China’s new tax treaty beneficial ownership rules strengthen anti-abuse provisions, expand safe harbors
February 26, 2018
This article was written by David Liu, a partner of FuJae Partners, and first published on MNE Tax, Multinational Tax & Transfer Pricing News.
China’s State Administration of Taxation (SAT) on February 6 published key guidance interpreting the term “beneficial owner” in the tax treaty context.
The definition is important because, under the OECD Model Tax Convention and most Chinese tax treaties with other nations, tax treaty benefits for interest and dividend income, such as reduced rates of withholding tax, can only be claimed by the beneficial owner of the dividends or interest.
China’s new guidance toughens the tax treaty anti-abuse provisions found in earlier guidance but, at the same time, extends the existing safe harbor rule, allowing entities that are unlikely to be vehicles of tax treaty abuse to be directly deemed a beneficial owner entitled to tax treaty benefits.
The new guidance, Bulletin of the State Administration of Tax Relating to “Beneficial Owner” Under Tax Treaties (Bulletin 9), which will take effect on April 1, 2018, replaces two earlier tax circulars, namely, the Notice on the Interpretation and Recognition of Beneficial Ownership under Tax Treaties (Notice 601), published in 2009, and the Bulletin of the State Administration of Taxation on Recognition of “Beneficial Owner” Under Tax Treaties (Bulletin 30), published in 2012.
In addition, Bulletin 9 incorporates some results developed in the 2015 OECD/G20 base erosion and profit shifting (BEPS) report on preventing tax treaty abuse.
That report suggested that countries add limitation on benefits (LOB) provisions to bilateral and multilateral tax treaties and that such provisions be added to the OECD Model Tax Convention.
Most of China’s bilateral tax treaties follow the OECD Model Tax Convention and, as such, contain provisions limiting tax treaty benefits to beneficial owners of dividends or interest to curtail tax treaty shopping by MNEs.
However, the OECD Model Tax Convention did not define what beneficial owner means in a tax treaty context, leaving the contracting states to interpret what beneficial owner means under their respective domestic law.
Moreover, as a civil law jurisdiction, China does not have domestic laws defining “beneficial owner.”
Prior to 2009, the term “beneficial owner” was an unknown concept under Chinese law, causing some confusion in the actual enforcement of tax treaty provisions.
In 2009, the SAT issued Notice 601 which formally adopted the OECD position on how beneficial owner should be interpreted. The notice provided that a beneficial ownership is a concept separate from its meaning under any domestic laws and shall be understood in line with the purpose of tax treaties, namely, to avoid double taxation.
Notice 601 also provided a detailed but non-exhaustive list of factors which will negatively affect an applicant’s beneficial owner status.
In 2012, the SAT published Bulletin 30 in which the SAT created a safe harbor rule.
Under the safe harbor, a publicly traded company of a state with which China has a tax treaty or a subsidiary thereof can directly be recognized as a beneficial owner of dividends received.
The safe harbor was created based on the finding that it is improbable that a publicly traded company is merely a vehicle for tax treaty shopping.
Both features, the safe harbor rule and the list of negative factors, have been preserved in the Bulletin 9, with some modifications.
Expanded Safe harbor rule
Under Bulletin 9, Bulletin 30’s safe harbor was expanded to cover other types of low-risk entities.
The following applicants, namely, those who apply to the Chinese tax authority for favorable tax treatment under a treaty, may be directly deemed a beneficial owner of dividend received:
– Governments of the other contracting state (the counterparty to the applicable tax treaty);
– A corporation publicly listed in and a resident of the other contracting state;
– An individual of the other contracting state; and
Entities 100% owned directly or indirectly by one or more of the above. In the case of indirect holding, the intermediate entities involved must be a resident of China or the other contracting state.
Refinement of the anti-abuse rules
As mentioned, Bulletin 9 also refines the anti-abuse rules set out in earlier guidance.
Previously, the factors listed were more technical, which eventually gave rise to aggressive tax planning around them.
Under Bulletin 9, subject to an analysis based on the totality of circumstances, the presence of following factors may nonetheless be detrimental to an application for tax treaty benefits:
– The applicant is obligated to pay or had paid 50% or more of the received proceeds to a resident of a third state within 12 months;
– The applicant’s business does not constitute a substantial business operation, defined as including manufacture, trading, and management. Whether a business is substantial is determined based on the risks and functions it assumes;
– The other contracting state does not tax or imposes only nominal tax on the proceeds received;
– The existence of a back-to-back loan agreement between the lender and a third party where the amount, interest, and timing for payment is similar to that under the loan agreement between the lender and Chinese borrower; and
– For royalties, the existence of a back-to-back licensing or transfer agreement between the applicant (licensor under which outbound royalties are payable) and a third-party licensor/transferor.
Derivative beneficial owner status
As a new feature, Bulletin 9 recognizes that applicants who are not otherwise qualified may still receive tax treaty benefit.
An unqualified entity can still be recognized as a beneficial owner if it is 100% owned by a person that is a qualified beneficial owner, and either, the applicant and the qualified beneficial owner are residents of the same state, or the qualified beneficial owner and any intermediate holding entities are from a state where withholding rates under applicable tax treaties are no less favorable than those under the treaty between China and the applicant’s state of residence.
Some of these provisions, including the substantial business operation test and the derivative beneficial owner status provision, are part of the LOB rule proposed in the final report of OECD BEPS project Action 6 (Preventing the Granting of Treaty Benefits in Inappropriate Circumstances as an amendment to the OECD Tax Model Convention).
This proposal was recently approved by the OECD Council and became part of its latest Model Tax Convention.
Even though some of these provisions are clearly open to different interpretations, one should be able to assume for now that they will be interpreted in line with the OECD position.
Implications of the new rules
Bulletin 9 is remarkable in two ways.
First, through Bulletin 9, the SAT has taken into consideration the complexity of international businesses and has refined the rules, so that qualified applicants can rightfully take advantage of the tax treaty through the safe harbor rule or by claiming derivative beneficial owner status.
Second, the SAT has ingeniously incorporated core provisions of the OECD LOB rule through interpreting the definition of beneficial owner, taking advantage of the fact that China does not have the beneficial owner concept under its domestic law.
Even though SAT’s quick reaction to international development is laudable, incorporating the LOB rule into domestic regulations may be against the OECD intention.
OECD included the LOB rule in its newest Model Tax Convention as a separate article probably because there is no universal or clear-cut standard on where the limitations lie and the OECD prefers that states negotiate their own version.
Unilaterally setting limitations on who from the other side should receive tax treaty benefits may not reflect and may even be contrary to the original common intention of the contracting states.
It remains to be seen what the reaction of other contracting states and tax residents of those states will be when adversely affected by Bulletin 9.