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By Matthew, April 16, 2010 10:45 am

One of the common questions that  I am asked here, and in fact in my role at Hwuason, is in relation to the tax treatment of H-Shares – shares in Chinese companies that are listed on the Hong Kong stock exchange. I briefly mentioned this issue once before in a post (that was inspired by a question I received) and now I will provide a slightly more fuller explanation of the tax treatment of such shares.

Dividends

According to Articles 3 and 6 of the Enterprise Income Tax Law, non-resident enterprises are required to pay tax in relation to the dividends from shares in a resident enterprise. The relevant tax rate on such income is 10%. Despite this, up until November 2008, the general practice was that dividends from H-shares were exempt from tax. In November 2008, the State Administration for Taxation issued Guoshuifa [2008] No. 897 which indicated that tax was payable on such dividends and that the resident Chinese enterprise was a withholding agent for its non-resident shareholders.

Capital Gains

It has not been clearly stated whether non-resident enterprise are taxable on capital gains from H-shares. The current practice, based on previous regulations, is that the income from the transfer of H-shares is exempt from tax. However, there is some genuine concern that such a practice will be changed in the near future. Given that dividends are now taxed, I think it would be doubtful that an exemption for capital gains will be continued in the future.

In terms of removing the risk of changes to the tax treatment off capital gains,  it may be advisable  for investors to take advantage of favourable DTAs that prevent China from taxing holdings below 25%. The merits of such an option would be subject to the particular circumstances, and the powers that China’s tax officials have in accordance with the General Anti-Avoidance Rule always needs to be kept in mind.

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By Matthew, April 15, 2010 3:45 pm

I have been meaning to discuss this issue since early last month, but havent been able to get around to it. A few of my posts since then have sorted skirmished around the issue without taking it directly head on.  This issue is obviously related to the issue of representative offices, but is of broader application.

In mid-February the Chinese tax authorities issued Guoshuifa [2010] 19 (“Circular 19″). Circular 19 outlines the State Administration of Taxation’s new administrative approach to collecting tax from non-resident enterprises. Prior to discussing the changes introduced in Circular 19, it is apt to briefly outline the general rules for the taxation of non-resident enterprises.

Taxation of Non-resident Enterprises

The taxation of non-resident enterprises depends upon whether they have a “permanent establishment” in China. Non-resident enterprises that do not have a permanent establishment will be liable to tax at 10% on income sourced or “derived” from China. Non-resident enterprises that do have a permanent establishment in China will be subject to tax at 25% on income (derived outside or inside of China) that is attributable to the permanent establishment.

Circular 19

Circular 19 applies to non-resident enteprises whether or not they have a permanent establishment in China. Article 3 of Circular 19 simply requires non-resident enterprises to maintain accurate accounts and to pay enterprise income tax in accordance with the income in those accounts.

Article 4 then provides that where accurate accounts have not been maintained, the authorities may deem the enterprise to have a specified profit level. There are three methods for deeming the requisite profits. The deemed profit rates under Article 4 will generally be more relevant in the case of a permanent establishment and is similar to the treatment of representative offices under Circular 18.

Article 5 then provides a deemed profit rate in respect of particular transactions. These profit rates are as follows

1. Engineering contracts, design, and labor consulting contracts – 15%-30%;
2. Management services – 30%-50%; and
3. Other labor services, or other operations – no less than 15%.

The tax authorities may impose a higher rate where they consider the actual profit to be higher. It is not clear whether Article 5 applies when a non-resident enterprise can, through accurate accounting records, establish that their profit rate on a particular transaction is lower than the prescribed levels. On a fair reading of the Circular, it seems that the better argument would be that these rates apply regardless.

Accordingly, from this there is two important things note:

1. Any company that does not presently operate a business in China but does enter into business arrangements with Chinese resident companies should review such arrangements to ensure that their actual profit is at least of that prescribed rates.
2. Not all such arrangements will result in the income being regarded as income sourced from China. However, it is imperative for non-resident companies to consider whether Chinese tax will apply in the circumstances and whether any alterations to an arrangement can be made to ensure that it does not.

Circular 19 does discuss a few other issues, including indicating a minimum 10% profit rate for the sale of machinery or merchandise by a non-resident enterprise to a resident enterprise, but the above are the main salient points for companies contracting with Chinese companies, or who have a permanent establishment, to consider.

Comments (2)

By Matthew, April 7, 2010 2:55 pm

I recently came across a PWC article on the new protocol to the China-Barbados DTA that indicated DTAs can restrict and preclude the GAAR in China. I have extracted the relevant information below (I reducted information not relevant to the point I am making)

This is a rather interesting topic. Many countries take different approaches to the issue. For example, Australia incorporates the terms of DTAs and provides that they will override Australia’s domestic laws except for Part IVA (Australia’s GAAR) – see Section 4(2) of the International Tax Agreements Act 1953 (Cth). Accordingly, Australian law unilaterally determined that its GAAR could not be overruled by a DTA.

Based on the article from PWC above, it seems that China has taken the view that its DTAs must explicitly provide a right to use the GAAR. I am surprised that China did not simply revise Article 58 of the Enterprise Income Tax Law which relevantly provides as follows:

Article 58 Where any provision in a tax treaty concluded between the government of the People’s Republic of China and a foreign government is different from the provisions in this Law, the provision in the treaty shall prevail.

Further, does the new Barbados-China protocol provide a basis for taxpayers to assert that pursuant to the Enterprise Income Tax Law, a DTA will always override the GAAR unless the relevant DTA permits China to apply its GAAR provisions? Not many of China’s DTAs explicitly address the China’s GAAR. Primarily because they predate the GAAR itself.

One thing to note is that the terms of the new protocal may merely be a  clarification that the GAAR will not be restricted by a DTA. PWC’s analysis suggest that it is more than this, hence their contrast between the pre and post protocol position. However, I am not sure that I totally agree. In fact, the local taxation officials (地税）in Xingjiang have already used the GAAR in relation to a Barbados company. The use of the GAAR in this context was endorsed by the SAT. Accordingly, it is not clear that China’s tax authorities accept that a DTA will restrict the GAAR.