Saving money: How multinationals can benefit from China's tax treaties

Foreign income taxes, including withholding taxes, actually paid by resident enterprises on non-China sourced income may be deducted from the total amount of payable EIT. A resident enterprise receiving dividends from a controlled foreign enterprise (a foreign enterprise in which the resident enterprise directly or indirectly holds a 20% share and that is within three tiers immediately below it) is also entitled to indirect foreign tax credits for the underlying taxes paid by the controlled foreign enterprise on the profits out of which dividends are distributed.

The foreign tax credit is limited to the amount of tax payable on the non-China sourced income under the EIT Law. This limitation is calculated on a country-by-country basis. Excess foreign tax credits may be carried forward for five years.

Non-resident enterprises

A non-resident enterprise (NRE) is subject to EIT at the rate of 25% on the China-sourced income derived by its place or establishment in China and on its non-China-sourced income effectively connected with the place or establishment.

A “place or establishment” is a domestic law concept similar to that of a permanent establishment (PE) under DTAs. The PE definition under a relevant tax treaty concluded by China may override and serve to limit the broad definition of place or establishment under domestic law.

Withholding tax

Withholding tax is imposed on China-sourced dividends, interest, royalties and rental income, gain from the transfer of property and other China-sourced income, which is derived either:

• by a NRE without a place or establishment in China, or
• by a NRE with a place or establishment in China, when the income is not effectively connected with it.

Dividends, interest, royalties and rental income paid by a PRC resident enterprise to a NRE are China-sourced income, while gain from the transfer of shares in a resident enterprise is regarded as such.

The statutory withholding tax rate on all forms of passive income paid to NREs is 20% but the Implementing Rules of the EIT Law reduce the rate to 10%. The statutory withholding tax rate is also subject to reduction or exemption by a DTA, when applicable.

Indirect transfers

Normally, gain derived by a NRE from the transfer of shares in a foreign enterprise is not China-sourced income, and thus not subject to withholding tax in China.

However, if a non-resident enterprise sells real property situated in China or property owned by a place or establishment in China (China taxable property) to a PRC resident enterprise through an indirect share transfer (i.e. by transferring the shares of the target asset's offshore holding company), the non-resident seller may be subject to EIT in China on capital gains based on the Several Issues of Enterprise Income Tax on Income Arising from Indirect Transfers of Property by Non-resident Enterprises (SAT Bulletin [2015] No. 7), issued by the SAT in February 2015. An indirect transfer generally will be recharacterized as direct if it lacks reasonable commercial purpose and does not fall within any safe harbors. It is also worth noting that the buyer should be the withholding agent. PRC tax authorities heavily focus on the economic substance of the offshore holding company to determine the reasonable commercial purpose.

China's tax treaties

China's tax treaties are generally based on the Organization for Economic Co-operation and Development (OECD) and United Nations (UN) model tax treaties.

A tax treaty can only apply if there is a resident recipient of the income. The treaty generally will not apply if the income is received by someone who is not a resident of a contracting state, even if the income is paid by a resident of the other state.

The main function of treaties is to limit contracting states' taxing rights. These limitations are contained in Chapter 3 of a tax treaty and present different forms, depending on how the taxing rights are allocated between the two contracting states.

Treaty provisions with mainstream countries, which are dealt with the PE, dividends, royalties, interest, and capital gains under China's tax treaties, can limit China's taxing rights on an NRE in various ways.

Permanent establishment

The PE definition under China's tax treaties may override and limit the broad definition of place or establishment under domestic law. Under the protection of an applicable tax treaty, an NRE in general will be exempt from EIT on its active income in China if it does not have a PE in, or drive any locally-sourced passive income from, China.

Typically, under the DTAs concluded by China, an NRE can create a PE in China on these grounds:

(a) a fixed place of business in China through which the NRE's activities are wholly or partially carried out (Physical PE); (b) a dependent agent that habitually exercises the authority to conclude contracts on behalf of the NRE in China (Agent PE); and (c) the furnishing of services in China through employees or other personnel for a period exceeding six months or 183 days, depending on the treaty, in any 12-month period in connection with one or related projects (Service PE).

To determine the time threshold for a Service PE, China used to have a rule under Guo Shui Han [2007] No.403, i.e., 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», which provided that a month is counted from the day an employee of a foreign company first enters China to perform services to the last day he is present for the same or connected projects, regardless of the number of days that the employee actually spends. During this period, however, for each consecutive 30 days that the foreign company does not have an employee in China to perform services for the project, one month is deducted from the total number of months. This rule was often referred to as the “one day equals one month” rule.

If, by using this method, the total number of months exceeds 6 months in any 12-month period, the foreign company will be deemed to have a PE in China. Thus, one day can equal one month, and it is theoretically possible that one day a month over seven months can create a PE.

This was repealed in 2011. The “one day equals one month” rule is no longer reflected in published regulations, although the practice is still followed by a number of local tax authorities because the SAT has not issued any new rule to replace it.

Therefore, China's tax treaties with the term “183 days”, rather than “six months”, are often regarded in practice as having more favorable terms because the above rule will not apply to DTAs with the more specific “183 days”.

The following table lists the periods under applicable DTAs for a Service PE for mainstream countries:

Table 1:

Dividends, interest and royalties

The domestic withholding tax rate on dividends, interest and royalties is 10%. Tax treaties may reduce the rate of withholding tax payable on these where the recipient is the beneficial owner of the relevant payments.

To qualify for reduced treaty rates, the recipient of the dividend, interest or royalty must be the beneficial owner of the income. A “beneficial owner” can be an individual, company or other organization that has ownership and control over the relevant income or the assets that generate it. In general, it needs to be engaged in substantive operating activities and specifically excludes agents and conduit companies.

To determine whether the recipient is a beneficial owner, PRC tax authorities focus on an economic substance analysis. The relevant factors to determine economic substance include the scale of the company's assets, the number of its employees, the amount of registered capital and the size of its operational activities. These criteria are outlined in the SAT's Circular on How to Interpret and Recognise the “Beneficial Owner” in Tax Agreements (Guo Shui Han [2009] No.601), issued on October 28 2009.

There is no clear threshold for how much substance is sufficient (e.g. number of employees, amount of capital). Thus, as a general rule, the more operations that can be located within the holding company, the better. Several Chinese tax cases suggest that a foreign entity located in a zero- or low-tax jurisdiction, like Hong Kong or Mauritius, will likely be denied beneficial owner status if it conducts little or no business activity other than that for which the entity owns the income-generating property or rights and if it has insufficient assets, business operations and personnel to match the income.

Table 2 lists the rates under applicable treaties for dividends, interest and royalties for mainstream countries:

Table 2: