June 2014 - New China-UK tax treaty enters into force
On 13 December 2013, the New Double Taxation Agreement (“New DTA”) between China and the United Kingdom (“UK”) finally entered into force.
The New DTA, originally signed on 27 June 2011 and amended by a protocol signed on 27 February 2013, replaces the treaty entered in 1984 and the protocol entered in 1996 (“Old DTA”).The New DTA applies to profits, income and capital gains arising in any tax year beginning on or after 1 January 2014for China, and to income tax and capital gains tax for any year of assessment beginning on or after 6 April 2014 andcorporation tax for any financial year beginning on or after 1 April 2014 for the UK.
Key provision in the new DTA
Reduction of Withholding Tax ( “WHT”) on passive income
The WHT rate for dividends is reduced from 10% to 5% if the beneficial owner is a company which holds directly at least 25% of the capital of the company paying the dividends.
Important observations on this clause:
- Under the UK domestic law, there is no WHT on dividends paid out by a UK company. Consequently, this clause would have no impact on Chinese parent company owning a UK subsidiary;
- As applicable to all tax treaties, from China’s perspective, under its Circular Guoshihan (2009) 81, a foreign company, i.e. a UK company in this case, can enjoy the reduced WHT rate only if the required ownership, i.e. 25% or more, was held at all times during the past 12-consecutive months before the receipt of the dividends; and
- There is an emphasis on the two words “holds directly” as a UK company indirectly owning 25% of the Chinese company paying the dividends do not qualify for the reduced WHT rate.
A 15% WHT rate is applicable on dividends paid on income or gains derived from immovable property by a tax exempted investment vehicle that is required to distribute most of its income or gains annually. This may not be relevant for dividends from China, as under Chinese domestic laws, there is no tax-exempt investment vehicle.
The WHT rate on dividends in all other cases is 10%.
Under the new DTA, the WHT rate on royalties or payments received for the use of, or the right to use, industrial, commercial or scientific equipment would be 10% but only on 60% of the gross amount of the royalties, thus bringing the WHT effective rate to 6%. For all other royalties, the WHT rate remains at 10%. Consequently, the New DTA reduces the UK WHT rate from 20% to 6% on royalties on the use of equipment and to 10% on the use of copyright, technology, etc.
In the New DTA, although the WHT rate on interest remains at 10%, the WHT rate for the payment of interests:
- is reduced from 20% to 10%, for payment from the UK
- is aligned with the Chinese domestic WHT rate, for payment from China.
Taxing right for capital gains
The New DTA clarifies that China retains the taxing right for China-sourced capital gains in the 3 situations below:
- Alienation of immovable property situated in China;
- Alienation of shares of real estate rich company, i.e. a company deriving more than 50% of its value from immovable property situated in China; or
- At any time during the 12-month period preceding such alienation, the UK investors owned directly or indirectly at least 25% of the shares of the Chinese company.
Therefore, except in the 3 situations mentioned above, UK investors in China could be exempted from the 10% WHT on capital gains in China.
Non-UK residents, such as Chinese residents, are not subject to UK tax on capital gains under the UK domestic law, unless the underlying asset of the company being disposed of is carrying business through a permanent establishment in the UK. Therefore, the Article on capital gains of the New DTA provides greater benefits to UK investors owning shares of a Chinese company. However, it is worth noting that non-UK residents may be subject to capital gains tax on high value residential property, i.e. whose value exceeds GBP 2 million.
Permanent Establishment (“PE”)
Under the New DTA, a PE is required for construction activities, including supervisory activities in connection to construction, exceeding 12 months (vs. 6 months in the Old DTA).
In addition, the New DTA introduces the definition of Service PE to be “the furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if the activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than 183 days in any 12-month period commencing or ending in the fiscal year concerned.”
Introduction of General Anti-Avoidance Rule (“GAAR”) and limitation of benefits provisions
A “miscellaneous rule” under Article 23 of the New DTA specifically enables the tax authorities to apply their domestic GAAR, notwithstanding the provisions of the DTA.
In addition, the New DTA introduces special anti-abuse provision to the articles related to passive income (i.e. dividends, interests and royalties) and specifies that the relevant preferential WHT rate in the New DTA will be denied if the main purpose, or one of the main purposes, of an arrangement is to take advantage of the relevant DTA article.
The New DTA places the UK in the same position as other locations commonly chosen for investing in China, such as Hong Kong and Singapore. The New DTA complement changes in recent years to UK domestic tax laws which aimed at improving UK’s competiveness as a holding company location. The most notable of these changes are the general exemptions from UK corporation tax for income arising from dividends and capital gains on the disposal of substantial interests in shares, provided that certain criteria are met.
Coupled with the fact that there is no UK WHT on dividends payment under the domestic law, the UK has a competitive advantage as a holding company location.
The need for an income recipient to demonstrate “beneficial ownership” under Circular 601 of the Chinese domestic law, and potential further developments anticipated in the context of the OECD’s Base Erosion and Profit Shifting Project, mean that intermediate holding companies with insufficient substance are unlikely to be able to claim treaty benefits. The UK may be a viable alternative option to other jurisdictions as multi-national companies would generally have operations in the UK.
For Chinese companies investing in the UK and other European jurisdictions, the UK is an attractive option given its extensive tax treaty network and its EU member state status. Indeed thanks to the interests and royalties directives, the EU parent-subsidiary can reduce the WHT rates to nil on payment of dividends, royalties and interests if certain requirements are met.