New challenges in the pursuit of tax treaty benefits

It has been almost two years since the PRC Enterprise Income Tax Law (EIT Law – 企业所得税法) took effect on January 1 2008, but the full consequences of the tax reform are still filtering through to various areas of business planning and activity in China. One of the key changes introduced by the EIT Law was that dividends paid by a foreign invested enterprise (FIE) to its foreign shareholders became subject to a 10% withholding tax. Dividends paid to foreign investors were exempted from tax before 2008, but this exemption was repealed when the EIT Law came into effect.

As the 10% withholding tax rate on dividends may be reduced under certain bilateral income tax treaties to which China is a party, foreign investors have greater incentives now than in the past to own a Chinese subsidiary indirectly through a special purpose vehicle (SPV) established in a jurisdiction that has a favourable tax treaty with China. For example, the tax treaties (arrangements) with Hong Kong, Singapore, Barbados, Ireland and several other jurisdictions reduce the withholding tax rate on dividends from 10% to 5%, if the recipient is a tax resident of the treaty jurisdiction and the “beneficial owner” of the dividends. Before 2008, the main tax reason to use an SPV was to avoid taxation in China upon exit from an investment in China. Typically, the jurisdiction where the SPV was established exempted the capital gain from local taxation or levied tax at a low rate. If a foreign investor wished to dispose of an FIE shareholding, it could sell the shares of the SPV without paying income tax in China on the capital gain from the sale.