A year ago, China put in place new administrative procedures for non-residents, including both individuals and enterprises, to claim benefits under tax treaties. This article examines how these laws now operate in practice.

Editor's note: This publication is running a series of articles by specialists from Baker & McKenzie, the international law firm, setting out recent legal and administrative changes in jurisdictions around the world of relevance to wealth managers and their clients. The article is republished with B&M's permission.

1, Administrative Procedure for Non-Residents to Claim Treaty Benefits in China

The State Administration of Taxation (“SAT”) released Guo Shui Fa [2009] No. 124 (“Circular 124”) on 24 August 2009, with effect from 1 October 2009, to put in place new administrative procedures for non-residents, including both individuals and enterprises, to claim benefits under tax treaties.

Circular 124 imposes on non-residents claiming treaty benefits an approval requirement when earning China-sourced passive income and a recordal requirement when earning China-sourced active income.

In order to enjoy treaty benefits under the dividends, interest and royalties provisions, non-residents should apply to the governing tax authority for approval. For recurring passive income, an approval is valid for three years for a non-resident earning the same item of passive income to enjoy benefit under the same treaty provision. For example, an approval for a Hong Kong resident to enjoy reduced dividend withholding rate on an equity investment in a PRC enterprise is valid for three years on the dividends received by the Hong Kong resident pursuant to the same equity investment.

In order to enjoy treaty benefits under the treaty provisions other than those mentioned above on passive income, non-residents should submit the required documents to the governing tax authority of record. Such provisions include the permanent establishment, business profits, independent personal services and dependent personal services provisions on active income. The submission for the record should be made before tax liability arises or at the time that the taxpayer declares the liability.

2, Definition of “Beneficial Ownership” under Tax Treaties

The SAT issued the Notice of the SAT Regarding Interpretation and Recognition of Beneficial Ownership under Tax Agreements (Guo Shui Han [2009] No. 601; “Circular 601”) to address which entities are treated as “beneficial owners” under treaty articles on dividends, interest and royalties.

Circular 601 was issued by the SAT on 27 October 2009 and released to the public on 5 November 2009. It also lists the factors that will be taken into account during a substance over form assessment of “beneficial owner” status.

According to Circular 601, a “beneficial owner” can be an individual, company or other organization that has ownership and control over the relevant income or the assets that generate the relevant income. In general, a “beneficial owner” is engaged in substantive operating activities.

Agents and conduit companies are specifically excluded from the definition of “beneficial owner”. A conduit company is defined as a company established for the purpose of avoiding or reducing taxes or shifting profits. It is considered to be a type of company which has only completed the formality of registration and fulfilled all legal organizational requirements, but is not engaged in substantive operating activities such as manufacture, sales, management, etc.

According to Circular 601, PRC tax authorities must evaluate whether an applicant (income-recipient) qualifies as a “beneficial owner” in order to grant treaty benefits on dividend, interest, and royalties.

To make their determination, the authorities approach each application on a case-by-case basis and evaluate the submitted documents through the filter of the “substance over form” principle. Circular 601 also provides a number of negative factors to consider when the determining “beneficial ownership”, including:

-- the income recipient must pay the receipts to a resident in a third country (region) within a short time-frame (such as 12 months from the date the income is received);

-- the applicant does not have or seldom has the right to control or dispose of the income or the property or rights arising from that income, and it does not bear or seldom bears relevant risks;

-- the income recipient does not have other operations besides the source income in question;

-- where the income recipient is a company, the volume of the applicant’s assets, scale, and employees is small and obviously does not match the amount of the income;

-- the income is non-taxable, exempted, or taxed at a very low effective tax rate in the treaty partner country or region;

-- in addition to the loan agreement pursuant to which interest income is generated and paid, there is a loan or deposit agreement between the creditor and a third party with similar loan amount, interest rate, execution date, etc.;

-- in addition to the agreement for the licensing of copyright, patent, technology, etc.

pursuant to which royalties income is generated and paid, there is an agreement for the transfer or licensing of the relevant copyright, patent, technology, etc. between the applicant and a third party.

To establish beneficial ownership to a relevant income, the burden is on the applicant to provide supporting documentation. Whenever necessary, the PRC tax authorities can obtain/verify information submitted by the applicant with the information exchange mechanism.