On 25 May 2022, China deposited its instrument of approval for the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) with the Organisation for Economic Co-operation and Development (OECD). The MLI has entered into force on 1 September 2022 for China.
The MLI was developed under the 2013 Base Erosion and Profit Shifting (BEPS) Action Plan 15 as a mechanism to simultaneously update existing bilateral double tax agreements (DTAs) between relevant jurisdictions. The OECD released the MLI on 24 November 2016, and China was one of the jurisdictions that endorsed the MLI. It incorporates many measures proposed by the BEPS action plans, including hybrid mismatch rules dealing with tax-transparent entities and dual-resident entities, treaty abuse rules preventing treaty shopping activities, permanent establishment (PE) rules preventing avoidance of PE status, and measures improving the mutual agreement procedure (MAP).
The MLI contains a matching mechanism. Signatory jurisdictions nominate DTAs within their treaty network as covered tax agreements (CTAs) for updates and select updates from a range of options under the MLI. Where two signatory jurisdictions both nominate the DTA they have with each other, and the jurisdictions select the same or compatible update options, the MLI updates may take effect. To make such a matching mechanism work, the signatory jurisdictions deposit their instrument of approval with the OECD, which discloses their choice of updates, or reservations not to update certain articles.
China DTAs to be covered by the MLI. China listed 100 out of its existing 112 DTAs as CTAs for the MLI. As of 30 June 2022, among the 100 CTAs, 47 counterparty jurisdictions have selected their DTAs with China to be covered by the MLI, and have deposited their instrument of approval with the OECD, meaning the MLI will enter into force for the DTAs pursuant to article 35 of the MLI.
CHINA’S MLI POSITIONS
China’s MLI positions in its instrument of approval are largely consistent with its positions at the time it signed the MLI in 2016.
- Principal purpose test (PPT) to prevent treaty shopping activities. Article 7 of the MLI proposes the PPT and limitation on benefits rules to prevent treaty abuse activities. China has chosen to adopt the PPT, which denies treaty benefits if one of the principal purposes of an arrangement or transaction is to obtain treaty benefits.
Compared to China’s domestic general anti-avoidance rules, which target arrangements or transactions with the sole or main purpose of obtaining tax benefits, the PPT appears to have a broader scope and may potentially impact arrangements or transactions that have reasonable commercial purposes.
- Holding period for dividend. China has adopted the 365-day look-back period rule for the purpose of determining the minimum holding period for the reduced withholding tax rate on the dividend. Since China already has a one-year look-back period rule under its domestic tax law, the change should not impact MNCs’ current treaty positions.
- Capital gain from alienation of shares or interests of entities deriving value primarily from immovable properties. China has updated the treaty article relating to the disposal of shares or interests in land-rich entities by expanding the scope of the article to cover the disposal of interests in partnerships and trusts with immovable properties. Notably, China is reserved on the 365-day look-back period rule for determining whether an entity was land-rich at any point. This is because China already has a three-year look-back period rule under its domestic tax law.
- Hybrid mismatch (tax transparent entities). China is reserved on the article relating to tax-transparent entities. One reason for this is that China has not finalised domestic tax rules for tax-transparent entities and would prefer to negotiate such rules on a bilateral basis.
- Dual resident entities. China has chosen to adopt article 4 of the MLI, which provides that the tax residency of a dual resident entity should be determined by MAP, rather than by defaulting to the place of effective management. In the absence of a mutual agreement between the competent tax authorities, the entity may not be entitled to treaty benefits unless the competent authorities agree otherwise.
- Avoidance of PE status. China has chosen not to update the PE articles, and not to adopt the proposals to address the commissionaire arrangement, specific activity exemption and contract-splitting scheme. However, China has been pushing back with the OECD on the PE issue. Even before the BEPS project, China has developed its own interpretation of PE that aligns with the new principles under the MLI.
- MAP and arbitration. China remains reserved on article 16 of the MLI, that a taxpayer can present an MAP request to either contracting state. China maintains its position that a taxpayer can only initiate an MAP request with the competent tax authority of the taxpayer’s resident jurisdiction or state of nationality (for non-discrimination cases), and that the competent authority will implement a bilateral notification or consultation process. Meanwhile, China has opted out of the article on mandatory arbitration.
As anticipated, China has chosen not to adopt many of the MLI articles that are not required under the minimum standard. However, this is not to say that MNCs can underestimate the implication of the MLI’s implementation in China. MNCs with cross-border transactions should keep the MLI in mind when evaluating their treaty positions.
As discussed, one significant modification to China’s DTAs is the PPT. Although the ultimate impact of the PPT remains unclear, MNCs that wish to claim treaty benefits should expect China tax authorities’ treaty administration to be enhanced to accommodate the change brought by the MLI, thus creating an additional burden and risk for MNCs.
Another trend the authors have observed in recent years is that China tax authorities exchange information with their foreign counterparts more frequently. Therefore, MNCs should be mindful that information historically not available to China tax authorities may be disclosed in the context of MLI when assessing their treaty positions.
Although China has opted out of the relevant MLI articles, it has unilaterally developed its own interpretation of PE that aligns with the new principles under the MLI. Therefore, China-based MNCs with cross-border transactions should continue to monitor their PE position in China.
Business Law Digest is compiled with the assistance of Baker McKenzie. Readers should not act on this information without seeking professional legal advice. You can contact Baker McKenzie by e-mailing Howard Wu (Shanghai) at howard.wu@bakermckenzie.com
