This article aims to provide you with the salient points of Circular 165.
1. Circular 601
According to Circular 601, “beneficial ownership” status in the context of DTAs should be determined based on the facts and circumstances of each case and in accordance with the principle of “substance over form”. The circular stipulated that the following factors/arrangements would adversely affect a tax relief applicant in qualifying as a “beneficial owner”:
Article 2.1 - if the relief applicant is obligated to pay or distribute more than 60% of the income to a resident of a third country within 12 months of receipt
Article 2.2 - if the relief applicant has almost no other business activities other than ownership of the assets or rights that generate the income
Article 2.3 - if the relief applicant is a corporation, where its assets, scale of operations and employees are relatively minimal and not commensurate with the amount of income received
Article 2.4 - if the relief applicant has almost no right of control or disposal over the assets or rights from which it derives the income and bears little or no risks
Article 2.5 - if the income earned is either exempt from tax or taxed at a low rate in the relief applicant’s jurisdiction
Article 2.6 & 2.7 - if interest/royalty relief applicant has entered into another loan or Intellectual Property (“IP”) agreement with third party lender or IP provider of which the terms are similar to the one entered into between the applicant and the PRC party (i.e. “back-to-back” arrangement)
The above factors require that the relief applicant should have sufficient “commercial substance” in order to qualify for the beneficial ownership status.
2. Announcement 30
Article 3 of Announcement 30 introduced a safe harbour rule to relief applicants who are qualified listed companies with investment in the PRC (directly or indirectly) to be deemed as the beneficial owner of the PRC sourced dividends:
(a) if the recipient is a corporation that is a tax resident of a DTA partner state and is listed in that jurisdiction;
(b) if the recipient is a subsidiary that is 100% owned by a corporation satisfying the condition mentioned in (a) above; and
(c) if the recipient is a subsidiary that is 100% indirectly owned by a corporation satisfying the condition mentioned in (a) above, provided that the intermediate holding company is also a tax resident of the same DTA partner state.
If the intermediate holding company in case (c) is not a tax resident of the same DTA partner state, this safe harbour rule will not apply.
3. Circular 165
The following adverse factors stipulated in Circular 601 are clarified by Circular 165:
Article 2.1: “if the relief applicant is obligated to pay or distribute more than 60% of the income to a resident of a third country within 12 months of receipt”
(a) Circular 165 addresses that if a Hong Kong relief applicant only distributes its “profits” to another Hong Kong resident enterprise, Article 2.1 should not be applied as adverse factor when assessing the relief applicant’s beneficial ownership status.
(b) On the other hand, if the Hong Kong relief applicant distributes profits to a non-Hong Kong resident enterprise, the applicant should submit its contractual obligations as documentary evidence with the respective tax authorities for assessment.
Article 2.2: “if the relief applicant has almost no other business activities other than ownership of the assets or rights that generate the income”
Circular 165 specifies that:
(a) investing in a PRC company is considered as a valid business activity; and
(b) article 2.2 aims to cover those relief applicants without any other investments or businesses i.e. with only one investment.
Article 2.3: “if the relief applicant is a corporation, where its assets, scale of operations and employees are relatively minimal and not commensurate with the amount of income received”
Tax authorities should consider all relevant facts when applying Article 2.3, in particular:
(a) tax authorities should not take a presumption that a relief applicant’s registered capital is equivalent to its assets. Source of funds and the risk it bears in relation to its investments should also be considered; and
(b) the job nature, the role and responsibilities of the relief applicant’s employees should be the key elements to assess whether they are commensurate with the amount of income received.
Article 2.4: “if the relief applicant has almost no right of control or disposal over the assets or rights from which it derives the income and bears little or no risks”
(a) Tax authorities should not disregard the Hong Kong relief applicant’s right of control or disposal merely because the applicant is controlled by its immediate parent company.
(b) In determining whether the applicant has the right of control or disposal, the tax authorities should take the following into consideration:
- whether there are any legal documents (e.g. articles of association, legal agreement etc.) granting the applicant the power of control and disposal;
- whether the applicant has exercised such rights other than further distribution (e.g. reinvestment, investing in other projects etc.); and
- whether the exercise of such rights was at the applicant’s discretion (e.g. through directors/shareholders’ resolutions)
Article 2.5: “if the income earned is either exempt from tax or taxed at a low rate in the relief applicant’s jurisdiction”
The fact that Hong Kong does not tax offshore source income is not a “key factor” in assessing the relief applicant’s beneficial owner status.
Safe Harbour Rule and Other Related Matters
Circular 165 also clarifies the safe harbour rule set out in Announcement 30 and other related matters:
(a) Relief applicant who fails the safe harbour rule does not automatically result in denial of its beneficial ownership status. In such a case, tax authorities should evaluate the applicant’s beneficial ownership status through the normal beneficial ownership assessment process.
(b) It is not the safe harbour rule’s objective to disqualify a relief applicant who fails the safe-harbour rule from being regarded as beneficial owners of the dividend received, in particular an applicant who is:
- directly or indirectly wholly owned by an unlisted Hong Kong resident company; and
- although ultimately controlled by a Hong Kong company, is immediately owned by an intermediate holding company that is located in a third jurisdiction.
(c) In a case that the relief applicant has investments in different locations in China, its beneficial ownership status should be treated the same among the relevant tax authorities from which the dividends are derived.
(d) All the relevant adverse factors under Circular 601 should be examined comprehensively.
(e) Taxpayer may apply for re-assessment of its beneficial ownership status if its business nature has changed substantially.
“Beneficial ownership” is a controversial topic globally. On 29 April 2011, the OECD released a public discussion draft entitled “Clarification of the meaning of ‘beneficial owner’ in the OECD Model Tax Convention”. Based on the comments received, a revised draft was released in October 2012. Comments on the revised draft have been received and are reviewed by the Working Party 1 on Tax Conventions and Related Questions of the OECD Committee on Fiscal Affairs. The current draft suggests an autonomous meaning should be given to the term “beneficial owner”, in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance. It is commonly agreed that agents, nominees, conduit companies acting as fiduciaries or administrators shall not be considered as beneficial owners. But the current draft still fails to address that a beneficial owner(s) shall exist in each case and whether such a beneficial owner shall be entitled to treaty relief.
In recent years, SAT is moving to strengthen enforcement against tax avoidance and tax treaty shopping. “Beneficial ownership” assessment is one of the major targets on which the PRC tax authorities have been focusing. Circular 165 is a welcome development as it clarifies the factors that would adversely affect a tax relief applicant in qualifying as a “beneficial owner” under Circular 601. It also re-emphasises that all relevant facts and circumstances should be taken into consideration during the beneficial ownership assessment process whilst all the adverse factors should be equally and comprehensively considered.
Foreign investors should carefully evaluate their prevailing situation to see if they can pass the beneficial ownership assessment and are supported by proper documentation. It is important for investors from both Hong Kong and other treaty jurisdictions to observe these principles and guidelines. Failure to do so may result in the relief applicants being denied as the beneficial owner and thus unable to enjoy the treaty reduced tax rate. Taxpayers should clarify and discuss with the local level tax authorities or tax professionals on the uncertain areas in relation to the interpretation and implementation of these circulars at an early stage.