HK a very favourable location in which to establish a shareholder company (usually termed a special purpose vehicle or SPV) for investment in China.

By Matthew, November 10, 2009

A significant new notice was issued by the SAT last
week which will impact upon the application of withholding
tax in China. Circular 601 is the latest interpretation
by the SAT of China’s tax treaties.

This Circular looks at the concept of beneficial
ownership as it is used in the treaties – in the
withholding tax provisions (i.e. royalties, interest and dividends).

To understand how the changes operate
it is important to under the operations of Double Tax Agreements (DTA).

DTAs operate so as to allocate or apportion taxing
rights between two contries where both countries
domestic laws provide a right to tax on a particular
transaction or arrangement. The DTAs generally favour
the country of residence and give limited rights
of taxation source countries (effectively the
country where the income is sourced from) except
where the income is attributable to a permanent
establishment in that source country.

In the case of dividends the source country
(that is, the country where the company paying the
dividends is located) is usually entitled to tax
a shareholder receiving such dividends but only at
a specified rate (the same with royalties and interest).

This rate is usually 10% in China’s DTAs but it varies
from country to country. Importantly the rate between
China and Hong Kong is 5%. As a result, and amongst
other reasons, this has made HK a very favourable
location in which to establish a shareholder company
(usually termed a special purpose vehicle or SPV)
for investment in China.

However, Circular 601 will significantly alter the
benefits of using a HK SPV. The effect of the circular
is that a HK SPV will be disregarded for determining the
country of residence where it has limited functions and
risk (basically where it does nothing but act as shareholder).

Most SPV’s have very little functions and risk and this means
that it is likely that such arrangements will no longer be
entitled to obtain the benefits of the lower rate unde the
China-HK DTA. Instead one would need to examine the
DTA of the country where the ultimate owner is located.

If no such DTA exists, then a withholding tax rate of
10% will apply (withholding tax in China is 20% under
the Enterprise Income Tax Law but this was reduced to 10%
under the Implementing Regulations).

This Circular is the latest act by the SAT to aggresively
reduce off-shore tax avoidance practices. It should also
be noted how this Circular is linked to the transfer pricing
rules (which examine a company’s functions and risks in
determining if related party transactions are reasonable).

The SAT will continue to place considerable emphasis on
function and risk going forward. As I have said previously
we now have a very different tax environment in China
than 2 years ago. Interesting times.