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The People’s Republic of China’s State Administration of Taxation (SAT) has issued a new notice, Guo Shui Han [2009] No. 601 (Notice 601), providing guidance on how to determine who is the “beneficial owner” under relevant tax treaties, including mainland China’s tax arrangements with Hong Kong and Macau.

The term “beneficial owner” appears in China’s tax treaties, for instance in articles concerning dividends, interests and royalties, but before Notice 601 was released in late October, the term had never been defined.

Who Is a Beneficial Owner?

Notice 601 defines the “beneficial owner” as the person who has the ownership and control right over the income or the rights or property based on which the income is derived. A beneficial owner generally engages in substantive operational activities and can be an individual, a company or any other entity. However, such entities as agents and “conduit companies” are excluded from being beneficial owners.

What is a Conduit Company?

Notice 601 further defines “conduit company” as a company that is established for the purpose of escaping or decreasing taxes, or transferring or accumulating profits. Such companies are only registered in the relevant jurisdictions to satisfy the organizational form required under the law, but do not engage in substantive operational activities such as manufacturing, distribution or management.

The Guiding Principle of Notice 601

Notice 601 provides that it is not enough to determine the beneficial owner only at the technical level or from the view of the domestic law. It must also take into account the purpose of tax treaties: that is, for avoiding double taxation and preventing fiscal evasion; to follow the principle of substance vs. form; and to analyze and judge based on the facts of particular cases.

Adverse Elements

Notice 601 specifies the following elements that are generally regarded as adverse to an applicant’s identification as a beneficial owner:

i) the applicant has the obligation to distribute or assign all or majority (e.g., more than 60 percent) of its income to a third country (jurisdiction) resident in a prescribed period (e.g., within 12 months of the receipt of the income)

ii) the applicant has no or little operational activities other than holding the property or rights based on which the income is derived

iii) the applicant, in case of being a company or entity, has relatively small or few assets, scale or staffing, which barely match the amount of income

iv) the applicant has no or little rights to control or dispose of the income or the property or rights based on which the income is derived, and bears no or little risks

v) the contracting country (jurisdiction) does not tax or exempts from tax the relevant income, or imposes tax at an effective tax rate that is extremely low

vi) in addition to the loan contract from which the interest is derived and paid, there exist between the creditor and third parties other loan or deposit contracts of which the amounts, interest rates and contract signing dates are similar

vii) in addition to the contracts on transfer of use rights on copyright, patent, technology, etc. based on which the royalties are derived and paid, there exists between the applicant and third parties other contracts on transfer of use rights or ownership of the relevant copyright, patent, technology, etc.

Burden of Proof

Notice 601 requires that when applying for enjoying treaty benefits, taxpayers must provide materials that can prove they are a beneficial owner and that are relevant to the above listed elements.

The local tax authorities are required to follow Notice 601 to determine the identification of beneficial owner in approving the applications for enjoying treaty benefits and to verify the relevant materials, when necessary, through exchange of information under the treaties. Dubious or difficult cases may be submitted to the SAT for determination.

Observations

Notice 601 is part of China’s recent series of efforts to strengthen tax administration over non-residents. Among such efforts, the SAT recently issued new procedural rules for foreign parties to claim treaty benefits (Guo Shui Fa [2009] No. 124, effective October 1, 2009). The new procedural rules generally require that the treaty benefits concerning passive income, such as dividends, interest, royalties and capital gains, are subject to approval by Chinese tax authorities, and the treaty benefits concerning active business income are subject to recordal with the Chinese tax authorities.

When the taxpayer applies for approval of tax treaty benefits, the taxpayer must submit certain documents, including:

• Application Form for Approval of Nonresident Enjoying Tax Treaty Benefits
• Reporting Form on Identification Information for Nonresident Enjoying Tax Treaty Benefits
• Tax resident certificate issued by the competent tax authority of the contracting state after the commencement of the prior calendar year
• Relevant ownership certificates, based on which the taxpayer receives the relevant income, such as documents on property right, contract, agreement, payment certificate, etc. and
• Other materials required by the tax authority for enjoying treaty benefits.

By requiring that taxpayers provide additional materials to prove and justify their beneficial owner status and thus enjoy tax treaty benefits, Notice 601 significantly increases the burden of proof on taxpayers.

Since most of China’s tax treaties do not contain an article on limitation of benefits, the major routes for China to limit treaty benefits or restrict treaty shopping are through the explanation of the concepts of residence and beneficial ownership. In most cases, a taxpayer is able to obtain a tax resident certificate from the taxpayer’s purported home tax authority, but it remains a question whether such a “resident” qualifies as the “beneficial owner.”

Notice 601 provides the most needed operational guidance to local tax authorities on how to determine a beneficial owner. It is expected that the local tax authorities will take a strict approach in enforcing Notice 601, particularly in view of the current tight economic environment. If any of the adverse elements presents in a particular case–-for example, if a Hong Kong incorporated holding company has no personnel or other assets–-its beneficial owner status is likely to be challenged.

But the good news is that Notice 601 recognizes management as one of the substantive operational activities. China’s domestic rules have not defined “management.” It would be useful to refer to the definition of the place of effective management (a place from which an enterprise exercises substantial overall management and control of its production and operation, personnel, financial and property). Although the “management” for the “beneficial owner” purpose may not necessarily rise to the level of “effective management,” it is fair to say that “management” would cover certain supervisory and coordinating functions involving operation, personnel, financial and property of subsidiaries in China. Therefore, if a holding company, located in a favorable tax jurisdiction that has a treaty with China, indeed has certain personnel who conduct genuine management activities, the holding company may still argue that it qualifies as the beneficial owner.

In summary, the immediate effect of Notice 601 on China-related tax planning is that foreign investors should at least avoid the relevant listed adverse elements in order to claim and preserve benefits under the relevant China tax treaties. On the other hand, since under its domestic law China has reduced its withholding income tax to 10 percent, taxpayers should consider whether it is cost effective to incorporate a treaty-protected holding company, if the main purpose is only to enjoy a treaty rate that is slightly lower than the 10 percent domestic rate.