By Tony Dong and Alice Zhang, King & Wood’s Tax Department
It is common for multinational companies to deploy offshore holding structures or set up special purpose vehicles ("SPVs") in tax havens to make investments, enter into cross border transactions or to list their IPOs. There are various reasons for companies to utilize offshore SPVs, and tax optimization is clearly one of the top considerations. For example, a company may take advantage of preferential tax treaty provisions or align profits to a low-tax jurisdiction or tax haven. However, in recent years, governments around the world have been tightening their tax administration of cross-border tax avoidance arrangements with TPG’s recent tax dispute in Australia is the latest example. The Chinese government has been actively involved in the game, and the State Administration of Taxation ("SAT") has issued a series of regulations in 2009 to strengthen tax scrutiny on non-residents.
On January 8, 2009, the SAT issued the Interim Implementing Rules for Special Tax Adjustments ("the Rules"), which was a major milestone in China’s crackdown on tax avoidance. The Rules introduce the general anti-tax avoidance provision which empowers tax authorities to launch anti-tax avoidance investigations and make tax adjustments on transactions without reasonable business purposes, including treaty shopping, abusive use of tax havens or abusive use of tax treaty benefits. When determining whether a tax arrangement was made to avoid taxes, Chinese tax authorities tend to focus on the substance of the arrangement, no matter what form the arrangement takes. Before making such a decision, the tax authorities will perform a comprehensive examination on a number of factors, including the form and substantive impact of the transactions, the execution date and duration of implementation of the transactions, the transactional methods, the connections between each step of the transactions, and tax consequences.
On April 22, 2009, the SAT then released the Guidance on Establishment of Tax Residence Status for Chinese-controlled Offshore Companies under Effective Management Rules, (“the Guidance”) which had a significant impact on "red-chip" companies and round-trip SPVs. Pursuant to the Guidance, if a Chinese-controlled offshore company is regarded as effectively managed in China, then it would be considered as a Chinese tax resident company and taxed on its worldwide income at the rate of 25%. Accordingly, a red-chip company incorporated in a low-tax region, such as Hong Kong, may be subject to Chinese enterprise income tax on its worldwide income. However, a dividend distribution between a Chinese controlled offshore company and other Chinese resident companies will be entitled to tax exemption treatment.
PRC tax authorities have also tightened their control of offshore companies over their ability to enjoy tax treaty preferential treatments, as witnessed by the strings of regulations issued by the SAT. These regulations cover not only substantive rules such as interpretations of various treaty provisions, but also procedural rules as to how to apply for tax treaty benefits. They impose stringent requirements on the entitlement of treaty benefits for offshore entities. For example, under the Circular on Application of Dividends Provision of Tax Treaties issued by the SAT on February 20, 2009, applicants qualifying for preferential treaty treatment on dividends are subject to certain requirements. In particular, if a recipient of dividends intends to apply the dividend provisions of tax treaties which require a threshold of equity holding (generally 25% or 10%), then such recipient must be a company and must meet the aforesaid threshold both in shares and in voting rights at any time during the 12 months preceding the receipt of dividends. In addition, the SAT’s Circular on Interpretation and Determination of Beneficial Owner under Tax Treaties ("Circular No. 601") directs local tax authorities to investigate whether an applicant satisfies the requirements to qualify as a beneficial owner, which is a pre-requisite to enjoying the benefit of reduced withholding tax on dividends, interest, royalties or capital gains under a tax treaty. According to Circular No. 601, a beneficial owner refers to an individual or any organization that has ownership and control over the income or the assets or rights generating the income. An agent or a conduit company is not regarded as a beneficial owner. A conduit company is a company established in a tax-exempt or low tax rate jurisdiction for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits, and where the company does not engage in substantive business activities like manufacturing, distribution or management.
The competent local tax authority examines whether a person or an organization is a beneficial owner case by case by reviewing the information provided by the taxpayer or through exchange of information protocols, if necessary. The Circular further lists seven types of unfavorable factors. Where any of these factors exist, an individual or an organization may not be recognized as a beneficial owner. Pursuant to these factors, many single-level offshore SPVs will be unlikely to satisfy the requirements for beneficial owners due to lack of substantive operating activities or unjustifiable business purposes.
In terms of procedural rules on applications for treaty benefits, the SAT issued the Administrative Rules for the Provision of Treaty Benefits to Non-residents (Trial) on August 24, 2009. The Rules introduce two different procedures – filing procedures and approval procedures, depending on the types of applications. Approval procedures apply to applications for treaty benefits of dividends, interest, royalties and capital gains. In other words, nonresidents shall make substantial disclosures, submit adequate supporting documents, and obtain the approvals of tax authorities in order to enjoy treaty benefits. Applications for other treaty treatment, such as business profits of permanent establishments or individual service provider, should be subject to filing procedures, under which the applicant or the party subject to withholding tax is required to submit documentation (including tax residency certificate). For the said reasons, it is critical for the applicants to proactively prepare such application documents to properly and sufficiently address the offshore company’s economic substance and business purposes.
In practice, Chinese tax authorities published their decisions on two real cases – a Xinjiang case and a Chongqing case. These decisions are clear signals for the tightened scrutiny on offshore SPVs and offshore transactions. In the Xinjiang case, a Barbados SPV acquired shares in a Xinjiang joint venture and subsequently sold the shares for a gain, and tried to avoid withholding tax on capital gains by applying China-Barbados tax treaty provisions. However, the Xinjiang state tax authority rejected the Barbados SPV’s eligibility to enjoy the treaty benefits on the ground that the Barbados SPV was not viewed as a tax resident of Barbados and the transaction through the Barbados SPV was for tax avoidance purpose. In the Chongqing case, a Singaporean investor contemplated disposal of its shares in a Chinese subsidiary and thus established an intermediate Singaporean company to hold the equity shares, and later sold the equity shares of the intermediate Singaporean company to a Chinese buyer to avoid paying capital gain tax in China. Chinese tax authorities disregarded the existence of the intermediate holding company in Singapore and imposed withholding taxes over the capital gains realized from the transfer of equity shares or the Singapore holding company.
Companies are advised to watch closely the changes in tax regulatory climate, review their holding structures and offshore transactions, particularly the positioning of offshore SPVs, to mitigate adverse PRC tax exposures and ensure the soundness of both tax compliance and tax efficiency.