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Press article: The use of various jurisdictions for investment in China

Tax Notes International


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Despite the recent global financial crisis, China remains one of the largest economies in the world and has the highest growth rate. The IMF’s forecast of the GDP growth rates for 2010 and 2011 are 10 percent and 9.9 percent, respectively, even higher than the 8.7 percent in 2009.1 With the anticipation of sustained growth, the influx of investment into China likely will continue.

Although investment can be made in a number of ways, this article looks specifically at the use of a holding company structure as a potentially tax-efficient method of inbound investment into China. By interposing an overseas holding company to hold a Chinese subsidiary, a foreign company can obtain business and tax benefits, the latter including possible lower withholding tax rates and access to beneficial tax treaties.

Included below is a comparison of the tax rules in eight jurisdictions often used to structure investment into China (including Hong Kong, long the gateway for inbound investment into mainland China) and an examination of recent steps taken by the Chinese tax authorities to improve the administration of taxes and ensure that nonresidents comply with their tax obligations in China.

Investment considerations

One of the most important issues a potential investor or fund needs to consider is the tax implications of an investment. For instance, two entities may be earning the same level of profits on their investments in China, but the difference between their after-tax returns can be substantial if one entity is subject to a dividend withholding tax of 10 percent and the other pays only 5 percent.

Is there a generic tax-efficient holding structure for investment into China? The answer can be both yes and no.

The answer can be no because the design of any holding structure depends on various factors, including:

  • the rate of withholding tax on dividends;
  • how dividends will be taxed in the country of residence of the investing entity;
  • the tax position of the investee company;
  • the appropriate gearing level;
  • the industry involved; and
  • the form of the investment.

The answer can be yes, however, if the focus is on the location of the investment holding company, and a thorough comparison of the applicable taxes in the various jurisdictions is undertaken. Of course, the local tax implications in the country of the overseas holding company must also be considered.

At the level of the Chinese subsidiary, it will be necessary to consider the Chinese withholding tax on dividends and capital gains. At the holding company level, the following will have to be taken into account:

  • taxes on dividends and capital gains;
  • withholding tax when the holding company pays dividends to its shareholders;
  • the effective corporate tax rate;
  • tax on distribution proceeds when the holding company is liquidated;
  • stamp duty that may be applicable when the shares of the holding company are transferred; and
  • the tax treaty network of the jurisdiction in which the holding company is located.

Also, China’s substance requirements under both its domestic law and its tax treaties must be considered. China has stringent requirements that a nonresident must meet to qualify for benefits under its tax treaties, and recent guidance issued by the State Administration of Taxation (SAT) emphasizes that ‘‘shelf or conduit companies’’ may not be used merely for the purpose of enjoying treaty benefits. The SAT has issued several circulars that contain detailed rules on the application and approval procedures and documentation requirements that apply to nonresidents claiming benefits under China’s tax treaties. For example, a major criterion of eligibility for the preferential tax rate on dividends under China’s treaties is that the nonresident must be the beneficial owner of the income.

According to the SAT, the presence of the following factors indicates that a nonresident may not qualify as the beneficial owner:

  • the nonresident transfers most (more than 60 percent) of its income within 12 months to residents of a third country;
  • the nonresident has no or only minimal business activities other than the holding of the property and/or rights from which the income is derived;
  • the nonresident’s business in terms of assets, scale of operations, and personnel is not commensurate with its income;
  • the nonresident has no or nearly no rights of control or disposal over the owned assets or rights generating the income; and
  • the country of the nonresident either imposes no tax or imposes tax at an extremely low effective rate.

The SAT will scrutinize both commercial and economic substance. Both the nonresident and the withholding tax agent in China are required to meet rigorous disclosure requirements (for example, identification of any direct or indirect shareholding in a Chinese company, a description of the major business operations and projects, information regarding the number of employees, details of related-party transactions, and so on) to demonstrate that the recipient is not disqualified by any of the previously mentioned factors and to support a beneficial ownership claim with a view toward obtaining reduced withholding tax rates under a tax treaty (for example, on dividends, interest, royalties, and capital gains).8 It is not sufficient for the nonresident simply to produce a tax residence certificate issued by the nonresident’s state of residence. The reduced tax rates under a tax treaty are not available until the approval of the in-charge tax bureau is granted. 

Comparison of tax jurisdictions

Multinational groups may have a choice of jurisdictions in which to locate a holding company as long as the substance requirements can be met.

This section looks at eight jurisdictions commonly used as holding company locations to determine their suitability for investment into China: Barbados, Belgium, Hong Kong, Ireland, Luxembourg, Mauritius, the Netherlands, and Singapore.

A comparison of the various relevant tax rates in these jurisdictions is shown in the table.

Following is a comparison of the tax implications of using the eight previously mentioned jurisdictions, taking as a starting point the Chinese tax treatment of dividends and capital gains.

Holding company location Barbados Belgium Hong Kong Ireland Luxembourg Mauritius Netherlands Singapore
P.R.C. WHT (%) on dividends 5 10 5 5 5 5 10 5
P.R.C. WHT (%) on capital gains (shareholding < 25%) Exempt Exempt Exempt Exempt Exempt Exempt 10 Exempt
Tax on dividends at HoldCo level Taxable in full with credit 95% exempt Exempt Taxable with credit Exempt Taxable on "gross" dividend Exempt Taxable with credit (first tier only)/exempt
Tax on capital gains at HoldCo level No tax on capital gains Exempt Exempt Exempt Exempt No capital gains tax Exempt Exempt
WHT (%) on dividends when HoldCo distributes dividends to shareholders Nontreaty
0 15-25 0 20 0 0 0/15
Coop/BV
0
Treaty
0 0-15 0 0 0 0 0-15 0
EU
0 0 0 0 0 0 0 0
Effective corporate tax rate (%) 1-2.5 33.99 16.5 12.5/25 21.84 + 6.75 Maximum 3 25.5 17
Tax on distribution of liquidation proceeds No Yes No No No No Exempt No
Stamp duty (%) on transfer of shares of HoldCo No No 0.2 1 No No No 0.2
Number of treaties 21 88 5 48 60 34 83 61

Dividends

Under Chinese domestic law, a 10 percent tax is withheld on dividends paid to a nonresident. Most of China’s tax treaties (with the exception of the treaties with Belgium and the Netherlands) reduce the withholding tax rate to 5 percent if the relevant shareholding and other requirements are met.

Capital gains

According to the Enterprise Income Tax Law, a 10 percent withholding tax is levied on capital gains derived by a nonresident enterprise without a permanent establishment in China from the direct transfer of an equity interest in a Chinese resident enterprise.

Direct transfers of shares

In the past, Barbados and Mauritius were commonly used as holding company jurisdictions to structure investment into China because China’s tax treaties with both counties included an exemption from the 10 percent Chinese withholding tax on capital gains arising from the disposal of shares in a Chinese company, regardless of the percentage of the shareholder’s participation.

Following changes to the China-Mauritius treaty and the Barbados-China treaty on September 5, 2006, and June 9, 2010,10 respectively, capital gains are no longer exempt if the (Barbadian or Mauritian) recipient of the gains holds, directly or indirectly, more than 25 percent of the Chinese company. (Gains derived on the disposal of a shareholding of less than 25 percent will continue to be exempt from tax.) China’s treaties with most of the other jurisdictions do not allow China to impose a tax on capital gains arising on the transfer of a shareholding of less than 25 percent in a Chinese company, except in the case of the treaty with the Netherlands, which allows tax to be levied regardless of the percentage of the shareholding. Under the tax treaty with Ireland, China does not tax capital gains even when the relevant shareholding is more than 25 percent.

As noted above, maintaining substance is paramount. The SAT has the authority to invoke the Chinese general antiavoidance provision for transactions whose dominant objective is the avoidance of tax.
There have been instances in the past when a company has failed to attain the required level of substance, and the SAT has accordingly denied treaty benefits. For example, the SAT denied the application of the Barbadian treaty in 2003 for capital gains arising from the disposal of a Chinese subsidiary located in Xinjiang because of the lack of substance of the Barbadian holding company. In another case, a Hong Kong company that disposed of a 20 percent shareholding of a Chinese company in October 2009 was held not to have met the ‘‘below 25 percent shareholding’’ requirement for purposes of the capital gains tax exemption under the China-Hong Kong tax arrangement because the Hong Kong company owned another 18 percent shareholding in the same Chinese company (that is, a total of 38 percent) through another Hong Kong group company.

Indirect transfers of shares

A strategy that has been employed in the past to avoid capital gains taxation in China involves using an overseas holding company to invest in China and then exiting the investment by transferring the overseas holding company. The jurisdiction of the holding company in these structures typically either taxes capital gains at a low rate or does not tax them at all and has concluded a tax treaty with China that provides beneficial withholding tax rates.

The SAT has challenged the treaty exemption of gains derived from these structures on the grounds of lack of substance. For example, in November 2008, the Chinese tax authorities held that capital gains arising from the transfer of the shares of a Singaporean company that held an equity interest in a Chinese company in Chongqing were capital gains arising from the disposal of the underlying Chinese company. As a result, the transaction was treated as a direct sale of the Chinese company by the parent of the Singaporean holding company and hence was subject to a 10 percent tax on the capital gains in China. The SAT took the position that the Singaporean company lacked economic substance because it did not engage in any business activities other than the holding of the shares, had only a minimal amount of capital and no employees, and was used merely for the purpose of avoiding capital gains tax. Practitioners have argued that most holding companies would not have substance because they normally do not have a significant amount of capital and do not carry on other business activities. In response, the SAT has agreed to centralize the application of the general antiavoidance provision (as it seems the Chongqing case was handled by the local tax authorities).

To discourage transactions with the dominant objective of avoiding China’s CGT through an indirect transfer of shares, the SAT issued Circular 698 in December 2009, signaling its intent to challenge these types of structures. Under Circular 698 (which applies retroactively from January 1, 2008), if a foreign investor indirectly disposes of the shares of a Chinese resident enterprise (that is, sells an offshore intermediary holding company that owns a Chinese resident enterprise), the SAT, using the substance over form principle, can disregard the existence of the intermediary holding company if it lacks a business purpose and was established for the purpose of avoiding tax. In this case, the foreign investor would be subject to Chinese withholding tax on capital gains derived from the transfer.

Further, Circular 698 imposes a documentation requirement on the nonresident investor if some conditions are met. Specifically, the nonresident investor must submit all transfer agreements and other relevant documentation regarding the equity transfer and the relationship between the nonresident and the offshore holding company to the local tax authorities within 30 days from the date the equity transfer agreement is signed if one of the following factors applies:

  • the effective tax rate of the country or jurisdiction of the overseas holding company being transferred is less than 12.5 percent; or
  • the country or jurisdiction of the overseas holding company being transferred does not tax offshore income.

Circular 698 establishes tight timelines for the withholding obligation and the submission of documentation.

If the withholding agent fails to file and remit the EIT related to the equity transfer, the nonresident only has seven days to ensure full compliance. The gain on the equity transfer will be determined based on the difference between the consideration for the transfer and the cost of the equity interest, without taking into account any undistributed profits and reserves of the Chinese resident enterprise that is being transferred.

When group companies with indirect Chinese equity interests are located in some jurisdictions, it may be possible for a multinational group undertaking a genuine commercial merger or acquisition to transfer its investment in China among those group companies without breaching the previously mentioned conditions, and thus make it possible for the multinational group to avoid falling within the scope of the reporting obligations.

Suitability of jurisdictions

Taking into account the minimum 12.5 percent tax rate requirement, it would appear that Barbados and Mauritius might not be the best choices for locating a holding company because their effective corporate tax rates are both lower than 12.5 percent (1 to 2.5 percent, and 3 percent, respectively).

Regarding the second condition above, Hong Kong generally does not tax offshore income and Singapore does not generally tax foreign-source dividends, foreign branch profits, or foreign-source service income in some cases. As a result, Hong Kong and Singapore also may not be the best holding company locations for purposes of an indirect transfer of Chinese investments.

Transaction cost considerations may also make Hong Kong, Singapore, and Ireland unattractive because all three jurisdictions would impose stamp duty on the transfer of shares.

Turning to other factors, it seems there could be tax leakage if the holding company is located in Barbados, Belgium, Ireland, or Mauritius because these jurisdictions impose a tax on dividends received. Although neither Hong Kong nor Singapore taxes capital gains, it is not uncommon for disputes with tax authorities to arise over what constitutes a capital gain as opposed to a revenue gain. In the case of dividend distributions, some countries — such as Belgium and Ireland — impose withholding tax when dividends are distributed to nontreaty recipients. Apart from stamp duty considerations, any tax on the distribution of liquidation proceeds also should be considered if the possibility of liquidating the holding company is being contemplated as an exit strategy. In this context, Belgium may not be the preferred choice because it may impose tax on liquidation proceeds in some circumstances. The tax treaty network of the proposed holding company jurisdiction is also a factor that cannot be ignored. In this respect, Belgium and the Netherlands have the largest number of treaties, although both Luxembourg and Hong Kong are negotiating new treaties or tax arrangements (at least 15 and 7, respectively) to incorporate the OECD’s exchange of information article.

Inbound investment through Hong Kong

Because of Hong Kong’s close proximity to China and the fact that it does not levy withholding tax on dividends or capital gains, it is not uncommon for a Hong Kong company to be used as the direct holding company for many Chinese investments. The advantages of a Hong Kong holding company from a tax perspective are as follows:

  • mainland China and Hong Kong have concluded a double tax arrangement that provides for one of the lowest withholding tax rates on dividends, royalties, and interest in the Asia-Pacific region;
  • Hong Kong does not tax dividend income or capital gains;
  • Hong Kong does not tax offshore income; and
  • Hong Kong does not impose withholding tax on dividends and interest payments.

Also, it generally takes less time for a Hong Kong company to establish a Chinese subsidiary as compared with companies in other jurisdictions, probably because China’s various regulatory authorities are already familiar with Hong Kong, and the time and effort devoted to translating and delivering the various formation documents can be minimized.

Although Hong Kong now has five double tax arrangements in effect (with Belgium, China, Luxembourg, Thailand, and Vietnam), from a Hong Kong tax perspective it is not crucial that there be an agreement between Hong Kong and the country of residence of the shareholders of the holding company because Hong Kong does not impose withholding tax on dividends and capital gains. What is important is whether the dividend income and/or capital gains will be taxable in the country of the recipient. Of the jurisdictions under review, most tax dividends and capital gains under given circumstances. However, a company holding shares in a Hong Kong company generally will enjoy more protection if it is located in a treaty country.

For example, Luxembourg’s participation exemption system generally exempts Hong Kong dividend income and capital gains. However, in Belgium there could be tax leakage because Belgium generally taxes dividend income. (Hong Kong’s tax agreements with Ireland and the Netherlands are not yet in effect.) The tax rules of the jurisdictions where the investors are located also should be taken into account. Some countries, such as Germany and the United Kingdom, have controlled foreign corporation rules that can effectively discourage indirect investment into some foreign jurisdictions.

Conclusion

For direct investment into China, the most important factor is that the investor has sufficient commercial and economic substance to withstand any challenge by the Chinese tax authorities: A holding company making such an investment should not simply be a shelf or conduit company if it is to enjoy benefits under China’s tax treaties.

If the requisite level of substance is present, a holding company can be located efficiently in Luxembourg, Hong Kong, or Singapore. If Ireland — which provides preferential exemptions for capital gains under its treaty with China — is used, care must be taken to ensure that no tax leakage will be suffered, because Ireland generally taxes dividend income. The Netherlands and Belgium may not be efficient locations for a holding company because China imposes a 10 percent withholding tax on dividends paid to residents of those jurisdictions, rather than the 5 percent that applies in the case of dividend recipients resident in the other jurisdictions under review.

For indirect investment into China, multinational groups with genuine merger and acquisition transactions involving the disposal of interests in a Chinese company could consider setting up a structure with at least two levels of holding companies for Chinese inbound investment to avoid the onerous reporting requirements.

For instance, Luxembourg Company A could be used as the first-tier holding company with a direct interest in a Chinese company, and Luxembourg Company B as the second-tier holding company above Luxembourg Company A. When Luxembourg Company B is sold, it could be argued that no reporting obligation arises because Luxembourg has an effective tax rate over 12.5 percent and taxes both onshore and offshore income (in other words, it does not breach either of the two reporting conditions under Circular 698). A similar structure could be used if a Hong Kong company is used as the first-tier holding company: A Luxembourg company could be used as the company holding the Hong Kong company, which in turn owns the Chinese company. The shares of the Luxembourg company could be sold in the future without triggering the reporting requirements. (See figure.) This is a structure generally used by many EU investors.

Without the presence of the Luxembourg company in the latter case, the dividend income from Hong Kong could become taxable in the hands of the EU investors because the interest in the Hong Kong company may not qualify for the participation exemption (a tax exemption on both dividend income and capital gains) in all EU member states.

Given the changing international tax environment as well as the ever increasing Chinese regulatory requirements, it is no longer a simple task to set up a taxefficient holding structure for Chinese investment. Thus, taxpayers are advised to seek professional advice before the implementation of any structure.

Contacts

Name:
Dirk Dewitte
Company:
Deloitte Luxembourg
Job Title:
Partner - Tax - International Tax-Corporate
Phone:
+352 451 452 363
Email
ddewitte@deloitte.lu

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