From “China Tax Insights”…(More on Circular 601)
A significant new notice was issued by the SAT last week which will impact upon the application of withholding tax in China. Circular 601 is the latest interpretation by the SAT of China’s tax treaties. This Circular looks at the concept of beneficial ownership as it is used in the treaties – in the withholding tax provisions (i.e. royalties, interest and dividends). To understand how the changes operate it is important to under the operations of Double Tax Agreements (DTA). DTAs operate so as to allocate or apportion taxing rights between two contries where both countries domestic laws provide a right to tax on a particular transaction or arrangement. The DTAs generally favour the country of residence and give limited rights of taxation source countries (effectively the country where the income is sourced from) except where the income is attributable to a permanent establishment in that source country. In the case of dividends the source country (that is, the country where the company paying the dividends is located) is usually entitled to tax a shareholder receiving such dividends but only at a specified rate (the same with royalties and interest). This rate is usually 10% in China’s DTAs but it varies from country to country. Importantly the rate between China and Hong Kong is 5%. As a result, and amongst other reasons, this has made HK a very favourable location in which to establish a shareholder company (usually termed a special purpose vehicle or SPV) for investment in China.
However, Circular 601 will significantly alter the benefits of using a HK SPV. The effect of the circular is that a HK SPV will be disregarded for determining the country of residence where it has limited functions and risk (basically where it does nothing but act as shareholder). Most SPV’s have very little functions and risk and this means that it is likely that such arrangements will no longer be entitled to obtain the benefits of the lower rate unde the China-HK DTA. Instead one would need to examine the DTA of the country where the ultimate owner is located. If no such DTA exists, then a withholding tax rate of 10% will apply (withholding tax in China is 20% under the Enterprise Income Tax Law but this was reduced to 10% under the Implementing Regulations).
This Circular is the latest act by the SAT to aggresively reduce off-shore tax avoidance practices. It should also be noted how this Circular is linked to the transfer pricing rules (which examine a company’s functions and risks in determining if related party transactions are reasonable). The SAT will continue to place considerable emphasis on function and risk going forward. As I have said previously we now have a very different tax environment in China than 2 years ago. Interesting times.
