New challenges in the pursuit of tax treaty benefits

The State Administration of Taxation (SAT) provided a more formal legal basis for disregarding the existence of an SPV that lacks economic substance in the Implementation Measures for Special Tax Adjustments (for Trial Implementation) (Circular 2 – 关于印发《特别纳税调整实施办法（试行）》的通知), issued on January 9 2009. Among other things, Circular 2 sets out detailed implementing rules for the anti-avoidance principles. Article 94 of Circular 2 specifically permits the tax authorities to disregard the existence of an enterprise that lacks economic substance, particularly one established in a tax haven.

On February 20 2009, the SAT issued the Circular on Issues Relevant to the Implementation of Articles on Dividends of Tax Agreements (Circular 81 – 关于执行税收协定股息条款有关问题的通知), imposing more stringent procedural and documentary requirements for favourable treatment under a tax treaty on dividends paid to non-resident shareholders. Circular 81 addressed the situation where the withholding tax rate on dividends under a tax treaty is lower than the 10% rate under domestic law. It reiterated the basic requirements for a dividend to enjoy the tax treaty benefit: (i) that the dividend must qualify as a dividend under the tax law of China, and (ii) that the recipient of the dividend must be a tax resident of the other treaty jurisdiction and must be the beneficial owner of the dividend. More significantly, Circular 81 formalised the procedure for obtaining tax clearance to pay a dividend and required the Chinese enterprise paying the dividend to provide evidence to the tax bureau showing that the above requirements are satisfied.

More recently, the SAT instituted an approval procedure for non-resident enterprises and individuals to obtain certain tax treaty benefits related to dividends, royalties, capital gains and permanent establishments (PE). The Measures for the Administration of Entitlement to Treatment under Tax Agreements by Non-residents (Trial Implementation) (Circular 124 – 非居民享受税收协定待遇管理办法 (试行) , which took effect on October 1 2009, requires the non-resident to submit a host of documents when applying for treaty benefits. For example, to claim the treaty withholding tax rate on dividends, a non-resident enterprise will need to disclose all of its direct and indirect shareholdings in Chinese enterprises, as well as provide a description of its major business operations in the treaty country, the gross income it derives in the treaty country, the number of its employees in the treaty country, and its related party transactions undertaken outside of China. Since Circular 124 came into effect recently, it remains uncertain precisely how the tax authorities will use this information when determining whether or not to approve treaty benefits. One possibility is that, in certain cases at least, they will use this information to determine whether the applicant has economic substance in the treaty jurisdiction and apply the anti-avoidance principle to deny treaty benefits where economic substance is lacking.

It is important to note that the few anti-avoidance cases the tax authorities have published to date have not specifically addressed the denial of treaty benefits based on a non-resident enterprise's lack of economic substance. Moreover, although we know that many local tax authorities have started to implement the reporting and documentary requirements under Circular 81 and Circular 124, we are not yet aware of a case in which a shareholder that had obtained a tax residency certificate in the other treaty jurisdiction was denied the dividend withholding tax rate under the treaty. But the situation may soon change with the issuance of Circular 601, which directly links the concepts of beneficial ownership and anti-avoidance in the context of possible abuses of tax treaties.

Circular 601 – beneficial ownership
The SAT issued the Circular on How to Interpret and Recognise the “Beneficial Owner” in Tax Agreements (关于如何理解和认定税收协定中“受益所有人”的通知)

– known as Circular 601 – on October 27 2009 and released it to the public on November 5. Circular 601 addresses the determination of beneficial owner status under the tax treaty articles on dividends, interest and royalties. Under most treaties, the recipient of dividends, interest or royalties must be the beneficial owner of the income to qualify for the treaty withholding tax rates. Circular 601 also lists the factors that will be taken into account during a substance over form assessment of beneficial owner status by the tax authorities in China.

According to Circular 601, a beneficial owner can be an individual, company or other organisation that has ownership and control over the relevant income or the assets that generate the relevant income. In general, a beneficial owner must be engaged in substantive operating activities.

Agents and conduit companies are specifically excluded from the definition of beneficial owner. A conduit company is defined as a company that is established with the purpose of avoiding or reducing taxes or shifting profits. It is further described as a company that has only completed the formality of registration and fulfilled legal organisational requirements, but is not engaged in substantive operating activities such as manufacturing, sales or management.

According to Circular 601, the tax authorities must evaluate whether an applicant (income recipient) qualifies as a beneficial owner on a case-by-case basis based on the “substance over form” principle. Several factors are listed in Circular 601 that the tax authorities may consider in a comprehensive assessment of whether an income receipt is a beneficial owner of dividends received from its subsidiaries in China. Some of the factors listed in Circular 601 that may indicate that an income recipient is not a beneficial owner include: the income recipient is obligated to distribute all or most of the income from its PRC subsidiary to a resident in a third country (region) within a short time-frame; the income recipient has minimal or no operations other than holding the property or rights that generated the income in question; the income recipient has minimal or no control over the distribution / disposal of the income from its PRC subsidiary (or the income-generating assets of its PRC subsidiary and bears minimal or risk in relation to such assets); the income recipient's assets, scale and number of employees is small and disproportionate to the income that it receives; the income received from the PRC subsidiary is not subject to tax, is exempted from tax or is taxed at a very low effective tax rate in the treaty partner's country or region. (Circular 601 also lists factors for interest and royalty, in Article 2(6) and (7).)

To establish beneficial ownership of income, the burden is on the income recipient to provide supporting documentation showing that it does not fall within the above factors. Circular 601 notes that, whenever necessary, the tax authorities can obtain additional information or verify the information submitted by the income recipient through the information exchange mechanism under the relevant tax treaty.

Circular 601 – Analysis
The test of beneficial ownership under Circular 601 involves three fundamental inquiries: (i) whether the income recipient has sufficient control over the receipt and disposal of the income; (ii) whether the income recipient has economic substance; and (iii) whether the income received is subject to tax in the treaty jurisdiction in which the income recipient is resident.

Meeting the standards
(a) Control over receipt and disposal of income: To show that the income recipient has control over the dividend income, it should not distribute the dividend received to another entity within a relatively short period of time (the example given in Circular 601 is 12 months). Corporate documents such as shareholder agreements should be put into place to clearly show that the income recipient has control over the income received (e.g. the board of directors of the income recipient must unanimously agree to distribute the received income).

(b) Economic substance: The SAT has not yet defined the meaning of “economic substance” for anti-avoidance purposes generally or for beneficial ownership purposes specifically. Some of the common techniques used internationally (such as establishing an office, conducting some degree of business activity, holding board meetings and maintaining books and records in the other treaty jurisdiction, or hiring employees to carry on its business in the other treaty jurisdiction or to manage the investments in China) are likely to be helpful to the taxpayer, but the degree of activity that will be required is not yet known.

(c) Taxation of income in the other treaty jurisdiction: Determining whether the income received is subject to tax in the other treaty jurisdiction could potentially be the most problematic factor for foreign investors with SPVs in treaty jurisdictions such as Hong Kong, Singapore, Barbados or Mauritius. Most jurisdictions that have favourable withholding tax rates (i.e. 5%) on dividends from China either do not tax offshore sourced dividends (e.g. Hong Kong) or exempt offshore sourced dividends from taxation (e.g. Singapore). Although the taxation in Mauritius and Barbados on offshore dividends is beyond the scope of this article, we note that tax authorities in many countries consider the taxation of offshore dividends in these two jurisdictions to be “low”.

Circular 601 also does not define what is considered to be a “low effective tax rate”. Further guidance is needed from the SAT on this issue.

Enforceability and unanswered questions
Although Circular 601 lays out the factors that the tax authorities should consider for determining “beneficial ownership”, at this stage questions remain about how it will be implemented. For example, Circular 601, as well as Circular 81 and Circular 214, require the income recipient or its withholding agent to provide a great deal of documentary evidence to prove that the recipient of dividend is eligible for the treaty benefits. These requirements will place a heavy burden on taxpayers to gather and produce the documents, as well as a burden on the tax authorities to review and analyse them.

Two things, at least, are unclear about Circular 601: (i) whether all of the factors listed Circular 601 have to be met for an income recipient to be considered a “beneficial owner” of dividends or how much weight should be given to each one; and (ii) whether an income recipient will have any recourse if the information requested is genuinely not available. In relation to the first question, Circular 601 describes the listed factors as considerations, implying that the tax authorities have a significant degree of discretion in making the determination. In relation to the second question, it is noted that the 1986 OECD report on conduit companies (Double taxation conventions and the use of conduit companies, Section II.B.14.b,) specifically stated: “…[I]t is usually difficult for the country of source to show that the conduit company is not the beneficial owner…as [such inquiry will] be highly burdensome…and even [the other treaty jurisdiction may not] have the necessary information regarding the conduit company…so even an exchange of information between the country of source and the country of the conduit company may not solve the problem…”

Circular 601 also does not discuss the recourse available to an income recipient who has been denied beneficial owner status. A foreign taxpayer potentially has recourse through the administrative review process in China or under the competent authority process under an applicable tax treaty, but formal procedures of this kind have seldom been used, at least partly because of concerns about long-term damage to the taxpayer's government relations in China. Typically, taxpayers seek to manage tax disputes to a mutually acceptable outcome before the first formal decision is issued, so as to avoid having to consider formal appeals after the fact. In the present context, however, the failure of a non-resident taxpayer to pursue all available recourse in China could affect the foreign tax credit available in the taxpayer's country of residence.

As an example, consider a US company that holds a PRC subsidiary through an SPV in Hong Kong. The Hong Kong SPV is subject to 5% withholding tax on dividends received from the PRC subsidiary. If the PRC tax authorities reject the Hong Kong SPV as the “beneficial owner” of the dividends, a 10% withholding tax could be levied. To claim this additional 5% tax for foreign tax credit purposes in the US, however, the US company generally must exhaust all practical and effective remedies (including, potentially, review by the competent authority).

Structure carefully
The recent tax circulars on tax treaty applications have introduced greater uncertainty as to how aggressively the PRC tax authorities will challenge treaty benefits in relation to dividends paid to foreign investors. The message, however, is becoming clear that the recipient of the income must be the true economic owner of the income to qualify for treaty benefits. Hence, when structuring investments in China with the goal of obtaining a tax treaty benefit, the taxpayer should make sure that the recipient of the income shows a sufficient amount of economic ownership under these new rules to qualify.

Jon Eichelberger and Roberta An Chang, Baker & McKenzie