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Please click on the links below to view more:   Interpretation and implementation notice for double tax arrangement between Mainland China and Hong Kong    The comprehensive tax arrangement for the avoidance of double taxation ("New DTA") between the Mainland China and the Hong Kong Special Administrative Region ("HKSAR") was concluded in August 2006 (please refer to our highlights of the New DTA in August 2006).  On 4 April 2007, the State Administration of Taxation of China ("SAT") has released a notice, entitled Guo Shui Han [2007] 403 ("Circular 403") to provide interpretation and implementation guidelines on the New DTA on the side of China.    Despite that it is the interpretation and implementation guidelines for the New DTA between the Mainland China and HKSAR, Circular 403 states that they shall be applicable to other tax treaties that the Mainland China has concluded with other countries/regions if the contents of the relevant articles are the same and no other interpretation and implementation guidelines have been provided before.  In light of such widespread and far-reaching implications, Circular 403 is of great interest to not only the tax residents in HKSAR, but also tax residents of other tax treaty countries/regions.  Amongst various points raised in Circular 403, we believe the following are the most important ones:   Read more...... Expand / Collapse Permanent Establishment ("PE")    Similar to many other tax treaties concluded by the Mainland China, the New DTA contains a clause for determining PE by reference to the length of time for the services rendered by a HKSAR enterprise in China.  The New DTA defines that a HKSAR enterprise shall be regarded as having a PE in China if it has provided services in China for more than 6 consecutive or cumulative months in any 12-month period.  As such, the definition of "a month" is of prime importance when determining PE cases.    In this regard, the SAT and HK Inland Revenue Department ("IRD") did not reach consensus when the IRD issued its Departmental Interpretation & Practice Notice on the New DTA in December 2006.  Now, the SAT's Circular 403 stipulates that when determining "6 consecutive or cumulative months in any 12-month period", the entire period starting from the first month when the first employee arrives China till the last month when the last employee leaves China should be counted.  For example, where a HKSAR enterprise may send the first staff into China to provide services on 16 April 2007 and pull out the last staff from China on 15 November 2007, it would be regarded as providing services in China for more than 6 consecutive or cumulative months in a 12-month period in China.  In other words, even if the employees are present in China for 1 day in a particular month, that would still be regarded as "a month".    On the other hand, Circular 403 allows exclusion of a period or periods of absence from China for the purpose of determining the "6 consecutive or cumulative months in any 12-month period".  Specifically, it provides that any period of 30 consecutive days without any employee working in China can be excluded as "a month".  By applying the previous example, if there is no employee of the HKSAR enterprise working in China during the periods from 16 June to 15 July 2007 (30 days consecutively) and from 1 October to 31 October 2007 (31 days consecutively), "two" months can be excluded for the purpose of determining the "6 consecutive or cumulative months in any 12-month period".  As a result, the HKSAR enterprise should not be regarded as having a PE in China.    Circular 403 also stipulates that, for projects lasting for periods of more than 12 months, similar treatments should be applied on a rolling 12-month basis.    Capital gain    The interpretation of 25% threshold for China tax exemption in relation to disposal of shares in a Chinese enterprise (whose assets are not primarily comprised of immovable property) under the New DTA is another area drawing much attention.  Again, the views of the SAT and IRD were diverged.  Now the SAT's Circular 403 provides a more stringent interpretation and implementation on the exemption condition.  That is, China tax exemption would not be granted in the case where the HKSAR seller of the shares in a Chinese enterprise has held 25% or more of the total shares in that Chinese enterprise during a prescribed period of time, even if the shares in that particular disposal being less than 25% of the total shares.  In other words, the Mainland China has the taxing right on the capital gain derived by the HKSAR seller, no matter how much proportion of the shares the HKSAR seller disposed in one transaction.    Circular 403 does not define the "prescribed period of time" of owning the shares before disposal, but only defers it to further discussion with the IRD.  Reference may be made to a similar clause laid down in the recently published Protocol to China/Mauritius tax treaty.  That Protocol states that "gains derived by a resident of a Contracting State [Mauritius] from the alienation of shares, participation, or other rights in the capital of a company which is a resident of the other Contracting State [China] may be taxed in that other Contracting State [China] if the recipient of the gain [Mauritius], during the 12-month period preceding such alienation, had a participation, directly or indirectly, of at least 25 percent in the capital of that company".  It is the first treaty in which China and the treaty country [Mauritius] lays down a 12-month grace period, during which if the shares held by a Mauritius seller is not more than 25%, China would not impose tax on the capital gain for any disposal.  However, it is not certain at the stage if similar consideration would be applied to the New DTA.    Income from employment    The New DTA has changed the basis period for counting the number of days of presence of individual employees for the 183-day threshold from a calendar year to any 12-month period commencing or ending in the tax year concerned.  Circular 403 clarifies that in the first year when this clause applies (in the tax year 2007 in the Mainland China), the 12-month period shall start from 1 January 2007.  In other words the 12-month period will not claw back to the previous year.    Circular 403 also clarifies that if the commencement date and cessation date of 12-month period fall into two tax years, the employment income derived in China during all the months within those two tax years shall be subject to Chinese Individual Income Tax ("IIT").  It provides an illustration to explain it: where a HKSAR employee provided services in China in the months of February, April, November, December of 2007, and the months of March, April, May, October and December of 2008, and the total number of days of services in China between the months from November 2007 and October 2008 exceeded 183 days in aggregate; then this HKSAR employee shall be subject to IIT not only in respect of the remuneration for these months, but also for the other months in 2007 and 2008, i.e. February and April of 2007 and December of 2008.    HKSAR employees should now plan their trips to China very carefully in order not to expose to IIT as far as practical situation allows.    Toll processing trade arrangement    Circular 403 has reconfirmed the technical position laid down in a previous tax circular which stipulated that where a HKSAR enterprise has toll processing trade arrangement in China and involves in the production, supervision, management or sale functions for the arrangement, then the HKSAR enterprise should be regarded as having a PE in China.  However, as a temporary measure to relieve the HKSAR enterprises having such arrangement in China from China tax burden, the HKSAR enterprise would not be so treated as far as the Chinese toll factory has reported taxes in relation to the processing fee and the HKSAR enterprise has reported 50% of its profits in HKSAR following the IRD's common practice.    However, Circular 403 does not provide a clear timeline for such temporary measure to continue.  So HKSAR enterprises having such arrangement may still need to review their business model to prepare for the withdrawal of such temporary measure.    Anti-treaty abuse provision    Circular 403 indicates that there could be anti-treaty abuse measures.  While the New DTA between the Mainland China and HKSAR is seen to be one of the most favorable amongst the double tax treaties/arrangements that the Mainland China has concluded so far, it is doubtless that the two governments are very careful to avoid the New DTA to be abused.  It is important to closely monitor the development in this aspect if multinational corporations are using HKSAR subsidiaries to make investments in China, provide services in China or conduct business with China.  Of course, we believe that reasonable business substance is always a strong foundation for enjoying treaty benefits in any circumstances.    Conclusion    While Circular 403 seeks to provide clarification on various issues arising from the practical application of the New DTA, it does not eliminate all uncertainties as there are still a few areas in which consensus between the SAT and IRD has yet to be reached.  We hope that their future discussions could resolve those inconsistent views.   Close Anti-treaty shopping provisions newly introduced into China's tax treaty network    The State Administration of Taxation of China ("SAT") issued a circular, Guo Shui Han [2007] No.131 ("Circular 131") on 28 January 2007 to clarify the interpretation of the Double Tax Treaty and its Protocol between China and Mexico effective 1 January 2007, It then on 16 March 2007 issued another tax circular, Guo Shui Han [2007] No.334 ("Circular 334") to clarify the interpretation of a specific article in the 2nd Protocol to the tax treaty between China and Korea which was effective 4 July 2006.  Both circulars express the intention of China to adopt anti-treaty shopping measures when dealing with tax residents from Mexico and Korea.   Read more...... Expand / Collapse Protocol to the tax treaty between China and Mexico    As clarified in Circular 131, Article 6 - Limitation of Benefits ("LOB") of the Protocol to the Sino-Mexico Tax Treaty should be interpreted in China as follows: The Equity Control Test: In order for a Mexico tax resident to enjoy the benefits granted under the Sino-Mexico Tax Treaty, above 50% of its equity interest has to be solely or collectively owned, directly or indirectly, by a Mexican individual resident, a Mexican resident enterprise and the central/local governments of Mexico; and   The Onward Distribution Test: To be entitled to the Sino-Mexico Tax Treaty benefits specifically pertaining to dividend, interest and royalty, the Mexico tax resident has to pass a 2nd test, i.e. it shall not dispatch more than 50% of its income in the form of dividend, interest or royalty to any party other than the 3 kinds of parties in the above Equity Control Test. Having said the above, Circular 131 does not deny a Mexico tax resident who does not fulfill the above tests from enjoying the Sino-Mexico treaty benefits, as far as it could demonstrate that the motives of its establishment, acquisition, maintenance and operation are not mainly aimed at gaining the Sino-Mexico treaty benefits.    2nd protocol to the tax treaty between China and Korea    Article 1 of the 2nd Protocol to the Sino-Korea Tax Treaty stipulates who should be the party qualifying for the treaty benefits.  Circular 334 provides SAT's interpretation on this Article in China as follows:    For a Korea tax resident enterprise (including corporations, trusts and other entities) which is owned or controlled, directly or indirectly, by non-Korea resident (be it an individual, several individuals or organizations), if this Korea tax resident enterprise's income tax amount is substantially less than what it should have paid (due to any forms of tax incentives offered under Korean tax legislations), were it owned or controlled by Korea tax residents, then the Sino-Korea Tax Treaty would not apply to such Korea tax resident enterprise in relation to its income derived from China.  A decrease in the income tax amount of the Korea resident enterprise by 50% is considered as "substantial" according to the illustration in Circular 334.    As an exception, a Korea resident enterprise failing the above test may be excluded from the scope of the Article if it carries on active business operations, i.e. at least 90% of its Korean taxable income is generated from trading or business activities rather than investment (passive) business, especially dividend, interest and royalty.    The objective of this Article is similar to the LOB article under Sino-Mexico Tax Treaty.    PwC observation    It is not uncommon to see multi-national groups interposing an intermediary conduit company (usually called "Special Purpose Vehicle" ("SPV")) in a country (Country B) between the ultimate parent in the home country (Country A) and its operating subsidiary in a foreign country (Country C).  Usually, Country B and Country C have concluded a tax treaty which offers more favorable tax treatments to the tax residents in their respective countries than the tax treatments offered under the tax treaty between Country A and Country C, if any.  In some cases, there is no commercial reason or business substance to set up a SPV in Country B other than gaining the treaty benefits offered under the Country B-Country C tax treaty.  In light of such "treaty shopping" tactics, some developed countries have formulated and added anti-treaty shopping provisions into their treaty network.  They usually impose different kinds of tests to screen out those "third-country" investors (i.e. not tax residents of either of the two treaty countries) who simply set up a SPV in the treaty country to gain the treaty benefits for investment (passive) income arising from the other treaty country.    The inclusion of the LOB articles in China's recent tax treaties and protocols with Mexico and Korea signifies that the Chinese tax authorities have become conscious about the treaty shopping tactics.  In addition, the Mainland-HK DTA has also contained a provision allowing the Mainland SAT and Hong Kong IRD to further formulate mechanism to prevent abuse of their DTA.  As stated in Circular 334, the LOB article under the Sino-Korea tax treaty is only treated as a trial run by the SAT to evaluate the effectiveness of such provision for countering treaty shopping tactics.  At this stage, it may be still too early to assess whether the Chinese tax authorities would tend to apply similar provisions in all of her tax treaties with more than 90 countries (regions).    Nevertheless, it is advisable for multi-national groups to closely monitor China's future development in this area and ensure sufficient commercial substance in their investment/operating structures relevant to their subsidiaries in China.  As indicated in the two circulars, transactions with commercial substance are not the target of anti-treaty shopping measures and are usually excluded from the scope of LOB articles in tax treaties. 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