Beneficial ownership gets international flavor in new overhaul

“Announcement 9 includes more qualifying scenarios for beneficial ownership where no tax avoidance motive appears to exist,” says Abe Zhao, international tax director at Baker McKenzie FenXun (FTZ) Joint Operation, China, in Beijing. “It also strengthens the business substance and anti-conduit elements in the previous Circular 601.”

NEGATIVE FACTORS REDUCED

The main body of the legislation centers on the so-called negative factors or reasons “not beneficial to a determination of an Applicant's status as a Beneficial Owner”. Circular 601's seven negative factors have either been changed, retained or deleted and in Announcement 9 now number five. They deny beneficial ownership if the applicant is obliged to pay 50% of the money received to a third party in another country within a year of receiving it – this was 60% under Circular 601; if the tax burden in the location where the applicant is tax resident is particularly low; if the applicant's business activities are not substantive enough; if loan or deposit contracts exist between the applicant and third parties, and if an agreement exists between the applicant and third parties to use the IP for which royalties have been generated and paid in China.

“The focus of the circular in respect of negative factors is on where the determination for beneficial ownership relates to dividend payments,” says Yan Xu, associate professor of law at the Chinese University of Hong Kong. “The circular deleted some negative factors in Circular 601 while making the other factors clearer and more operable.”

Circular 601 emphasized economic substance of the beneficial owner in determining whether an applicant qualified as a beneficial owner. The circular, in fact, managed to confuse taxpayers, as it disqualified from beneficial ownership anyone that had little or no operational activity, or only owned assets or rights. At the same time, it defined 'substantive operational activity' as manufacturing, trading, management or other similar activities, but denied applications for beneficial ownership from taxpayers that primarily carried on investment, holding or managing activity.

“Announcement 9 has consolidated the relevant rules and made it clear in what circumstances the carrying on of investment, holding or management activity is considered qualifying as substantive operational activity,” says Xu. “The clarification of the rules will help bring legal certainty to the applicants and would be beneficial to Hong Kong as Hong Kong has many companies engaging in investment, holding or management activities.”

Zhao, however, believes Announcement 9 could have made the negative factors more stringent than under Circular 601: “The bar on when investment holding activities represent a substantive business operation has been potentially raised. That is the most important change.”

He explains that Announcement 9 states that a treaty applicant will only be considered as running a substantive business by virtue of holding Chinese subsidiaries if it carries out the full range of investment management functions such as pre-investment research, investment evaluation and analysis, investment decision-making, investment execution, and subsequent administration, and assume the relevant risks corresponding to these functions.

“If the investment management activities of a treaty applicant playing the role of a holding company do not meet the above requirement, the treaty applicant needs to engage in other operating activities such as manufacture, distribution, service functions as a remedy,” says Zhao. “These other operating activities must be carried out on a substantial scale, or a conclusion will be reached that the treaty applicant does not conduct substantive business and does not qualify as a beneficial owner.”

BROADER SAFE HARBOR RULE

The safe harbor rule for dividends of listed companies has become broader under the new rules, as governments and individuals are now included. The rules now say that an applicant is eligible for treaty benefits if it is the government of the other contracting state, an individual or company that is a tax-resident in the other contracting state, or a company which is 100% directly or indirectly owned by either of these three, as long as “the intermediate layer under the indirect shareholding situation is a PRC resident or a resident of the other contracting state”. Applicants do not have to take the negative factors into account to apply this rule to dividends.

The safe harbor rule is also relevant where an applicant could avail of the beneficial ownership rules even if the negative factors are against them. It is one example of where Announcement 9 extends the criteria for beneficial ownership, while restricting the opportunities for avoidance. This has also been referred to as the “same country, same treaty benefit” rule and relates to recipients of dividend payments in a multi-layer holding structure.

SAME COUNTRY , SAME TREATY BENEFIT

Under the beneficial ownership regime before the introduction of Announcement 9, if the immediate dividend recipient did not qualify for tax treaty benefits according to the safe harbor rule of Public Notice 30 or the seven negative factors of Circular 601, they could not have them. However, Announcement 9 does entitle them to the benefits in two situations:

• where the entity that, directly or indirectly, owns 100% of the applicant qualifies for beneficial ownership under the circular's five negative factors, and it and the applicant are tax residents of the same jurisdiction; and

• if the applicant and its 100% shareholder are tax residents of different jurisdictions but the shareholder is a beneficial owner under the five negative factors, and it and all the other intermediate shareholders in the structure are tax residents of jurisdictions that have treaty benefits related to dividends that are equal to or better than those where the applicant is tax resident.

While the same country, same treaty benefit rule looks favorable to taxpayers, it only applies to dividend payments, not to interest or royalties, and is only relevant where the holding company has a 100% direct or indirect stake in the applicant.

TAX RESIDENCY

Even if taxpayers believe they qualify for treaty benefits under Announcement 9, they will struggle to convince the authorities if they cannot prove where they come from. Proof of tax residency is an important element of making a legitimate claim for beneficial ownership. To support their status as a beneficial owner, taxpayers must produce a tax residency certificate for the jurisdiction where they are resident and which has a tax treaty with China. The announcement refers specifically to Hong Kong and Macau taxpayers under this heading.

Xu says this requirement is important when placed alongside the ability given to taxpayers under Announcement 9 to self-assess whether they qualify for beneficial ownership and can claim treaty benefits, rather than apply to a tax authority.

“This means the procedure has become much simpler and more efficient,” she says. “However, in doing so, the applicants must ensure they and other relevant persons have a tax residence certificate at hand, demonstrating they are the tax residents of a jurisdiction that has concluded a DTA with China. A typical example is Hong Kong. If an applicant from Hong Kong considers itself a qualified beneficial owner, the applicant can claim treaty benefits, provided that the applicant has obtained a tax residence certificate from the Inland Revenue Department of Hong Kong. The IRD has tightened the issuance of tax residence certificates, which is part of the global trend in strengthening tax administration on cross-border taxation matters in the post-BEPS era.”

ANTI-AVOIDANCE

But while China is intent on making it easier for taxpayers to claim beneficial ownership, it also wants to make sure they don't take any short-cuts in seeking the most tax-efficient arrangements. Under article 10 of the circular, the relevant anti-avoidance provisions, such as the principal purpose test (PPT), a minimum standard under Action 6 of the BEPS Project to prevent the abuse of treaty benefits, or the main purpose test in different tax treaties between China and other jurisdictions, such as Germany and the UK, or China's general anti-avoidance rules (GAAR) can override beneficial ownership.

The PPT combines subjective and objective elements. The subjective refers to the situation where treaty benefits should be refused where it is reasonable to conclude that an arrangement or transaction was only put in place to obtain the treaty benefits. While the objective piece says the treaty benefits should be available if it is determined that that was the aim of the particular tax treaty.

“The Chinese GAAR states that corporate transaction or arrangement that lack business purpose and commercial substance will be subject to adjustment by Chinese tax authorities,” says Zhao. “The PPT provisions in Chinese new treaties prescribe that if the main purpose for entering into certain transactions or arrangements by taxpayers is to secure treaty benefits and obtaining those benefits would be contrary to the purpose of the treaty, such benefits will be denied.”

LOOKING OVERSEAS

The inclusion of the PPT and the use of illustrated examples and guidance show clearly that China is paying attention to tax policymaking around the world.

“The new rules reflect the current trend in Chinese economic policy and international tax developments and are consistent with our expectations,” Zhao says. “Tax policies play an important role in making China an attractive place for foreign investment, especially considering that some other countries have already taken measures to increase the competitiveness of their tax regimes in recent months.”

“Externally, taxpayers have been calling for legal certainty, transparency and consistency in tax policy making and enforcing,” says Xu. “Internally, Chinese tax officials have been observing how their counterparts in other jurisdictions make and implement tax rules and policy, and the national tax agency has the aspiration to improve tax administration and to harmonize the relationship with the taxpayers.”

Announcement 9 contains a short but direct message from China that is being heard in other jurisdictions all over the world more and more. It says countries will provide tax rules that are not as strict as what they are replacing, but reserve the right to come down hard on anyone who abuses their goodwill.

Jingyi Wang,

Post-doctoral Fellow in Taxation, HKU

Yan Xu,

Associate Professor of Law, CUHK

Abe Zhao,

International Tax Director, Baker McKenzie FenXun (FTZ) Joint Operation