ABG Limited which is established in Mainland china in 1998 would now want to pay out dividends to Gamma Limited which is a private company incorporated in Hong Kong. What is the tax percentage to be paid by Hong Kong Company for the amount received by ABC Limited? According to the a completely rewritten corporate income tax law, the Enterprise Income Tax Law, that came into effect on 1 January 2008. The new system applies to both FIEs and ordinary domestic Chinese companies, with the contrast to the existing tax system. The taxation of FIEs is governed by a separate law, the Foreign Investment Enterprise Tax Law.
It states that the dividend withholding tax exemption for FIEs is removed, so the generally applicable 20% withholding tax rate applies (the law allows the State Council to reduce or eliminate this tax, and it is expected that the Council will use its power to reduce the withholding rate to 10%, but not to nil) The 0% rate only applies to interest received by the Hong Kong Government or recognized institutions. Caishui (2008) No. 130 (25 September 2008)-Computation of WHT on passive income. It states categorically that unlike the former treatment under the repealed FEITL, WHT is to be applied on the total amount of passive incomes (e. . dividends, interest, rental, royalties, capital gains and so on) without any indication on the continuance of the deductibility of Business Tax in the WHT calculation. Future more Circular 130 reiterates that no other taxes or expenses (not limited to BT) can be deductible in calculating the WHT for non-resident companies (retroactively) effective from 1 January 2008. So up till now without the Double Taxation Arrangement ABC Limited would be required to withhold 10% of the amount payable to Gamma and distribute rest.
On 21 August 2006 there was an arrangement signed between Hong Kong and China or the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income. According to the arrangement Article 10 talks about the reduced rates for dividends to be received by a Hong Kong resident from investments in Mainland enterprises will be reduced from 20% to 10%, and a Hong Kong business from 10% to 5%. If Gamma limited would like to enjoy the reduced rate of 5% on the dividend from ABC Limited. Gamma would have to do proof the following 2 requirements. . Gamma Limited holds at least 25% of capital in ABC limited the PRC Company. 2. Gamma Limited has to satisfy the “beneficial ownership test” in Mainland China as set out under Guoshuihan [2009] No. 601 (“Circular 601”). After meeting these two requirements, Gamma Limited would be required to ensuring any offshore exit does not contravene Circular 698 if the Parent Company Alpha Limited intend to undertake an “Offshore Disposal” in the future. Gamma Limited is required to meet the above two requirements plus not contravene Circular 698.
If Gamma is successful to proof the hold a minimum stake of 25% in ABC Limited and they can satisfy the beneficial ownership test and not contravene Circular 698. Gamma Limited would be allowed to receive the 5% Tax credit and only be liable to pay a 5% Withholding Tax But if Gamma limited is not able to proof anyone or both of the requirements or it contravene Circular 698. Gamma limited would be required to pay at the rate of 10% for the dividend or if Gamma limited is hold by another company which is in a country that has double taxation arrangement with PRC and can satisfy the beneficial ownership test in PRC.
A declaration may be made under Bulletin 30 such that the Company holding Gamma can enjoy the reduced tax rate. Example is Nanjing case, the company was not able to proof that they are the beneficial owner and therefore did not qualify for tax-free treatment under Caishui [2009] No. 59 and could not enjoy the 5% rate. 2B) What is Guoshuihan [2009] No. 601? Guoshuihan [2009] No. 601(“Circular 601”) deals with the requirements in double tax treaties that he recipient of PRC sourced interest, dividends and royalties should have “Beneficial ownership” over the relevant income in order to qualify for any preferential double tax treaty treatment.
Who is beneficial owner in Circular 601? 1. Beneficial owner is a person that has the ownership and control over the income or the rights or assets that generates such income. 2. Beneficial owner can be an individual, corporation or other organization. 3. A “beneficial owner” shall generally engage in “substantive business activities” which is further referred to as manufacturing, trading and management activities, etc. under Article 1 of Circular 601. [The latter indicates that the PRC tax authorities can now accept that it is unreasonable and unrealistic to expect all treaty residents (and all on-resident recipient of dividend, royalties and interest) to be manufacturing or trading companies. ] But and Agents and conduit companies will not be regarded as the “beneficial owner” of such income. [A conduit company is elaborated in Circular 601 as a company that is established for the purposes of avoiding / reducing tax or shifting / parking profits. Such a company is registered in a country with the mere intention of putting in place the necessary legal form but it does not carry on substantive business activities such as manufacturing, trading or management, etc. According to the “substance over form” principle, Circular 601 further identifies the following “7 adverse factors” which may be reviewed by the PRC in-charge tax authorities to assess that a recipient of income should not qualify as the beneficial owner, are; 1. The treaty non-resident has an obligation to pay or distribute more than 60% of its income to a resident of a third country (region) within 12 months of receipt. 2. The treaty non-resident does not have or almost does not have any other business activities apart from the holding of assets or rights from which the relevant income is derived. 3.
Where the treaty resident is a corporation, its assets, scale of operations and employee/staff are relatively few and not commensurate with the amount of income received. 4. The non-resident has no or almost no controlling rights or disposal rights over the assets or rights from which it derives the income and bears very little or no risks. 5. The income earned is either exempt from tax or taxed at a very low effective tax rate in the non-resident’s jurisdiction. 6. Loans into the PRC are part of a back-to-back arrangement with the offshore lender with very similar amount of principal, interest rate and time of conclusion 7.
Rights to use copyrights, patents, technology or other intellectual property in the PRC are part of a back-to-back arrangement with the offshore intellectual property provider. If the Alpha Company would like to receive dividends from ABC Limited via the HKSAR company at the reduced rate of 5 %( Article 10). Should not fall in the above 7 adverse factors. The test of whether beneficial ownership exists would depend on a collective assessment of a totality of factors. Instead of a single or specific negative factor could override or outweigh other factors. What should Gamma Limited have to get the reduced rate of 5%? . Gamma Limited should have a properly constituted board of directors to make bona fide decisions regarding the offshore SPV(s)’ income, assets and business operations, with all decisions made at the board meetings fully documented. 2. Gamma Limited should have some (or at least one) employee to carry out substantive activities in Hong Kong where the dividend will be distributed. 3. Gamma Limited should also have actual business premises in Hong Kong where the dividend will be distributed. 4. Gamma Limited should be capitalized with sufficient appropriate shareholder capital. 5.
Gamma Limited should have assets and activities other than that, which give rise to the China-sourced income. 6. Gamma Limited should have very similar amount of principal, interest rate and time of conclusion with the offshore for “back-to-back” loan and royalty. If Gamma Limited has all these or most of it PRC tax authorities will give a green signal as a beneficial owner and Gamma Limited can enjoy the 5% reduced rate. But as we know that all the Directors of the company are US citizens either carrying out their duties and resides in USA or China. Gamma does not employ and staff nor maintains any establishment in Hong Kong.
Given all these facts most of the requirements cannot be met and according to Circular 601 Gamma would not be given the rights to be a beneficial owner of the dividends. If Gamma Limited would challenge the PRC tax authorities would use Nanjing case (2010) where they disregarded the application under 601 and did not qualify for tax-free reorganization status. Future more they would use Jinan Case to proof that the Gamma limited has just been formed for the purpose being benefited from the tax treaty. And therefore move upper in the structure and evaluate if Beta limited which is a BVI company.
But it would make no sense to see if the company has a beneficial ownership. As BVI is a tax haven country and China have no double taxation agreement with BVI. But we will still carry out the beneficial owner test. The Directors of the company are US citizens either carrying out their duties and resides in USA or China. Beta does not employ and staff nor maintains any establishment in Hong Kong. Given all these facts most of the requirements cannot be met and according to Circular 601 Beta Limited would not, be given the rights to be a beneficial owner of the dividends. Now we will move to Alpha.
As we can see that Alpha can fulfill most of the requirements of the beneficial ownership in Circular 601. If Alpha Limited would have not fulfilled the above 7 adverse factors in Circular 601, Announcement 30 would come in place and it states that a company that is a tax resident of a DTA partner state and is listed in that jurisdiction (Listed Parent) will automatically satisfies the beneficial ownership criteria in respect of PRC dividends received. Although Alpha will still need to pay 10% Withholding Tax for the dividend as the 5% rate is for Hong Kong not for a USA company.
Taking into consideration that the Hong Kong Company Gamma has been given the green signal as a beneficial owner and received the dividend on the reduced rate of 5%. After the dividends are disturbed the value of ABC limited would be reduced significantly. Example before distribution the value of each stock is $2 and the number of shares owned are 5million shares. Saying that Gamma Limited owns 100% of the ABC limited. The total share capital would be $10million. After paying the dividend the price of each stock falls to $0. 2.
So the total share capital now is $1million. But Gamma limited stills owns 100% ownership is ABC limited. The value of the stock would not reduce the percentage of ownership in a company. And therefore cannot apply DIPN No. 44 (August 2008) ; Paragraph 5 of Article 13. AS Gamma has more than 25% shares and therefore taxable for Capital gain in the PRC. If Gamma limited wanted to qualify under DIPN No. 44 (August 2008); Paragraph 5 of Article 13 and not be attacked by the direct or indirect disposal. They should comply with the followings. . Gamma limited should not hold less than 25% of shares of ABC Limited. 2. And the amount hold of less than 25% should not be less than 12 months. If both are fulfilled Gamma limited would not be required to pay tax on the disposal of the shares. Example is suppose Gamma Limited owns 20% of ABC Limited and holding it for 12 months and now is planning to dispose it via BVI. As the threshold is minimum 25% of shares but Gamma limited only has 20% and it has held the company for 12 months. Gamma limited would not be liable to pay tax.
And Circular 698 defines the equity transfer income as the difference between the equity transfer price and the cost of the shares. The equity transfer price includes all types of consideration received by the foreign investor, including cash, non-monetary assets, and equity. If the foreign investor transfers the shares to a related party using a non-arm’s length price, the Chinese tax authorities may adjust the equity transfer price. The cost of the shares refers to (i) the purchase price paid by the foreign investor hen acquiring the Chinese investee company or (ii) the capital contribution made by the foreign investor to the Chinese investee company to acquire its equity (or thereafter). The most controversial rule pertains to the treatment of the retained earnings of the Chinese investee company. Under the former tax regime that applied to foreign-invested enterprises (“FIE”), the retained earnings of the Chinese investee company could be excluded from the equity transfer price in calculating the taxable gain. “Circular 698 now requires that the retained earnings of the Chinese investee company be included in the equity transfer price”.
This new rule may give rise to double taxation where the retained earnings are taxed once upon the equity transfer and then again when they are distributed as dividends to the new shareholders. So this will lead to 2 cases one would appear. 1. The SPV is sold at an arm’s length price. 2. The SPV is not sold at an arm’s length price If the price, what BVI limited will be disposed is within the arm’s length the gain on capital would be equity transfer price (including the Retained earnings price) less the cost of equity investment. If the price, what BVI limited isn’t within the arm’s length.
The China tax authorities would make the cost of share the purchase price paid or the capital contribution made by Raphael limited the UK Company. If Gamma only has to pay 5% Withholding tax how can Gamma remit back the cash to Alpha limited in an efficient manner. 1. Gamma can transfer the dividend amount to BVI Company as a form of dividends as BVI has zero tax rates on receipts and distribution of dividends. Then Alpha can borrow the dividend amount as a form of loans on the interest rate of USA to avoid thin capitalization from the BVI Company.
And afterwards BVI Company can record the loan as bad loans. 2. Alpha Limited can borrow the dividend amount from the USA bank on the rate of 0. 25%-0. 5% and Gamma Limited can be the guarantee of the loan. And Gamma limited can use the dividend amount to deposit in a Hong Kong bank in fixed deposit and this interest income will be charged in Hong Kong under Section 15 (1)(f) at the rate of profit tax but the remaining amount can be used to pay the interest expense in USA.
Gamma can either invest their money in a HK local bank or invest in some Indian banks in Hong Kong as their fixed deposit rates are higher example 2. 25%. So suppose if there is a dividend amount of 1m the amount is saved in an Indian bank at 2. 25% the yearly interest income would be 22500 and this amount would be subject to HK profit tax of example 16. 5% the remaining amount in hand would be 18788. The interest expense would say 1m @ 0. 5% would be $5000. We would still have 13788 on hand. Even if the USA interest keeps on increasing we can have an excess amount if the interest is no higher than 1. % C) As Gamma Limited and Beta Limited are ignored by the Chinese tax authorities for the purpose of Guoshuihan [2009] No. 698 and Guoshuihan [2009] No. 601 leaving Alpha Limited holding 100% of the ABC limited. Although if Alpha Limited may not qualify as the Beneficial owner by Circular 601, Announcement 30 would come in place and it states that a company that is a tax resident of a DTA partner state and is listed in that jurisdiction (Listed Parent) will automatically satisfies the beneficial ownership criteria in respect of PRC dividends received.
When ABC Limited declares dividends to Alpha Limited, Alpha would be required to pay a rate of 10% as Withholding tax in China according to the their Double tax agreements. They won’t be able to enjoy the 5% rate as that applies for the Hong Kong and a few others like Luxembourg. There are two cases similar as Alpha Limited. The first one is The Chongqing case, the local tax bureau disregarded the existence of an SPV which had been registered in Singapore and imposed income tax on the capital gains derived from the sale of the SPV.
Contemplating disposal of its shares in a Chinese subsidiary, a Singapore company (the parent) established an intermediate Singaporean company to hold the shares of the Chinese subsidiary. The parent later sold the intermediate Singaporean SPV to a Chinese buyer. Taking into consideration that the Singapore SPV had a very small amount of capital and had not engaged in any business activity other than to merely own shares of the Chinese subsidiary, the Chongqing tax bureau determined that the SPV lacked economic substance and treated the transaction as an equity transfer by the Singapore parent of the Chinese subsidiary.
Consequently, the Singapore parent was required to pay a 10% capital gains tax in China as if it had sold the Chinese company directly. The SAT not only approved the case, but by issuing Circular 2 in the following year, also provided a strong regulatory basis for disregarding the existence of any SPV if it is viewed to lack “economic substance. ” Circular 698 addresses very types of abuses which are reflected in this case, specifically, when an SPV is established in a low tax rate treaty jurisdiction (i. e. , Singapore), for the purpose of escaping the liability for capital gains tax.
The second case is Xingjiang case, it is stated a Barbados SPV sold its Chinese subsidiary in Xinjiang province at a gain; nevertheless, the tax bureau of the province denied Barbados SPV the benefit of the capital gains tax exemption available under the China-Barbados tax treaty. The Chinese company in Xingjiang (the XingjiangCo), established in 2003, was a joint venture of two Chinese companies (ACo. and BCo. ). In June 2006, a U. S. company established the Barbados SPV, whose directors were all U. S. citizens. One month later, BCo. ransferred some of its shares in the XingjiangCo to the Barbados SPV for a price of $33. 8 million. 11 months later, the Barbados SPV sold its shares of XingjiangCo back to BCo. for approximately $46 million, and attempted to avoid withholding tax on capital gains by claiming treaty benefits. The Xingjiang Taxation Bureau investigated the status of the SPV as well as the overall transaction itself and determined that the Barbados SPV was not a tax resident in Barbados, and on that basis, denied its tax exemption benefit claim. The tax bureau also found that there was no legitimate business purpose in the transaction.
Specifically, it found that the SPV had no intent to participate in the operation of the XingjiangCo or to take any risk and that the deal resembled more of a loan; consequently, the arrangement was viewed as an abuse of the tax treaty. The tax bureau decided this case based on the GAAR provision of the EIT Law and its implementation rules even though the transactions occurred before the effective date of the EIT Law. Circular 601, which was issued in the following year, addressed the “beneficial ownership” issue, which was reflected in the Xingjiang case.
And therefore Alpha would be required to pay 10% on the gain on disposal in the following manner. After the distribution of dividends the Retain earnings amount would be reduced significantly. During the disposal of ABC Limited if So this will lead to 2 cases one would appear. 1. The SPV is sold at an arm’s length price. 2. The SPV is not sold at an arm’s length price If the price, what ABC limited will be disposed is within the arm’s length the gain on capital would be equity transfer price (including the Retained earnings price) less the cost of equity investment.
If the price, what ABC limited isn’t within the arm’s length. The China tax authorities would make the cost of share the purchase price paid or the capital contribution made by Raphael limited the UK Company. As it is stated in Circular 698 defines the equity transfer income as the difference between the equity transfer price and the cost of the shares. The equity transfer price includes all types of consideration received by the foreign investor, including cash, non-monetary assets, and equity.
If the foreign investor transfers the shares to a related party using a non-arm’s length price, the Chinese tax authorities may adjust the equity transfer price. The cost of the shares refers to (i) the purchase price paid by the foreign investor when acquiring the Chinese investee company or (ii) the capital contribution made by the foreign investor to the Chinese investee company to acquire its equity. And according to the new law it requires that the retained earnings of the Chinese investee company be included in the equity transfer price”.
