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FINANCE: China tax alert for year of Tiger

Tax and Finance

Chinese New Year is the longest and most significant festival in China. It officially got under way on 14 February this year, shifting from the Year of Ox to the Year of Tiger.

While most Chinese New Year celebrations are taking place in China, many companies outside China would be busy seeking to stay on top of the corporate requirements and the recent tax changes affecting their investment in China.

Companies are well advised to review their holding structures, and this should be done in partnership with your in-house team and your external advisors to ensure you take into account the recent changes in China, and implement sustainable tax strategies that help your business achieve its ambitions.

The Chinese State Administration of Taxation (“SAT”) has recently issued two Circulars (Circular 601 and Circular 698) which together represent the SAT’s latest attempt to tighten up access to Treaty benefits. Notably, it appears that the SAT has begun to adopt a substance-over-form approach when targeting cross border tax avoidance, and has increased activities in this area.

Circular 601 targets avoidance of treaty benefits on dividends, interest and royalties by interposing conduits / holding companies that essentially have no commercial purposes other than to obtain a more favourable tax rate.

Under Circular 601, in order to receive the benefit of a reduced withholding tax on dividends, interest, royalties or capital gains under a double tax agreement, you will now have to prove that you have “beneficial ownership” by submitting information and documents to the local tax authority.

The local tax authority now uses two tests to assess who has “beneficial ownership” - the technical test which examines whether restrictions apply to the investor’s ownership of the income; and the substance-over-form test which looks at the economic reality of the transaction rather than at its legal form.

Whilst both tests must be considered, they appear to be highly subjective with the final decision being made based on a totality of factors as opposed to a single decisive factor. We are expecting further guidance from the SAT regarding the actual application of the tests.

The following factors are considered to be unfavourable when testing beneficial ownership:

  • The recipient is obligated to distribute 60% or more of the Chinese-sourced income to a resident in a third jurisdiction within a certain period;

  • The recipient conducts little or no business activities other than holding the rights to the income received;

  • The recipient’s assets, size of business operations and human resources are disproportionately small when compared to the income received;

  • The recipient has virtually no rights to control the income or rights giving rise to the income and bears little or no risk;

  • The recipient is exempt from tax or is not subject to tax in their own jurisdiction or taxed at a very low rate;

  • The recipient receives interest income from a loan agreement and has an agreement which is substantially the same with a third party;

  • The recipient receives royalty income from an intellectual property transfer agreement and has an agreement with another party which relates to the same intellectual property.

The SAT has hinted that the critical factor is having business substance. However, it is unclear how much substance is needed in order to be the “beneficial owner”. What is clear is that if all you have is a holding company with a tax residency certificate, then there is a significant risk the holding company will be viewed as an agent and not the ultimate beneficial owner.

Circular 698 (with retrospective effect from 1 January 2008) provides further guidance on Corporate Income Tax administration on gains from equity sales derived by non-residents and also targets capital gain tax avoidance.

More specifically, in the case of an indirect sale of equity interests in a Chinese resident company through the disposal of shares in a non-Chinese intermediate holding company, Circular 698 asserts SAT’s rights to invoke the general anti-avoidance rules, to disregard the intermediate holding company if its existence serves no commercial purposes except for the avoidance of tax liabilities.

Circular 698 gives the SAT authority to “look-through” the immediate parent in order to determine which party is actually the beneficial owner and therefore prove that the immediate parent is not entitled to the reduced withholding tax rates provided in the relevant double tax agreement.

Prior to the enactment of Circular 698, retained earnings and reserves were excluded from the calculation of gains made from equity sales by non-residents.

Circular 698 now defines taxable gains from equity sales as the difference between the sales consideration and the purchase cost. Sales consideration includes cash, non-monetary assets and rights as well as the Chinese resident company’s retained earnings and reserves, whilst the purchase cost is the capital contribution to the Chinese resident company, or if acquired through a previous owner, the original price paid by that owner for the interest.

Non-resident sellers are now required to file a return and pay tax on gains from any direct sales of Chinese resident company shares within 7 days of the earlier of the transaction date or the date of receiving the sale proceeds. However, if a withholding agent has withheld tax on the equity gain, this obligation is removed. Any gain derived from the buying or selling of Chinese company stocks on public stock exchanges are also excluded.

In the case of indirect equity sales through the disposal of an intermediary located in a jurisdiction with an effective tax rate of less than 12.5%, Circular 698 imposes a self-reporting obligation on the non-resident seller.

The non-resident seller has 30 days from the conclusion of the equity transfer agreement to submit the following documentation to the local tax authority:

  • The equity transfer agreement;

  • A statement describing the relationship between the seller and the intermediary;

  • A statement describing the relationship between the intermediary and the Chinese resident company;

  • A statement outlining the seller’s commercial purpose for establishing the intermediary; and

  • Any other information required by the tax authority in charge.

If after examining this information the authority concludes that the indirect sale lacks commercial purpose and the main purpose of the intermediary is to avoid Chinese tax, the SAT may disregard the intermediary and “look-through” to the non-resident investor.

This transaction will then be placed under the 7 day self-reporting and payment obligation which applies to direct sales of Chinese resident company shares. If the non-resident fails to comply with the 7 day requirement they will incur penalties and surcharges.

The SAT has not put a limit on the number of entities which can be “looked-through” and therefore there is potential for any indirect transfer to be subject to capital gains tax.

Circular 698 also contains a transfer pricing element which allows the tax authorities to adjust prices between related parties if such prices are not calculated on an arm’s length basis.

In a situation where a seller disposes of its equity interests in multiple subsidiaries at the same time, the Chinese resident company whose equity is being disposed is now required to submit the transfer agreement to the tax authority. In a case where the agreement fails to demonstrate an accurate allocation of the transaction value to the resident companies, the SAT can adjust the value according to appropriate methods.

If you have investments in China it is critical that you ensure you have an effective plan in place to deal with these recent changes in Chinese tax administration.

For any further details please contact Joanna Doolan, Tax Partner at Ernst & Young and co-ordinating partner for the Ernst & Young NZ China Overseas Investment Network and Florence Wong Senior Manager at Ernst & Young

This article provides general information, does not constitute advice and should not be relied on as such. Professional advice should be sought prior to any action being taken in reliance on any of the information.