterprise in undertaking the processing of the supplied materials.

5. Concerning Article 9, Associated Enterprises

Implementation of this provision involves the determination of, and tax administration in respect of, associated enterprises, and when handling the special relationship between the payer and the beneficial owner as mentioned in the seventh paragraph of Article 11, Interest, and the sixth paragraph of Article 12, Royalties that involves a tax adjustment, matters shall be handled in accordance with domestic laws and relevant provisions.

6. Concerning Article 11, Interest

Pursuant to the provisions of Article 11, Interest, of the Arrangement, Hong Kong residents, regardless of whether they are enterprises or individuals, shall pay income tax on interest income derived from the mainland of China at a tax rate of 7%. In order to prevent abuse of the Arrangement, individuals who are at once deemed temporary residents of Hong Kong and permanent residents of a third party and resident individuals of Hong Kong who have lost their permanent residence status in Hong Kong and become a resident of a third party are not eligible for treatment under the Arrangement.

For savings deposit interest derived from the mainland of China, a resident individual of Hong Kong may carry out the procedures to enjoy the preferential treatment under the Arrangement directly with the savings institution on the strength of a valid document such as his/her ID card, home return permit or proof issued by the Internal Revenue Department of Hong Kong. The specific levy procedure shall continue to be carried out in accordance with the State Administration of Taxation, Circular on Issues Relevant to Individual Income Tax on the Interest Income that Foreign Nationals and Residents of Hong Kong, Macao and Taiwan Derive from Savings Deposits (Guo Shui Fa [1999] No.201).

For other forms of interest income derived from the mainland of China by a resident individual or legal person of Hong Kong, his/her/its withholding agent may apply on the strength of the relevant documentation (proof of resident status, the contract giving rise to the interest income, etc.) for the preferential treatment under the Arrangement to the tax authority of the place where the interest was derived. The local tax authority shall carry out the relevant tax levy matters based on the tax rate specified in the Arrangement.

7. Concerning Article 13, Capital Gains

(1) Gains derived from the transfer of shares in a company the property of which comprises mainly immovable property

In the fourth paragraph of Article 13 and in Article 2 of the Protocol concerning gains derived from transferring company shares, if a company's property mainly comprises immovable property, the word "mainly" in the provision specifying that the Party in whose territory the immovable property is located has the right to levy tax means, pursuant to the Protocol, not less than 50%. For the time being, such provision shall be understood as meaning that immovable property accounted for at least 50% of the company's booked assets at one point during the time the shareholder held the company's shares and shall be implemented in such light.

(2) Gains derived from the transfer of shares of other companies

In the fifth paragraph of Article 13 concerning gains derived from the transfer of company shares, if the shares are equal to not less than 25% of the equity of a resident company in the territory of one Party, the following principle shall, for the time being, be followed when understanding the provisions of that Party in accordance with which tax may be levied: if a Hong Kong resident once held at least 25% of the shares of a mainland company, when he/she derives gains from the transfer of all or part thereof, the mainland of China shall have the have the right to levy taxes thereon.

(3) Notwithstanding the foregoing, the Parties may, through negotiations, separately determine a specific time limit for the term "at one point".

8. Concerning Article 14, Income from Employment

The term "income from employment" means the income that a non-independent individual derives from the provision of services. Item (1) of the second paragraph of this Article revises the original phrase in the Arrangement, which read "stays for not more than 183 days in succession or in the aggregate during the relevant tax year" to read "stays for not more than 183 days in succession or in the aggregate in any 12-month period commencing or ending in the relevant tax year" and, for the time being, this provision shall be interpreted and implemented as follows:

(1) The phrase "stays for not more than 183 days in succession or in the aggregate in any 12-month period commencing or ending in the relevant tax year" means stays for not more than 183 days in succession or in the aggregate in a 12-month period counting forward from the month in which any entry date fell or backward from the month in which any departure date fell.

Calculating based on the foregoing principle, if a resident individual of Hong Kong stays for more than 183 days in succession or in the aggregate in a 12-month period and the beginning month and ending month fall in two different tax years, he/she shall be liable for tax obligations for all the income he/she derived during all the working months in the mainland of China during the two tax years.

For example, if an individual from Hong Kong engages in employment activities in the mainland of China in February, April, November and December of 2007 and March, April, May, October and December of 2008 and during the period between November 2007 and October 2008 he/she stayed more than 183 days, he/she shall be liable for taxes for all the months he/she stayed in the mainland of China in the tax years in which the period between November 2007 and October 2008 falls and during which period his/her stay reached 183 days, namely the 2007 and 2008 tax years, i.e. this includes both the months he/she stayed in the mainland of China during the 12- month period between November 2007 and October 2008 as well as February and April of 2007 and December of 2008, months that also fell in the tax years during which the 12-month period fell.

(2) The actual determination of tax obligations and calculation of taxable income may be accomplished as follows:

(a) during the time limits for tax filings or from the departure dates of the relevant individual, count backwards 12 months and determine whether that individual stayed for 183 days in succession or in the aggregate during those 12 months, and if the 183 days is reached, he/she shall be determined to have tax obligations for all his/her months worked in the mainland of China during the relevant one or two tax years;

(b) when actually calculating the taxable income for the relevant months and determining the applicable formula, the method and formula specified in the State Administration of Taxation, Circular on Issues Relevant to the Implementation of Tax Agreements and the Individual Income Tax Law (Guo Shui Fa [2004] No.97) shall continue to apply.

9. Provision of Services by Independent Individuals

The definition of the term "enterprise" in Article 3 of the Arrangement includes entities with legal personality and individuals and the definition of the term "business" includes the business activities of entities with legal personality and individuals. Accordingly, the Arrangement does not set out separate provisions for the provision of services by independent individuals. The tax obligations of independent individuals who provide services may be determined based on the provisions concerning permanent establishments. If a Hong Kong resident engages in business activities in the mainland of China in his/her capacity as an independent individual and, in accordance with the provisions concerning permanent establishments, he/she fulfills the criteria for constituting a permanent establishment, his/her income derived from the mainland of China in his/her capacity as an independent individual shall be handled in accordance with the relevant provisions of the Individual Income Tax Law.

10. Concerning Article 21, Methods for Elimination of Double Taxation

The Arrangement adds a third paragraph on indirect deduction, which refers to a company that is a resident of one Party conducting investment activities in the territory of the other Party. If the shares in the company in the territory of the other Party invested in total not less than 10%, the dividends derived from that company shall be deductible from the enterprise income tax liability in the territory of the other Party.

11. Concerning Article 23, Consultation Procedure

Pursuant to the first paragraph, if a taxpayer is of the opinion that a measure taken or to be taken by a Party or both Parties has resulted or will result in taxes not complying with the Arrangement being levied on him/her, he/she may ignore the remedies available under the internal laws of the Parties and directly submit the facts of the case to the competent authority of the place where he/she is a resident (which must be done within three years). If an objection occurs when a tax authority at any level is applying the Arrangement and it needs to contact and negotiate with the Hong Kong tax authority, it shall report the same to the State Administration of Taxation, and the matter shall be resolved through consultations between the State Administration of Taxation and the Internal Revenue Department of Hong Kong.

12. Concerning Article 24, Exchange of Information

Once the Arrangement has been implemented, the tax authorities of the Parties may engage in information exchanges. The information for which an exchange request is made may be information on taxpayers for the year prior to commencement of implementation of the Arrangement, provided that such information is applicable to taxation in tax years following the implementation of the Arrangement.

13. Concerning Article 25, Miscellaneous Rules

The term "laws and measures concerning tax avoidance" mentioned in this Article shall be understood to include provisions for preventing abuse of the Arrangement.

14. Miscellaneous Provisions

With respect to other provisions not clarified herein, if the same are consistent with the provisions of agreements executed with other countries by China, reference may be made to interpretive documents relating to those agreements and related implementation procedures, etc., when handling matters. If the provisions of relevant articles that have been explained herein are completely consistent with the provisions of relevant articles of agreements executed with other countries by China, but have not been clarified in previous interpretive documents for such agreements, the interpretations hereof shall similarly apply to the interpretation and implementation of the identical articles of such agreements. Existing documents interpreting articles of the Arrangement shall continue in effect provided that they are consistent with the provisions of the articles of the Arrangement.

Each region is requested to correctly understand and implement the provisions of the Arrangement and to promptly report to the International Tax Department of the State Administration of Taxation problems arising in the course of implementation.

Appendices:

1. Application Form for Proof of Resident Status (for Individuals) in Connection with the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income

2. Application Form for Proof of Resident Status (for Companies, Partnerships, Trusts and Other Entities) in Connection with the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income