China targets favourable withholding tax rates
China's tax authorities are challenging the use of special purpose vehicles (SPV) that give foreign firms based in China favourable tax rates.
The authorities are concerned that SPVs benefit from preferential withholding tax rates as established in tax treaties with other jurisdictions.
A foreign investor wanting to dispose of an investment in China can sell their shares of the SPV without paying corporate income tax in China on the capital gain from the sale. Typically, the jurisdiction where the SPV is established will also exempt the capital gain from local taxation.
Tax treaties can reduce the withholding tax rate significantly. The treaties with Hong Kong and Singapore effectively reduce the rate on dividends from 10% to 5%.
The State Administration of Taxation (SAT) issued a notice in late February that aims to address the use of foreign-owned SPVs.
Notice 81 addressed the situation where the withholding tax rate on dividends under a tax treaty is lower than 10% rate under domestic law in China. The notice ruled that certain conditions must be met for the recipient of the dividend to enjoy the treaty benefit.
The recipient must be a tax resident of the other treaty jurisdiction and must be the beneficial owner of the dividend. The SAT also said that the dividend must qualify as a dividend under the tax law of China.
The notice explained that the SAT will now require the non-resident taxpayer or the withholding agent to provide a host of documentary evidence to prove that the recipient meets these requirements.
«Foreign investors in China will want to monitor developments in this area, as well as to evaluate their holding structures for investments in China in light of these emerging anti-avoidance principles and practices,» said Brendan Kelly, co-head of of Baker & McKenzie's China tax practice in Shanghai.
«Although SPV structures will continue to provide benefits, it may become more important than in the past for an SPV to have some degree of economic substance,» Kelly added.
The notice formed part of the country's enterprise income tax legislation that was ratified on January 1 2008.