China tax: State Administration of Taxation (SAT) issues guidance on definition of "beneficial owner"
Circular 601 is the latest development in China's focus on cross-border taxation and it supplements recent circulars aimed at strengthening the administration of nonresident enterprises claiming treaty benefits. (The International Taxation Division of the SAT recently issued circulars in relation to the implementation of the dividends article of tax treaties, nonresidents claiming treaty benefits and implementation of the royalties article.)
Highlights of Circular 601
Beneficial owner: Circular 601 provides that the term beneficial owner refers to a person who has the right of ownership and control over the item of income, or the right or property from which that item of income is derived. It further notes that a beneficial owner, generally, must be engaged in substantive business activities and can be an individual, a corporation or any other group.
Agent or conduit companies: Circular 601 states that an agent or conduit company will not be regarded as a beneficial owner (and, therefore, will not qualify for treaty benefits) if the entity is considered a "conduit company," and the circular sets out guiding principles as to the type of entities the SAT would consider to be conduit companies. Specifically, Circular 601 states that a conduit company normally refers to a company that is set up for the purpose of avoiding or reducing tax or transferring or accumulating profits. Additionally, conduit companies are generally those that are registered in their country of residence merely to satisfy the legal requirements of tax residence and are not companies that engage in substantive activities such as manufacturing, sales and management.
Specific factors to assist in determining the beneficial owner: According to Circular 601, the presence of the following would be considered factors that could negatively affect an applicant's status as the beneficial owner:
1. The applicant is obliged to distribute most of its income (e.g. more than 60%) to a resident of another country within a prescribed time period (e.g. within 12 months from the date of receipt);
2. The applicant has no or minimal business activities;
3. Where the applicant is an entity such as a corporation, its assets, scale of operations and personnel deployment are not commensurate with its income;
4. The applicant has no or minimal control and decision-making rights and does not bear any risks;
5. The income of the applicant is nontaxable or, if subject to tax, is subject to a low effective tax rate;
6. In the case of interest income, there is a loan or deposit contract between the applicant and a third party, the terms of which (i.e. the amount, interest rate, signing dates) are similar or close to those of the loan contract under which the interest income is received; and
7. In the case of royalty income, there is a license or transfer agreement between the applicant and a third party, the terms of which are similar to the terms under which the royalty income is received.
In addition, when a taxpayer applies for treaty benefits, it will need to provide documentation to the local tax authorities to support its claim as being the beneficial owner of the relevant income and that it does not fall within the scope of any of the above. The circular envisions the use of the exchange of information mechanism in tax treaties to obtain information relevant for the determination of the beneficial owner issue. Complex cases will be handed over to the International Tax Division of the SAT.
Comments
The OECD concept of beneficial ownership, a substance-over-form approach that takes into account the underlying purpose of bilateral tax treaties, appears to have been the foundation for the SAT's position in Circular 601. According to the OECD, in a conduit arrangement, the economic benefit goes to a person that is not entitled to use the tax treaty of the state of residence of the conduit company, and a net tax advantage results because little or no taxation occurs in the state of residence of the conduit company. While the SAT generally embraces these concepts in determining whether a conduit company exists, the detailed and restrictive factors in Circular 601 to determine conduit company status may have the effect of denying treaty benefits to a broader range of companies than would be "caught" under the broad OECD principles. In addition to taking a more granular approach than the OECD, Circular 601 also seeks to incorporate anti-avoidance concepts when determining whether an entity is the beneficial owner of an item of income.
Circular 601 seems to emphasize that the beneficial owner must engage in substantive activities, which creates a significant challenge for holding companies that seek treaty benefits but do not typically engage in any manufacturing, sales or service activities, but instead merely hold investments. A typical securitization vehicle, in particular, would encounter problems particularly given the test that refers to the obligation to "on-distribute" the entity's income. Such companies will need to be particularly diligent in ensuring the company has built up sufficient substance and being able, when required, to furnish evidence of such substance. Potential actions to support a claim of beneficial owner include the following:
- Sufficiently capitalizing the company with equity;
- In dealings with the company, strictly respecting the legal form, i.e. the separate legal entity status of the company, the control and decision-making rights the company should exert in relation to the item of income, or the rights and assets from which the item of income is derived;
- Employing in the company local management who are appropriately qualified, have decision-making rights and who manage the company's assets and its investments;
- Avoiding blatant back-to-back arrangements; and
- Leaving an appropriate "spread" in the company in relation to income received, particularly in relation to debt instruments, and implementing a staged approach to the onwards distribution or payment of income received.
Circular 601 does not explicitly state whether the Chinese tax authorities would "look through" an intermediate holding company that is not considered the beneficial owner of an item of income, and grant applicable treaty benefits, if any, to the entity that, in fact, is the beneficial owner of that item of income. (In the Canadian Prevost case, the Canadian tax authorities looked through the Dutch intermediate holding company to its Swedish and U.K. shareholders. The OECD Commentary (on articles 10 paragraph 12.2, 11 and 12 paragraph 4.2) indicates that the tax authorities should look through "… an intermediary, such as an agent or nominee located in a Contracting State or in a third State …") However, investors should not presume that the Chinese tax authorities will likewise take this approach in all situations.
Circular 601 clearly is a landmark development in China's growing tax treaty law. It should also be taken as a warning that China's tax authorities, in line with the global trend, will continue tightening their approach to granting tax treaty benefits. Furthermore, the documentation requirement is likely to increase the compliance burden on foreign taxpayers and will add complexity where foreign taxpayers are dealing with an unrelated entity. While the issuance of the circular is not unexpected, it does mean that many of the traditionally adopted structures for investing into China will need to be re-examined. Even if investors decide to retain existing structures, they would nonetheless be well advised to take appropriate measures to strengthen their respective positions should they face a "beneficial ownership" challenge.
TAX NEWS - NOVEMBER 2009
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