January 01, 2010

Circular on Interpretation and Determination of "Beneficial Owners" Under Tax Treaties

Issuing Body: State Administration of Taxation
Issuing Date: October 27, 2009
Effective Date: October 27, 2009

Attempting to crack down on tax avoidance, China's State Administration of Taxation (SAT) has issued the Circular on Interpretation and Determination of "Beneficial Owners" Under Tax Treaties (Beneficial Owners Circular). This action may severely restrict the ability of offshore holding companies to take advantage of preferential tax treatment afforded by tax treaties between China and foreign countries or regions, including Hong Kong and Macau, that are meant to prevent double taxation. As a result, foreign investors may find it difficult if not impossible to enjoy preferential tax rates on dividends and other passive income by establishing a shell company that does little more than distribute profits to those foreign investors.

As of October 1, 2009, pursuant to the SAT's Circular on Printing and Distributing the Tentative Administrative Measures on Tax Treaty Treatment for Non-Residents, any resident of a region or country with which China has a tax treaty (a treaty resident) may only enjoy preferential tax rates on dividends, interest, royalties or capital gains derived from China subject to the approval of local Chinese tax authorities. The Beneficial Owners Circular provides guidelines to local tax authorities on how to determine whether an individual, corporation or other organization qualifies as a "beneficial owner," a pre-requisite to enjoying benefits under tax treaties.

Definition of Beneficial Owners

The term "beneficial owner" is a contentious and evolving issue in international tax law, and there is no consistent view or guidance on how exactly a beneficial owner should be determined. In addition, most existing tax treaties do not contain a clear definition of "beneficial ownership." Thus domestic Chinese law will apply in such circumstances.

According to Article 1 of the Beneficial Owners Circular, a "beneficial owner" is defined as a person with ownership and control over income, or over the rights or assets that generate such income. A beneficial owner can by law be an individual, corporation or other organization. In order to qualify as a beneficial owner, the individual or organization must generally engage in "substantive business activities," which is further referred to in the Beneficial Owners Circular as manufacturing, trading and management activities. However, the circular provides no additional description or definition of "management activities," which means that, in most cases, the term will be subject to the interpretation and discretion of local tax authorities.

Enterprises Excluded From Being Beneficial Owners

The Beneficial Owners Circular clearly states that agents and conduit companies shall not be regarded as "beneficial owners." The term conduit company refers to a company that is established for the purpose of avoiding or reducing tax, or for the purpose of transferring or accumulating profits. Such companies are only registered in the country where they are located so as to satisfy legal organizational requirements and do not engage in any substantive operational activities such as manufacturing, trading or management.

Unfavorable Factors in Determining Beneficial Owner Status

The Beneficial Owners Circular makes it clear that the term "beneficial owner" should not be interpreted only from a technical perspective. Rather, it should be analyzed and determined on a case-by-case basis, taking note of different facts and circumstances, and in accordance with the "substance over formality" principal. Moreover, the situation should be analyzed not only from the perspective of domestic law, but also for the purpose of interpreting tax treaties (i.e., for avoiding double taxation and the prevention of fiscal evasion and tax avoidance).

The Beneficial Owners Circular further sets forth seven factors that may cause a treaty resident not to qualify as a "beneficial owner":

  1. The treaty resident is obligated to pay or distribute all or a major portion (e.g., 60 percent or more) of income to a third country within a prescribed time limit (e.g., within 12 months) after receiving the income.
  2. The treaty resident conducts litter or no business other than ownership of the properties or rights that generate the income.
  3. If the treaty resident is a corporation or other entity, its assets, scale of operations and number of employees are relatively small and do not correspond with the amount of income distributed.
  4. The treaty resident has no or almost no controlling or disposal rights to income and assets, and assumes little or no risk on the income, or on the properties or rights that generate the income.
  5. The country or region where the resident is legally domiciled does not levy tax, grants tax exemption on the proceeds or levies taxes at an extremely low rate.
  6. In addition to a loan agreement that generates interest, the treaty resident has other loans or deposit contracts with a third party that are similar in respect to amount, interest rate and execution date.
  7. In addition to a license or other agreement to transfer copyright, patent rights or technology that generates royalties, the treaty resident has another licensing or transfer agreement with a third party in respect to ownership or the right to use copyright, patent rights or technology.

If the treaty resident does not satisfy the requirements of Article 1 of the Beneficial Owners Circular (has ownership or control over income, or over the rights or assets that generate such income, and engages in "substantial business activities"), and a comprehensive analysis of the seven factors listed above indicates that the treaty resident serves merely as a conduit for profits, the applicant shall be determined not to be a "beneficial owner."


When interpreting certain key matters related to the Beneficial Owners Circular (i.e., definition of management activities and required documentation for proving the status of beneficial owner), local tax authorities appear to have considerable discretion in making a final determination, depending on how such factors are interpreted. Indeed, even a multi-investment holding company might satisfy at least one or two unfavorable conditions that possibly disqualify a company from recognition as a beneficial owner. As a result, companies would be well advised to review the structure of their holding companies immediately and exhibit caution before applying for dividend distribution to offshore holding companies. They might even consider injecting personnel and operating assets into the holding company, if practical.

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