With the recent focus on Irish tax treatments and investigation into the tax profile of a well-known high-tech corporation, reviewing tax structures has become a hot topic. Nobody wants to pay more taxes than is legally required. However, the line between tax avoidance and evasion remains slim.
Private equity investors frequently review tax planning when structuring a deal, and then move on to the real business of ensuring/monitoring asset performance, trusting external advisers to keep them updated on changes. However, this “build and forget” model may not be as sound as many private equity investors assume. When changes in tax enforcement patterns occur, legal ambiguity and conflict of interest may delay warnings.
For private equity investors into China, this issue needs to be reviewed in light of the State Administration of Taxation’s (SAT) recent issuance of its Opinion on Implementing the Dividends Provision Under the Tax Arrangement Between Mainland China and Hong Kong in Cases Involving Beneficial Ownership (Circular 165) and other pronouncements made in the past few years.
Treaty shopping in Hong Kong
Treaty Shopping is widespread and can be a legal tax mitigation method whereby a taxable investor reviews tax treaties/laws among jurisdictions to find favourable rates on taxable items such as withheld income or capital gains. For example, a parent corporation domiciled in a tax haven (TopCo) may own a corporation in a second country (OpCo). Any dividend from OpCo to HoldCo are subject to withholding tax in the operating jurisdiction at the normal rate for that jurisdiction, unless a tax treaty between the two jurisdictions provides otherwise. If a favourable tax treaty is not present, professional advisers often assist companies to mitigate their tax exposure by inserting a holding company from a favourable tax treaty jurisdiction into the structure.
The PRC has a variety of current tax treaties with various jurisdictions. One of the most popular is with Hong Kong, where tax rates on dividends are reduced from 10% (the applicable rate in the PRC) to 5% (a rate withheld prior to distribution to the Hong Kong shareholders). However, if the ultimate “beneficial owner” is determined to be outside of Hong Kong – making the Hong Kong entity effectively a shell – the treaty tax benefits are not available.
Determining what constitutes a beneficial owner under PRC tax law becomes an important issue when structuring an offshore investment. These issues were first outlined in the SAT’s Notice Concerning the Meaning and Determination of ‘Beneficial Owner’ in Tax Treaties (Circular 601) and Announcement Concerning the Determination of Beneficial Owner Under Tax Treaties (Announcement 30). Circular 601 stipulates that only beneficial owners can receive the benefit of a tax treaty, generally outlines the definition of beneficial owner, and proposes seven factors that would negatively impact such a determination. Announcement 30 builds on that by clarifying that listed holding companies are beneficial owners, that having a legitimate business purpose by itself was not enough (i.e. the structure cannot be designed just to avoid tax) and that the seven factors should be considered collectively in making an assessment on tax status.
Circular 165 seeks to clarify the definition of beneficial owner with specific reference to the terms of the Hong Kong tax treaty with the PRC, by detailing how to interpret several of the negative factors listed in Circular 601.
Regarding these factors, Circular 165 provides that:
- when determining the applicability of the tax treaty to a Hong Kong entity, the local SAT bureau should review relevant materials regarding i) the entity’s profit distribution situation (e.g. does it distribute profits and to what degree are those prefixed) and (ii) degree of control by its non-Hong Kong parent company, all as evidenced by its articles of association, relevant agreements and other corporate documents;
- investment companies with merely one project will not necessarily be disqualified from receiving the benefit of the tax treaty, but must be carefully reviewed in the context of the other factors;
- the assets of the Hong Kong entity should be analysed in comparison to the income of the entity, and assets should not be considered registered capital;
- the employees’ responsibilities and substance of work should be examined, rather than the number of staff; and
- since Hong Kong employs a territorial system of taxation, and the PRC government has seen fit to enter into a tax treaty with Hong Kong, the fact that Hong Kong’s tax rate is low should not be the key factor.
Circular 165 also reiterates the language of Announcement 30 regarding it being a collective determination based on a review of all of the factors, with no one factor disqualifying the applicant.
Anti-treaty shopping measures
Circular 165 should be considered a shot across the bow of Hong Kong entities claiming beneficial ownership status of the PRC/Hong Kong tax treaty. Circular 165 was issued after consultation with the Hong Kong tax authorities and after some SAT-conducted studies of the actual practices in Hong Kong. The PRC has issued various other “anti-treaty shopping” measures through statements regarding the enforcement of tax treaties and renegotiating existing tax treaties.
Furthermore, private equity investors who avail themselves of the beneficial owner definition under a tax treaty should not assume that external accounting firms will provide the necessary oversight and warning. For auditors, there may be a conflict of interest. After setting up or signing off on a structure, changes in interpretation or enforcement might lead to difficult discussions regarding restructuring or booking more withholding. Also, as an application for treatment as a beneficial owner under a tax treaty must be filed each time a dividend is issued, and the continued applicability of the treatment re-examined, there is a chance that, after such a reinterpretation or change of enforcement, the SAT will determine that the entity is disqualified. In such cases, authorities have the ability to retroactively seek taxes not previously paid on dividends that were previously allowed, and assess interest penalties on such ‘late’ payments.
Simon Luk is a partner and chairman of Asia practice at Winston & Strawn in Hong Kong. He can be contacted on +852 2292 2000 or by email at email@example.com
Mark Jacobsen is a registered foreign lawyer (California, USA) at Winston & Strawn in Hong Kong. He can be contacted on +852 2292 2000 or by email at firstname.lastname@example.org