PRC Tax: International and M&A Tax Services
Implications of China's foreign tax credit regime on outbound investment structures
Jointly issued by the PRC State Administration of Taxation (SAT) and Ministry of Finance, the "Notice on Foreign Tax Credit Issues for Enterprise Income Tax" (or Circular No. 125) provides detailed interpretations and guidelines on the foreign tax credit ("FTC") rules stipulated in article 23 and 24 of the Enterprise Income Tax Law ("EIT Law") and the relevant implementation rules. While the PRC State Administration of Taxation (SAT) is expected to issue further guidance on the subject very soon, as explored below, the Circular has significant implications for the structure of outbound investments by Chinese companies, with this issue of Tax Analysis seeking to assist taxpayers in exploring a more efficient structure for their international investments.
Highlights of Circular No. 125
1) Tiers of foreign companies qualifying for FTCs
The Enterprise Income Tax Law and its implementation rules provide that a PRC tax resident company should be able to claim FTCs against its own taxes paid in China for the foreign taxes paid by a foreign company that is at least 20% directly or indirectly held by the PRC company. Circular No. 125 provides that an indirect FTC is limited to three tiers, that is:
. First tier: a foreign company with at least 20% of its shares held directly by a single resident company;
. Second tier: a foreign company with at least 20% of its shares held directly by a single first-tier foreign company and, in the aggregate, at least 20% of its shares are held directly or indirectly by a resident company via one or more foreign companies satisfying the above shareholding requirement; and
. Third tier: a foreign company with at least 20% of its shares held directly by a single second-tier foreign company and, in the aggregate, at least 20% of its shares are held directly or indirectly by a resident company via one or more foreign companies satisfying the above shareholding requirement
Chinese enterprises making foreign investments normally adopt a single-tier (direct) holding structure to hold shares in a foreign company. Multi-tier (indirect) holding structures, however, are becoming more widely adopted, with Chinese enterprises establishing one-tier or multi-tier intermediary holding companies in low-tax jurisdictions to hold the shares in the foreign companies.
Chinese enterprises often cite a number of advantages to the indirect holding structure, such as a deferral of Chinese EIT on capital gains derived from futuredisposals by retaining the gains at the intermediary holding company level, flexible offshore deployment of cash generated overseas and the overall attractiveness of the structure to strategic investors or overseas IPO, among other advantages.
Based on the above provisions in Circular No. 125, Chinese enterprises should consider the tier limit in planning global holding structures given that FTCs are not available for dividends distributed from foreign companies below three tiers.
2) Limit of holding percentage
Based on Circular No. 125, FTCs cannot be claimed where the holding percentage of a Chinese enterprise in the foreign company is less than 20%. In such cases, however, relief may still be possible under the "Methods for elimination of double taxation" clause in certain tax treaties concluded between China and foreign countries. For example, China's tax treaties with Australia, the U.S. and Canada, among others, provide that, if the Chinese enterprise owns not less than 10% of shares in the foreign company, foreign taxes paid by the foreign company attributable to the dividends repatriated to the Chinese enterprise may be creditable by the Chinese enterprise.
Under the indirect holding structure, however, it is unclear whether such treaty clauses can be relied on to circumvent the 20% shareholding minimum. The crux of the uncertainty is whether the Chinese tax authorities will agree to "look through" the intermediary holding companies by regarding the Chinese resident enterprise as the beneficial owner of the dividends and treating the dividends as sourced from the lowest-tier foreign company rather than the intermediary holding company. Only if the tax authorities agree to do so and grant relief accordingly, will Chinese resident enterprises with indirect holding structures in foreign investments be able to benefit from such a treaty clause.
Similarly, under the direct holding structure, it would be more straightforward for Chinese resident enterprises to enjoy the tax sparing provisions in certain tax treaties (e.g., that with Thailand) so that dividends distributed to Chinese resident enterprises from foreign subsidiaries eligible for tax exemption or reduction in the foreign countries may not be subject to additional Enterprise Income Tax in China. However, under the indirect shareholding structure, it is also unclear whether the tax sparing provision could be applied by "looking through" the intermediary holding companies by reference to the "beneficial owner" concept.
3) Calculation of indirect credit
Circular No. 125 also provides the following formula to calculate the indirect tax credit attributable to the higher tier enterprise:
(Current Tier FTP + Lower Tier FTP) multiplied by Dividends repatriated to the higher tier enterprise divided by Aftertax profit of the current tier enterprise
For purposes of the formula, "Current Tier FTP" is the foreign tax paid on profits and investment income by the current tier enterprises, and "Lower Tier FTP" is the foreign tax paid by lower tier enterprises but attributable to the current tier enterprise.
It is worth noting that, based on this formula, if a Chinese resident enterprise holds foreign operating companies in high-tax jurisdictions and low-tax jurisdictions respectively through an intermediary holding company, the foreign taxes attributable to the dividends distributed from the foreign operating companies (i.e., foreign taxes eligible for FTC) depend on the relevant proportion of dividends distributed from the high-tax foreign operating company and the low-tax foreign operating company. In other words, if the high-tax foreign operating company repatriates a greater amount of dividends than that from the low-tax foreign operating company, there will be a greater amount of foreign taxes attributable to the dividends distributed from the intermediary holding company, leading to a greater foreign tax credit against Chinese EIT (subject to the FTC limit).
4) Calculation of FTC limit
Circular No. 125 further provides the formula for calculating the foreign tax credit limit on a per-country basis:
Total China EIT on WWTI multiplied by Taxable income sourced from a particular country divided by Total WWTI For purposes of the formula, "WWTI" is worldwide taxable income. "Total China EIT on WWTI" is the total China EIT payable on WWTI in accordance with the EIT Law and implementation rules and is normally calculated by applying the statutory Enterprise Income Tax rate of 25%.
This formula indicates that the FTC limit for a particular foreign jurisdiction could be raised by increasing the foreign source revenue or reducing the foreign costs and expenses, leading to a greater taxable income sourced from a particular foreign jurisdiction. For example, provided the actual foreign taxes paid in a particular foreign jurisdiction are fixed, if a greater part of the common expenses incurred for both China and foreign operations can be allocated to the China operations on a reasonable basis, the taxable income sourced from the foreign jurisdiction could be increased, leading to a greater FTC limit for that jurisdiction.
5) Simplified approach of FTC calculation
Circular No. 125 provides a simplified approach for foreign-source business profits and dividends that are eligible for an indirect FTC if the Chinese enterprise cannot determine the relevant foreign income tax payable and paid in the foreign country for objective reasons. Under this approach (unless the simplified approach is specifically disallowed), the FTC limit may be calculated as 12.5% of such foreign source income. This approach may be applied even though the taxpayer obtains certain tax certificates or proof of taxes paid from the foreign competent tax authorities.
In practice, local tax authorities are more likely to adopt this simplified approach for administrative ease and to increase tax revenue, possibly leading to double taxation for income and dividends sourced from high-tax jurisdictions.
Tax structuring for outbound investment
As the above analysis of Circular No. 125 shows, a tax efficient structure for outbound investment has a substantial impact on the timing of EIT liabilities on foreign source income and on the amount of foreign taxes creditable for EIT purposes.
1) Branch versus subsidiary
Different business entities used in foreign investment will have different tax implications, particularly when the effective tax rate of the foreign country (including corporate income tax and withholding tax on profit distribution) is lower than China's Enterprise Income Tax rate.
If a Chinese enterprise sets up a branch in a low-tax foreign country, it may be subject to additional Chinese Enterprise Income Tax in the current period for the income derived from the foreign branch. On the contrary, the profits derived by foreign subsidiaries in the foreign country would not be subject to additional EIT until actually repatriated to the Chinese parent company in the form of dividends. Therefore, EIT could be effectively deferred if the investors temporarily retain the after-tax profits of foreign subsidiaries offshore.
2) Direct versus indirect holding structure
As discussed in item 2) of the last section (Limit of holding percentage), the direct holding structure has among its advantages direct resort to certain benefits under tax treaties, such as tax sparing and lower holding threshold for an FTC claim (i.e., the shareholding threshold for an foreign tax credit would be 10% under a tax treaty, rather than the 20% under China's domestic tax law).
It is worth noting that there is considerable uncertainty on the applicability of such treaty benefits (i.e. the tax sparing and lower holding threshold for FTC claims) under the indirect holding structure. Even though Chinese resident enterprises are allowed to claim the relevant treaty benefits on the basis of "beneficial owner", it may be difficult in practice for them to provide adequate documentation to demonstrate such "beneficial owner" status.
From a Chinese income tax perspective, the possibility of deferred or even reduced Enterprise Income Tax seems to be among the major advantages for the formation of an indirect holding structure.
Under the direct shareholding structure, additional Enterprise Income Tax (up to 25%) would be imposed on dividends repatriated from foreign companies with an effective tax rate lower than the statutory Enterprise Income Tax rate of 25% in China. Under the indirect shareholding structure, however, Enterprise Income Tax could be deferred if the dividends distributed by the second- and third-tier foreign subsidiaries are retained in the first-tier holding companies for further overseas investments or other reasonable commercial purposes rather than repatriated to the parent company in China.
Furthermore, the indirect holding structure is able to mix the dividends sourced from high-tax and low-tax jurisdictions, with FTCs maximized and Chinese EIT minimized on an aggregate basis. A detailed analysis of this mechanism is provided in item 3) of this section.
3) Profit repatriation under the indirect holding structure
Under the indirect holding structure, "foreign taxes attributable to the dividends" and "FTC limit for a particular country" are central concepts in calculating additional Chinese Enterprise Income Tax liabilities when second- and third-tier foreign subsidiaries distribute dividends to the Chinese resident enterprise through a first-tier intermediary holding company.
The final indirect FTC is determined as the lower of the "foreign taxes attributable to the dividends" and the "FTC limit for the dividends".
"Foreign taxes attributable to the dividends" - Based on the formula for an indirect tax credit as described above, the foreign taxes attributable to the dividends repatriated by the foreign intermediary holding company to the Chinese resident enterprises depend on the amount of dividends distributed by the lower-tier foreign companies and the foreign taxes attributable to such dividends.
"FTC limit for a particular country" - The FTC limit should be calculated on a per-country basis, but it is not clear whether a "look through" principle will be used in this determination. As further analyzed below, there are two percountry calculation options available under the indirect holding structure, with the availability of look-through playing a pivotal role: (1) where there is look-through with respect to the intermediary holding company and the income is regarded as sourced from the country in the lowest tier; or (2) where there is no look-through with respect to the intermediary holding company and the income is regarded as sourced from the first tier.
Due to the timing differences in the accumulation and distribution of the after-tax profits and actually paid foreign taxes on each tier of foreign companies, it is necessary to have a mechanism (e.g., a tracking schedule) to track the after-tax profits and foreign income taxes of each foreign company in order to calculate the foreign taxes attributable to the dividends distributed from the intermediary holding company to the Chinese enterprise.
The following example illustrates the FTC calculation under the indirect holding structure according to the two options mentioned above. Assume that a Chinese enterprise directly holds 100% of the shares in a foreign intermediary holding company (e.g., a Hong Kong company with no income tax or withholding tax on dividend income or repatriation), which in turn holds 100% of the shares in two foreign operating companies, with one located in a hightax jurisdiction (effective tax rate 30%) and the other in a low-tax jurisdiction (effective tax rate 10%). The before-tax profits of both foreign operating companies are $1 million; therefore, their income taxes are $300,000 and $100,000, and the after-tax profits are $700,000 and $900,000, respectively. For simplicity, the dividend withholding tax is not considered, and we assume there is no difference in the book-tax reconciliation in all jurisdictions.
Option I: Look-through of the intermediary holding is available and the income is regarded as sourced from the country in the lowest tier
Under this option, if the high-tax foreign operating company repatriates all the after-tax profits in the form of dividends to China, the actual foreign income tax paid for such dividends (i.e., $300,000) is greater than the FTC limit of $250,000 (i.e., the before-tax profit of $1 million multiplied by China's 25% EIT rate), thus no additional China EIT is payable when the after-tax profits are repatriated to China. However, an excess FTC is generated and has to be carried forward.
In contrast, if the low-tax foreign operating company repatriates all the after-tax profits in the form of dividends to China, the actual foreign income tax paid for such dividends (i.e. $100,000) is lower than the FTC limit of $250,000, thus additional China Enterprise Income Tax of $150,000 is levied as soon as the after-tax profits are repatriated to China.
The above analysis shows that, when a proportion of the after-tax profits of the foreign operating companies are to be repatriated to the Chinese enterprise for a domestic investment project, it is more tax efficient if the after-tax profits derived by the high-tax foreign operating company are distributed to the Chinese parent company without any additional China EIT. The after-tax profits of low-tax foreign operating company could be retained offshore to take the deferral advantage of the China EIT liability.
In practice, however, it is likely that both the high and low tax subsidiary distribute their after-tax profits to the foreign intermediary holding company in the same period, a proportion of which are further repatriated to China by the intermediary holding company. Where the "per-country" principle is applied to the lowest-tier foreign companies, a certain mechanism (e.g., first-in first-out (FIFO), weighted average, or last-in first-out (LIFO)) will apply to determine the source of the dividends and calculate the foreign tax credit limit.
The below shows the consequences of a FIFO versus weighted average mechanism, assuming that the low-tax foreign operating company distributes after-tax profits of $900,000 to the intermediary holding company, followed by the distribution of after-tax profits of $700,000 by the high-tax foreign operating company to the intermediary holding company, with a repatriation of $1 million by the intermediary holding company to the Chinese parent company, all in the same financial year.
If the source of foreign income is determined on the FIFO basis, $900,000 out of the total $1,000,000 dividends received by the Chinese company would be deemed as sourced from the low-tax jurisdiction, with the remaining $100,000 deemed as sourced from the high-tax jurisdiction.
b. Weighted average
If a weighted average method is adopted, there would be $562,500 (i.e. 900,000*1,000,000/1,600,000) sourced from the low-tax jurisdiction and $437,500 (700,000*1,000,000/1,600,000) sourced from the high-tax jurisdiction.
To summarize, if the Chinese tax authorities permit calculation of the FTC limit per country by "looking through" to the lowest-tier foreign companies that distribute dividends from their operating profits, it is advisable for the Chinese enterprises to reasonably arrange the timing and amount of dividend distributions by the high-tax and low-tax operating companies to mitigate additional Chinese Enterprise Income Tax to be levied on the dividends repatriated and lower the excess foreign tax credit limit, so that tax-related cash flows may be better managed.
Option II: Look-through of the intermediary holding company is NOT available and the income is regarded as sourced from the first tier
In this case, the dividend income received by the Chinese enterprise would be deemed as sourced from the immediate intermediary holding company jurisdiction. Therefore, the foreign taxes attributable to the after-tax profits of high-tax and low-tax companies could be mixed at the intermediary holding company level, reducing or even eliminating the additional Chinese Enterprise Income Tax liabilities to be levied on such foreign source dividends upon distribution to the Chinese company.
Following the example in Option I, assume that all the dividends of the high-tax and low-tax operating companies are repatriated to the intermediary holding company ($1,600,000 in total), with foreign income taxes of $400,000 attributable to such dividends. If the intermediary holding company repatriates $1 million to the Chinese parent company, the foreign taxes attributable to such dividends amount to $250,000 (according to the calculation formula of "taxes indirectly attributable to the foreign source dividends", i.e. 400,000*1,000,000/ 1,600,000 = 250,000). Since the FTC limit of the dividends is $312,500 (i.e., the before-tax profits $1,250,000 multiplied by China's 25% EIT rate), additional EIT of $62,500 (i.e. 312,500 - 250,000 = 62,500) must be paid when the dividends are repatriated to China.
Therefore, the excess foreign tax credit generated from the high-tax foreign operating company may offset the additional Chinese EIT to be levied on the dividends repatriated by the low-tax foreign operating company, leading to a reduced income tax liability on the aggregate basis (the additional Chinese EIT is $62,500, which is lower than the amounts of $150,000 or $93,750 under the FIFO or weighted average method of Option I).
In addition, the effective foreign income tax rate of the dividends repatriated to China may be equal to or greater than 25% (leading to no additional Chinese EIT to be levied) if the proportion of dividends sourced from the high-tax foreign company and the low-tax foreign company can be appropriately arranged.
For example, suppose that the high-tax and low-tax foreign operating companies distribute their after-tax profits of $700,000 (with attributable foreign taxes of $300,000) and $300,000 (with attributable foreign taxes of $33,333), respectively, to the intermediary holding company. If the intermediary holding company repatriates $1,000,000 to the Chinese parent company, the foreign taxes indirectly attributable to the dividends amount to $333,333, which is equal to the FTC limit $333,333 (i.e. (1,000,000+333,333)*25%=333,333), with no additional Chinese EIT to be levied.
In sum, under Option II, the indirect holding structure will allow the Chinese parent company to arrange the timing of future profit repatriation and mix the profits derived from the high-tax and low-tax jurisdictions, leading to a maximum FTC limit and deferred or reduced additional Chinese EIT on foreign source income.
In light of the foregoing, whether the indirect foreign tax credit is subject to "look-through" will have great impact on the effective tax rate. Therefore it is critical for the pending implementation rule to clarify on this.
4) Tax planning on business operations in low-tax jurisdictions
Since the effective tax rates of the host countries for the outbound investments by Chinese enterprises are generally greater than 25%, dividends repatriated from subsidiaries in such countries are normally not subject to additional Chinese EIT and lead to excessive foreign tax credit. Meanwhile, a number of Chinese enterprises also have set up companies in low-tax jurisdictions. Substantial Chinese EIT will be levied if the after-tax profits of subsidiaries in such low-tax jurisdictions are repatriated. Having said that, if Chinese enterprises set up companies in low-tax jurisdictions that have transactions such as financing, trading, technology licensing, etc., with their investments in high-tax jurisdictions, with proper arrangement of the investment and dividend distribution policy in the high-tax jurisdictions, the aggregate tax liabilities may be potentially reduced or deferred.
Circular No. 125 provides further interpretations of China's FTC regime under the Enterprise Income Tax Law and its implementation rules, making it easier for the tax authorities and taxpayers to calculate and apply for foreign tax credits. The above analysis of Circular No. 125 shows that different investment and holding structures (e.g., branch or subsidiary, direct or indirect holding structure, number of tiers for indirect holding structure, multiple foreign operating companies, etc.) and the arrangement of profit repatriation from foreign subsidiaries are likely to greatly impact the aggregate tax liabilities of Chinese enterprises. Therefore, it is advisable for Chinese enterprises that already have substantial outbound investments or are considering investing overseas to review the existing or proposed global investment structure and financing model to take advantage of the tax planning opportunities provided by Circular No. 125, as well as balance its impact on operating profits, dividends and capital gains.