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In bilateral tax treaties and tax arrangements, identifying the “Beneficial Owner” of a non-resident entity is an important task when the entity derives dividends, interest or royalties from China and claims tax treaty benefits. Since 2009, China’s State Administration of Taxation (S.A.T.) has released several circulars, including Guo Shui Han [2009] No. 601 (Circular 601), Bulletin of the S.A.T. [2012] No. 30. Circular 601, Circular of the S.A.T. on the Interpretation and the Determination of "Beneficial Owners" in Tax Treaties (Guo Shui Han [2009] No. 601), that define the term Beneficial Owner and set out seven “negative factors” that could affect a nonresident’s status as a Beneficial Owner. Bulletin 30, Bulletin of the S.A.T. on the Determination of "Beneficial Owners" in Tax Treaties (Bulletin of the S.A.T. [2012] No. 30), issued in 2012, clarified the determination of Beneficial Owner status and introduced a safe harbour, which provided for automatic qualification as a Beneficial Owner where the recipient of dividends is a qualifying listed company or is wholly owned by a qualifying listed company. Nevertheless, taxpayers and local-level tax authorities in China have encountered numerous technical and practical problems when dealing with Beneficial Owner cases under the principles of Circular 601 and Bulletin 30.
Bulletin 9
In February 2018, the S.A.T. released Bulletin of the S.A.T. on Matters Concerning "Beneficial Owners" in Tax Treaties (Bulletin of the S.A.T. [2018] No. 9 (Bulletin 9)), which explains the principles that will apply for determining whether the recipient of income is the Beneficial Owner when applying China’s tax treaties. Bulletin 9 repeals Circular 601 and Bulletin 30 while retaining certain provisions and amending others, including the rules for determining Beneficial Owner status, the safe harbour, and the requirement to produce a tax residence certificate. Bulletin 9 expands the ways in which a nonresident can achieve Beneficial Owner status. At the same time, it revises the list of negative factors that, if present, prevent the recipient of income from being considered a Beneficial Owner, making it more difficult for nonresidents to obtain tax treaty benefits. Finally, the official interpretation notes accompanying Bulletin 9 contain practical examples that provide detailed guidance and clarification for both taxpayers and local Chinese tax authorities on how to understand and implement the rules in the bulletin.
Bulletin 9 will apply to tax payments or withholding obligations arising on or after 1 April 2018 and provides welcome clarification on various aspects of the rules regulating Beneficial Owner status. Management of multinational corporations (M.N.C.s) are advised to review how the changes brought in by Bulletin 9 will affect their status as Beneficial Owners. In some instances, Bulletin 9 may increase the possibility that a member of the M.N.C. may enjoy treaty benefits under an existing structure or business model. In other instances, internal restructuring may be necessary in order to meet the requirements of Bulletin 9. If the extended safe harbour rule or the "same country/same treaty benefit” rule cannot be applied, revisions to the global structure of the M.N.C. may be required in order be claim treaty benefits. Either way, proper and sufficient documentation must be assembled in anticipation of questions that may arise from the S.A.T.
Bulletin 9 v. Circular 601
Table 1 below compares the negative factors in Circular 601 with the new provisions within Bulletin 9.
| Table 1 | |
| Circular 601 | Bulletin 9 |
| 1. The recipient is obligated to distribute or pay all or most of the income (e.g. more than 60%) to a resident(s) of a third jurisdiction within a prescribed period of time (e.g. within 12 months after the income is received). | 1. The recipient is obligated to pay more than 50% of the income to a resident(s) of a third jurisdiction within 12 months after it receives the income. “Obligated to pay” for this purpose means that the recipient of the income has a contractual obligation to pay or, if there is no contractual obligation to pay, the recipient actually has made a payment(s). |
| 2. Other than holding the rights or property from which the income is derived, the recipient conducts no or very few other business activities. | 2. The business activities carried out by the recipient of the income do not qualify as substantive business activities; substantive business activities include substantive manufacturing, trading and management activities, etc. The determination of whether the recipient has carried out substantive business activities will be based on the functions performed and risks assumed by the recipient. Substantive investment management activities can qualify as substantive business activities. Where a recipient carries out both non-substantive investment management activities and other business activities, it will not be considered as being engaged in substantive business activities if the other business activities are insignificant. |
| 3. Where the recipient is an entity, such as a corporation, its assets, the size of its business and the number of its personnel are comparatively small (or insufficient), and not commensurate with its income. | Deleted |
| 4. With respect to the income or the property or rights from which the income is derived, the recipient has little or no right to control or dispose of the relevant income/property and bears few or no related risks. | Deleted |
| 5. The recipient is exempt from tax on the relevant income or the income is not taxable in the residence jurisdiction, and if the income is taxable, the effective tax rate is extremely low. | Unchanged, now factor 3 |
| 6. In addition to a loan agreement under which interest arises, and is paid, the creditor has concluded another loan agreement or deposit agreement with a third party and that agreement contains similar terms, such as the amount, interest rate and signing date, etc. to the first-mentioned loan agreement. | Unchanged, now factor 4 |
| 7. A license or transfer agreement exists between the non-resident and a third party relating to the right to use, or the transfer of the ownership of, the copyright, patent or technology covered by the license agreement, based on which a royalty is derived and paid. | Unchanged, now factor 5 |
Guidance within Bulletin 9
As shown in the amendment to the first unfavourable factor, above, the S.A.T. not only looks into the existence of a contractual obligation to make payment within 12 months but also examines whether any payment is made within the 12-month period. The term “payment” is given a broad application. According to the explanatory notes of Bulletin 9, payments include intercompany transactions. Examples are (i) netting of intercompany payables and receivables and (ii) the extension of loans to group companies after the receipt of income from China. Each is considered to be an unfavourable factor in determining whether the recipient of income is the Beneficial Owner.
Bulletin 9 sets out detailed guidance regarding the second unfavourable factor, involving a fact pattern in which the recipient fails to conduct substantive business activities. Substantive business activities include (i) manufacturing, trading and management activities and (ii) investment and management activities. The explanatory notes to Bulletin 9 provide guidance on what is meant by investment and management activities. These activities include pre-investment research, project analysis, investment decision, investment execution, post-investment management, industry analysis, market research, regional headquarters function, treasury function, and financing function. Presumably, they must be carried on by executives or employees of the recipient of the income.
The explanatory notes to Bulletin 9 provide several case studies. Based on the S.A.T.’s analysis of the cases, it appears that the S.A.T. now applies a standard that calls for a higher threshold of activity before it will conclude that substantive business activities exist. Accordingly, where an applicant carries out both (i) non-substantive investment and management activities (bad activities) and (ii) other business activities (good activities), an example in the explanatory notes concludes that the other business activities are not significant when the income generated from good activities constitutes less than 8% of the total income of the entity.
The third and fourth unfavourable factors in Circular 601 are deleted because their assessment criteria have already been incorporated into the second unfavourable factor in amended form under Bulletin 9.
As noted above, Bulletin 30 introduced a safe harbour for listed companies that derive Chinese-source dividend income. Bulletin 9 expands the scope of the safe harbour to include dividends received by (i) a listed company resident in the other state, (ii) an individual resident in the other state, (iii) the government of the other state, and (iv) recipients that are wholly held by one or more of the foregoing entities or persons, provided the recipient is resident in the other state. In these cases, the recipient of the dividends will be deemed to be the Beneficial Owner of the dividends and it will not be necessary to consider any of the five negative factors.
Bulletin 9 v. Bulletin 30
Table 2 compares the rules in Bulletin 30 with the new rules introduced by Bulletin 9.
| Table 2 | |
| Bulletin 30 | Bulletin 9 |
| If a resident of the other contracting state applies for preferential tax treatment of Chinese-source dividends under a tax treaty it automatically will be recognised as a BO provided it is a company listed in the other contracting state or is wholly owned directly or indirectly by a company listed in the other contracting state that also is a resident of that other contracting state (except for cases where the shares of the recipient are held indirectly through a company resident in a jurisdiction other than China and the other contracting state) and the dividends are derived from the shares held by the listed company. | The following recipients of Chinese-source dividends automatically will be recognised as BOs and will not be required to undergo a comprehensive assessment of the five negative factors:
|
Examples
An example within the interpretation notes shows a shareholding structure under which multiple parties that qualify for the safe harbour hold the shares of the entity receiving the Chinese-source income. This fact pattern is illustrated in Diagram 1 below.
Diagram 1
In this case, Company D is a resident of Hong Kong. It invests in a company that is resident in the P.R.C. Company D receives a dividend from the P.R.C. resident company. Company D is wholly owned by a Hong Kong resident individual, the Hong Kong government and a Hong Kong-resident company that is listed on an exchange in Hong Kong. Company D can be automatically recognized as a Beneficial Owner.
Bulletin 9 also requires that the shareholding percentage in the safe harbour rules be met at all times during the 12 consecutive months before dividends are received, reflecting a requirement for shareholder continuity. A similar requirement can be found in other S.A.T. guidance. To illustrate, see (i) Circular 81 (Guo Shui Han [2009] No. 81), where "preferential tax treatment can be granted provided the nonresident company owns, directly, at least 25% of the shares of a Chinese resident company at all times during the 12 consecutive months before receiving the dividends", and (ii) Article 10 (relating to dividends) of Circular 75 (Guo Shui Fa [2010] No. 75), where "if a Singapore resident company owns directly at least 25% of a Chinese resident company at all times during the 12 consecutive months before receiving the dividends, the Singapore resident company may be entitled to benefits under the China-Singapore tax treaty."
Bulletin 9 allows a path for a recipient of dividends to qualify for tax treaty benefits even when the recipient does not qualify for the safe harbour or as a Beneficial Owner on its own. Under this provision, which, will significantly increase the chances for a recipient to enjoy treaty benefits, the recipient will be recognized as a Beneficial Owner if:
- Its shareholder wholly owns, directly or indirectly, the equity of the recipient,
- The shareholder can meet the Beneficial Owner requirements,
- None of the five negative factors apply, and
- The conditions in one of the two scenarios below are satisfied.
Scenario 1
The direct or indirect shareholder meets the Beneficial Owner requirements and is a tax resident of the same jurisdiction as the recipient of the dividends. Where these two facts exist, treaty benefits will apply to the recipient of the dividend whether ownership is direct or indirect. If the ownership is indirect, neither the number of intermediary tiers nor the country of residence of the intermediary entities is a relevant factor.
The interpretation notes include an example as shown in Diagram 2. Company E is a resident of Hong Kong. It invests in a Chinese Resident Company and receives dividends. Although Company E, itself, does not meet the Beneficial Owner requirement, it can be recognized as the Beneficial Owner by virtue of being wholly owned by its indirect shareholder, Company F, also a Hong Kong resident, provided that Company F can meet the Beneficial Owner requirements. The conclusion is the same whether Company F owns Company E directly or indirectly through a company resident in the British Virgin Islands, which does not have a tax treaty with China.
Diagram 2
Scenario 2
In this scenario, the person that can meet the Beneficial Owner requirements is not a tax resident of the same jurisdiction as the recipient. However, that person, and any intermediary shareholders, are all "qualified persons". As defined in Bulletin 9, a qualified person is a person that is resident in a tax treaty jurisdiction and is entitled to treaty benefits pursuant to the relevant treaty (or arrangement) between China and the person’s country of residence on Chinese-source dividends. The benefit to which the person is entitled is the same as or better than the benefit to which the recipient would be entitled.
In Diagram 3-1 and 3-2, Company D is a Hong Kong resident. Company D invests in a Chinese resident company and receives dividend income. Company D cannot meet the Beneficial Owner requirements, but its 100% indirect shareholder, Company E, is resident in the U.K. Company E can meet the Beneficial Owner requirements. In Diagram 3-1, an intermediary shareholder, Company F, is resident in Malaysia. Company F is entitled to the benefit of a 10% withholding tax under the China-Malaysia tax treaty on dividends received from a Chinese company. This rate is higher than the 5% rate to which Company D would be entitled under mainland China-Hong Kong tax arrangement. Company F is not a qualified person. Therefore, Resident D cannot be recognized as a Beneficial Owner by virtue of its shareholder, Company E, which is resident in the U.K., even though Company E is entitled to a 5% withholding tax rate under the China-U.K. tax treaty.
Diagram 3-1
In Diagram 3-2, the intermediary shareholder, Company G, is resident in Singapore. Company G is entitled to a 5% withholding tax rate under the China-Singapore tax treaty. This withholding tax rate is the same rate to which Company D is entitled Resident D would be entitled under the mainland China-Hong Kong tax arrangement. Therefore, Company G is a qualified person. Similarly, U.K. Resident E is a qualified person because it is entitled to a 5% withholding tax rate on dividends under the China-U.K. treaty. As a result, Company D can be recognized as a Beneficial Owner by virtue of its indirect shareholder Company E.
Diagram 3-2
It is clear from Diagrams 2, 3-1 and 3-2 that a recipient obtaining Beneficial Owner status only by virtue of its 100% indirect shareholder that meets the Beneficial Owner requirements faces a tougher hurdle when it is not resident in the same country as the recipient of a dividend. Where the Beneficial Owner and the recipient are residents in different countries, all companies in the chain of ownership must be entitled to a withholding tax rate on China source dividends that is equal to or less than the withholding tax to which the recipient entity is entitled.
In line with the shareholding period under the safe harbour rules, in scenario 1 and scenario 2, Bulletin 9 requires the shareholding percentages be met at all times during the 12 consecutive months before dividends are received.
Of course, the above safe harbour provisions are but one of many hurdles that must be overcome. Other hurdles exist in Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances) of the O.E.C.D.’s (Organization for Economic Co-operation and Development) B.E.P.S. (Base Erosion and Profit Shifting) project. There, inter alia, offsetting positions in a swap arrangement may cause the recipient of a dividend to lose its status as a Beneficial Owner. This issue is illustrated in Diagram 4:
Diagram 4
Here, Company A is a Hong Kong resident. In principle, Company A can be directly identified as the Beneficial Owner of the dividend under principles in Bulletin 9. However, its status as a Beneficial Owner may be lost if it were to enter into an economic arrangement to offload the benefit of the dividend to another party. Here, Company A and a U.S. company, Company B, enter into a beneficial interest swap agreement under which Company B pays a fixed interest on a notional principal amount to Company A in exchange for the dividends it receives from Company C, a company resident in China. Economically, Company A exchanged its anticipated dividend flow for the equivalent of a fixed yield on a debt security. Because the economic right to the dividend is enjoyed by Company B in the U.S., the tax authorities can challenge the Beneficial Owner status of Company A even though it meets the safe harbour under Bulletin 9.
The extension of the eligibility of the safe harbour rule and the adoption of the same country/same treaty benefit rule reflect the S.A.T.’s implementation of the principal purpose test (P.P.T.). This signals a big step forward for the Chinese tax authorities in aligning their interpretation of tax treaties with international standards, a development that welcomed by nonresident taxpayers.
Conclusions
Generally speaking, the technical principles and administration guidance set out in Bulletin 9 will bring both hope and concerns to nonresident taxpayers. On the one hand, extending the eligibility of the safe harbour rule and adopting the same country/same treaty benefit rule for dividend income will increase the chances for nonresident taxpayers to enjoy tax treaty benefits. The clearer guidance will also reduce the difficulties faced by local level tax authorities in their post-filing administration.
These benefits come with a cost. In order to prevent tax treaty abuse, the negative factors have been strengthened in Bulletin 9. The Chinese tax authorities will look into both the form and substance of arrangements and will pay more attention to the substantive business activities of an applicant. Although the implementation of the P.P.T. mechanism reflected in Bulletin 9 is expected to benefit many taxpayers, it is anticipated that the P.P.T. will result in increased challenges to the plans of other taxpayers. A foreign investor in China that can successfully overcome the hurdles of the Beneficial Owner test and the five negative factors in Bulletin 9 may still be denied treaty benefits if the tax authorities determine that the arrangement was carried out to obtain a tax advantage.
The following decision tree (Diagram 5) sets out the requirements for obtaining Beneficial Owner status for China’s tax treaty purposes:
