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China withholding tax paid on passive income - Hong Kong profits tax considerations
Introduction
Under the China Corporate Income Tax ("CIT") Law, non-tax resident enterprises ("non-TREs") (i.e. companies incorporated in a foreign country and with its place of effective management located outside China) which have no permanent establishment in China are subject to China withholding tax ("WHT") on their passive income derived from China. Passive income that is subject to WHT in China includes dividends, rentals, interest, royalties and gains from transfer of properties.
In January 2009, the State Administration of Taxation ("SAT") issued Guoshuifa [2009] 3 ("Circular 3") setting out the detailed requirements in relation to the enforcement of the collection of WHT on China-sourced passive income received by non-TREs. For the key points of Circular 3 and its implications from the China tax perspective, please refer to our China Tax News Flash Issue 6, March 2009: "Tighter tax collection measures on passive income of foreign enterprises from China".
This News Flash examines the Hong Kong profits tax issues on passive income derived from China by Hong Kong incorporated companies having their effective management in Hong Kong and without a permanent establishment in China (i.e. a non-TRE for China tax purposes).
Sources of passive income derived by a Hong Kong company from China
The sources of passive income are determined differently according to China CIT Law and the Hong Kong Inland Revenue Ordinance ("IRO"). In China, Article 7 of the Detailed Implementation Regulations ("DIR") of the CIT Law specifies the sources of various types of passive income as follows:
- For income derived from the transfer of properties, where the property concerned is an immovable property, the source shall be determined according to the location where the immovable property is situated; where the property concerned is a movable property, the source shall be determined according to the location of the enterprise, establishment or place which transfers the property; where the property concerned is equity investment, the source shall be determined according to the location of the investee enterprise.
- For dividend and profit distribution, etc. from equity investment, the source shall be determined according to the location of the enterprise which distributes the dividend and profit distribution.
- For interest income, rental income and royalty income, the source shall be determined according to the location of the enterprise, establishment or place which bears and/or pays the income or the residence location of the individual who bears and/or pays the income.
In Hong Kong, as a general principle, income will be regarded as having a Hong Kong source if it is "arising in or derived from Hong Kong". In case of interest income of financial institutions, the income will be with a Hong Kong source if it "arises through or from the carrying on of business in Hong Kong".
Because of the differences between China and Hong Kong in determining the sources of income, it is possible for the same income to be regarded as having a source both in China and in Hong Kong. Under the Arrangement between the Mainland China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation on Income ("China/HK DTA"), both China and Hong Kong may have taxing rights on the passive income derived from China by Hong Kong companies. Since the way the source of an income is determined is different in China and in Hong Kong, the presumption that passive income derived from China should have its source outside Hong Kong and should not be subject to Hong Kong profits tax is not always true. There are situations where the passive income derived from China may still be subject to Hong Kong profits tax. The Hong Kong Inland Revenue Department ("IRD") will seek to tax such China-sourced passive income where it falls within the scope of the IRO notwithstanding that China WHT may have been imposed on the same income and thus resulting in double taxation.
In this News Flash, we discuss the Hong Kong profits tax issues of those passive incomes that have a China source according to Article 7 of the DIR of the CIT Law.
Dividends 
Dividends derived from an investee in China are not subject to Hong Kong profits tax as they are offshore in nature. As a result, there should be no double taxation issue.
Rental income from immovable properties
Rental income of a Hong Kong company will be subject to China WHT if the rental is borne or paid by a Chinese company or a Chinese individual irrespective of the location of the property. From the Hong Kong profits tax perspective, the source of rental income is determined according to the location of the property. In the situation where a Hong Kong company derives rental income from an immovable property located in China and the rental is borne or paid by a Chinese company or a Chinese individual, the rental income will be regarded as having a source outside Hong Kong and will not be subject to Hong Kong profits tax (because the property is located outside Hong Kong) although China WHT will be imposed on the rental income (because the payer is located in China). Hence, there should be no double taxation issue. On the other hand, if a Hong Kong company derives rental income from an immovable property located in Hong Kong but the rental is borne or paid by a Chinese company or a Chinese individual, the rental income will be subject to Hong Kong profits tax (because the property is located in Hong Kong) and technically China WHT can also be imposed on the same income (because the payer is located in China). This potentially gives rise to double taxation.
Interest
According to Departmental Interpretation & Practice Notes No. 13 - Taxation of Interest Received ("DIPN 13") issued by the IRD, the "provision of credit test" will be used in determining the source of interest income derived by companies other than financial institutions, provided that the companies are not carrying on a money lending business in Hong Kong. Under the provision of credit test, the place where the funds from which the interest was derived were provided to the borrower will be the source of the interest income. In most cases, the loan arrangement with a Chinese borrower can be structured in such a way that the provision of credit is in China rather than in Hong Kong. In such cases, the interest derived from China will not be subject to Hong Kong profits tax. However, there may be situations where the provision of credit is in Hong Kong and hence the interest is taxable under the deeming provision of section 15(1)(f) of the IRO, resulting in double taxation if the interest is borne by a Chinese payer in China. For interest derived by non-financial institutions which carry on a money lending business in Hong Kong, based on the Orion Caribbean [note1] case and DIPN 13, the "operation test" (i.e. one looks to see what the taxpayer has done to earn the profit in question and where he has done it) instead of the "provision of credit test" can be used in determining the source of interest income. Whether the interest income has a Hong Kong source in such cases depends on the amount and importance of the activities performed by the lender in Hong Kong and has to be determined on a case-by-case basis. Accordingly, it is possible that the interest income derived by a Hong Kong money lending business from a Chinese borrower may be subject to both China WHT and Hong Kong profits tax. Interest received by financial institutions may be subject to tax in Hong Kong under the deeming provision of section 15(1)(i) of the IRO as long as the interest is derived through or from carrying on of their businesses in Hong Kong even though the funds are made available to the borrowers outside Hong Kong. The current practice of the IRD for determining the source of interest income derived by financial institutions is to look at two factors, namely the funding for and the initiation of the loan, as explained in Departmental Interpretation & Practice Notes No. 21 - Locality of Profits ("DIPN 21"). For example, if both the funding for and the initiation of a loan are in Hong Kong, the interest will be fully taxable whereas if either of these two activities is done outside Hong Kong, only 50% of the interest will be taxable. Double taxation arises if the same interest is subject to China WHT. [note1]: Orion Caribbean Limited v. CIR 4 HKTC 432
Royalties
Based on DIPN 21, the source of royalty income derived by a Hong Kong company carrying on business in Hong Kong is determined in the same way as that of trading profits. Accordingly, the IRD may seek to argue that royalties received by a Hong Kong company from a Chinese company in China are with a Hong Kong source, if the agreement for the Hong Kong company to acquire the intellectual property in question is effected in Hong Kong or if the licensing agreement with the Chinese company granting it the right to use the intellectual property is effected in Hong Kong. Since the payer is a Chinese company, the royalties will also be subject to China WHT, resulting in double taxation.
Gains from transfer of properties
Gains derived from the transfer of properties in China will be subject to Hong Kong profits tax if they are considered by the IRD as both of revenue in nature and with a Hong Kong source. While it is unlikely the gains derived from the transfer of immovable property in China will be considered as having a Hong Kong source, it is possible for the gains derived from the transfer of shares or equity interests in a Chinese company to have a Hong Kong source. For example, a gain derived by a Hong Kong company from the disposal of equity in a private Chinese company (i.e. the company is not listed on a stock exchange) may be subject to Hong Kong profits tax if the Hong Kong company is considered as engaging in a share trading business (i.e. the gain is revenue in nature) and the contracts of purchase and sale of the shares are effected in Hong Kong (i.e. the gain is with a Hong Kong source). Based on Article 13 of the China/HK DTA on capital gains, the gain will also be subject to China WHT if it is derived from a disposal of (i) 25% or more of shareholding in a Chinese company; or (ii) shares in a Chinese company of which the assets are comprised mainly (i.e. 50% or more) of immovable property in China.
Relief for double taxation
Relief is available in Hong Kong if the above passive income is subject to both China WHT and Hong Kong profits tax. Subject to certain conditions discussed below, there are two possible forms of Hong Kong profits tax relief for the China WHT paid on passive income derived from China. First, the WHT may be allowed as a tax credit against the Hong Kong tax payable under section 50 of the IRO and Article 21 of the China/HK DTA. In order to claim a tax credit, the passive income must be subject to tax in both China and Hong Kong.
Alternatively, the WHT may be deducted as an expense under section 16(1) of the IRO if it is an expense incurred in the production of chargeable profits in Hong Kong. As set out in Departmental Interpretation & Practice Notes No. 28 ("DIPN 28"), a foreign tax that is a charge on the profits themselves is not deductible under section 16(1) of the IRO (as it is an appropriation of profits) whereas a foreign tax that must be borne regardless of whether a profit is made is allowable as a deduction under section 16(1) of the IRO (as it is incurred for the purpose of producing profits). In other words, to be allowed as a deduction, the foreign tax in question must be one that is charged on the gross amount of the earnings that are themselves chargeable to Hong Kong profits tax. Foreign taxes that take the form of a WHT on income derived by way of interest or royalties are referred to in DIPN 28 as a typical example of foreign taxes that are deductible under section 16(1) of the IRO.
Dividends
China-sourced dividends are those dividends distributed by companies located in China. As explained above, these dividends are usually considered to have a source outside Hong Kong and not taxable in Hong Kong. As such, double tax relief is not applicable.
Rental income from immovable properties
Article 21 of the China/HK DTA on elimination of double taxation allows tax credit in Hong Kong for China WHT suffered by a Hong Kong company on income with a China source. In the case described above where a Hong Kong company is subject to both China WHT and Hong Kong profits tax on the rental income paid by a Chinese company in respect of a property located in Hong Kong, it is uncertain whether the IRD would agree that the rental income, though technically subject to China WHT, has a China source and allow tax credit under section 50 of the IRO. Alternatively a claim for deduction under section 16(1) of the IRO is possible.
Interest
In cases where the interest income is subject to both China WHT and Hong Kong profits tax, tax relief in the form of tax credit may be available for Hong Kong profits tax purposes. Under Article 21 of the China/HK DTA and section 50 of the IRO, a tax credit will only be available for a company that is a tax resident of Hong Kong for the China/HK DTA purposes. Alternatively, tax relief is also possible in the form of tax deduction. As the WHT imposed on interest received by non-TREs from China is levied based on the gross income received, such WHT represents a charge on gross receipts and must be paid regardless of whether a profit is made. Accordingly, the WHT should be deductible under the general deduction provisions of section 16(1) of the IRO as an expense incurred for the purpose of producing chargeable profits so long as the income is also subject to Hong Kong profits tax.
Royalties
Similar to interest income, if royalties derived by a Hong Kong resident company are subject to both WHT in China and Hong Kong profits tax, the taxpayer should be able to claim either tax credit under section 50 of the IRO or tax deduction under section 16(1) of the IRO.
Gains from transfer of properties
Where the gains derived from transfer of shares or equity interests in a Chinese company are considered as having a Hong Kong source and of revenue nature by the IRD, the gains from the disposal of these shares or equity interests will be subject to both WHT in China and Hong Kong profits tax. Since the China WHT for transfer of equity is levied on the gain derived from the transfer (i.e. the gross income received minus the net book value of such property) rather than on the gross receipts, technically a relief for the China WHT paid on such gains by means of a tax deduction may not be allowed. A tax credit in accordance with Article 21 of the China/HK DTA and section 50 of the IRO will be available instead. In case of any gains from the transfer of immovable property situated in China, there should usually not be a double taxation issue in Hong Kong.
Summary
The table below summarises the Hong Kong profits tax exposures of different types of passive income derived by non-TREs from China and the reliefs that are available.
| |
Source from Hong Kong profits tax perspective |
Tax credit in Hong Kong for China WHT under section 50 of the IRO |
Tax deduction in Hong Kong for China WHT under section 16(1) of the IRO |
| Dividends from Chinese companies |
Likely offshore and not taxable in Hong Kong |
Not Applicable |
Not Applicable |
| Rental income from immovable property located in China |
Likely offshore and not taxable in Hong Kong |
Not Applicable |
Not Applicable |
| Interest received from Chinese companies by non-financial institutions which do NOT carry on money lending business |
Likely sourced outside Hong Kong if the provision of credit is outside Hong Kong |
Not Applicable |
Not Applicable |
| Interest received from Chinese companies by non-financial institutions which carry on money lending business |
Could be subject to Hong Kong profits tax under section 14 of the IRO |
Possible [note2] |
Possible |
| Interest received from Chinese companies by financial institutions |
Could be subject to Hong Kong profits tax under section 15(1)(i) of the IRO |
Possible [note2] |
Possible |
| Royalties from Chinese companies |
Could be subject to Hong Kong profits tax under section 14 of the IRO |
Possible [note2] |
Possible |
| Gains from transfer of immovable property located in China |
Likely offshore and not taxable in Hong Kong |
Not Applicable |
Not Applicable |
| Gains from transfer of shares or equity interests in a Chinese company |
Could be subject to Hong Kong profits tax under section 14 of the IRO if they are revenue in nature and with a Hong Kong source for Hong Kong profits tax purpose |
Possible [note2] |
Unlikely | [note2]: No credit would be available for business tax, if applicable, withheld from or suffered on the payments.
PwC Observations
The status of a Hong Kong tax resident
For the purposes of the China/HK DTA, a Hong Kong incorporated company or a foreign incorporated company that is normally managed or controlled in Hong Kong will generally be considered by the IRD as a tax resident of Hong Kong. If a company is a tax resident of both China and Hong Kong as defined in Article 4 of the China/HK DTA, the "tiebreaker rule" in the DTA dictates that the company shall be deemed as a resident of the place in which its effective management is situated. It is not uncommon for foreign banks to set up their operations in Hong Kong in form of a branch instead of a separate legal entity. Uncertainty may arise, however, in determining the tax residency of such Hong Kong branch set up by foreign banks for the China/HK DTA purposes because of the different approaches adopted by the IRD and the SAT in looking at the tax residency of a branch. As elaborated in paragraph 27 of the Departmental Interpretation & Practice Notes No. 44 - Arrangement between the Mainland of China and the Hong Kong Special Administrative Region for the Avoidance of Double Taxation on Income ("DIPN 44"), the IRD takes the view that if the Hong Kong branch of an overseas bank is managed in Hong Kong, the branch will be regarded as a Hong Kong tax resident. On the other hand, according to Guo Shui Han [2007] No. 403 ("Circular 403"), the SAT takes the view that the tax resident status of the branch is determined by the overall management and control of the bank. Although we understand the view in Circular 403 is under reconsideration of the SAT, before this is changed, the tax resident status of a Hong Kong branch of an overseas bank remains uncertain for the China/HK DTA purposes. A company incorporated outside Hong Kong that is normally managed or controlled in Hong Kong will need to present a Hong Kong Tax Resident Certificate ("TRC") to the Chinese tax authorities to support its Hong Kong tax resident status. In the TRC Application Form (Form IR1313A), the IRD requires the taxpayer to provide the following information:
- Nature of business
- Location of headquarters and locations of main branches
- Business activity in Hong Kong
- Management and other staff residing in Hong Kong (directors / partners / trustees, senior management personnel, other staff)
- Whether the directors' / partners' meetings were normally held in Hong Kong
- With regard to the daily business operation in Hong Kong, whether the persons residing in Hong Kong normally: (i) formulate strategic policies, (ii) determine business directions (iii) set work plans (iv) implement management's decisions (v) choose business financing (vi) evaluate business performance
These appear to be the factors used to determine the place where the company is "normally managed or controlled". Application for a Hong Kong TRC should be lodged with the IRD with the form mentioned above. Under the current practice of the IRD, a TRC will only be issued to a company seeking relief under the China/HK DTA upon a referral request from a Chinese tax authority.
Eligibility to tax credit in case of a Hong Kong branch
As mentioned above, there may be situations where the Chinese tax authority does not agree with the IRD's position of treating a Hong Kong branch of a foreign bank (also possibly of a foreign non-bank corporation) as a Hong Kong tax resident for the China/HK DTA purposes. In such cases, China WHT is levied based on the rate stipulated in the domestic law of China rather than the reduced treaty rate. It is not absolutely clear whether the China WHT paid according to the domestic tax law can be allowed as tax credit under section 50(1) of the IRO for Hong Kong profits tax purposes. Technically speaking, the WHT paid in China is charged under the Chinese domestic tax law rather than in accordance with the provisions of the China/HK DTA and therefore is arguably not creditable under section 50(1) of the IRO. However, in practice, the IRD may possibly allow a tax credit for the WHT paid in China up to the amount of WHT at the treaty rate. The remaining WHT paid not allowed as tax credit may be deducted as an expense under section 16(1) of the IRO.
Tax credit or tax deduction
In cases where the China WHT paid is either creditable under section 50 of the IRO or deductible under section 16(1) of the IRO, an interesting question is whether there is a choice between tax credit and tax deduction for a taxpayer. DIPN 44 states that where the China/HK DTA and the IRO contain different provisions relating to the same matter, preference will be given to the provisions that are most beneficial to the taxpayers. On the other hand, section 50(1) of the IRO may arguably be interpreted as taking precedence over section 16(1) of the IRO because of the use of the term "shall have effect" in that section. That is, in cases where a double tax agreement is applicable, section 50(1) of the IRO shall have effect and take precedence (i.e. a tax credit must be claimed and there is not a choice of claiming a tax deduction on the foreign tax paid). For Hong Kong salaries tax purposes, the current practice of the IRD is that an individual taxpayer can either claim an income exemption under section 8(1A)(c) of the IRO or a tax credit for foreign individual income tax paid under section 50(1) of the IRO. Following the same principle, it would appear that corporate taxpayers could also have a choice between claiming a tax credit or a tax deduction for Hong Kong profits tax purposes. However, given the uncertainties involved, a clarification from the IRD on this issue will be helpful.
Is it always beneficial to claim a tax credit?
Assuming that there is a choice between claiming a tax credit or a tax deduction for the China WHT paid for Hong Kong profits tax purposes, taxpayers should assess which form of relief is more beneficial to them according to their specific circumstances. In most cases, claiming a tax credit should be more beneficial than claiming a tax deduction because a credit is a dollar-to-dollar tax saving whereas the tax saving from claiming an expense deduction is the amount claimed as deduction multiplied by the applicable tax rate. However, there are cases where claiming a deduction could be better. This is because the maximum amount of tax credit allowable is limited to the Hong Kong profits tax payable calculated at the prevailing tax rate on the foreign income net of the related expenses incurred pursuant to section 50(3) of the IRO. Although section 50(5) of the IRO states that excessive foreign tax paid not allowed as a tax credit can be allowed as a deduction, such excessive amount can only be deducted against the foreign income in respect of which the foreign tax is paid. The ultimate effect is that no Hong Kong tax is payable on that foreign income but there will not be any benefit beyond that. On the other hand, under section 16(1) of the IRO, the China WHT paid can be fully deductible as an expense. This would mean that in cases where the WHT rate is higher than, say the margin between the interest received and the related expenses and a loss is resulted, such loss can be used to offset other taxable income in the same year of assessment or be carried forward to offset the taxable income in future years of assessment. In such a way, the tax savings from claiming a deduction could be higher than claiming a tax credit.
Concluding Remarks
Double taxation on passive incomes derived from China by a Hong Kong company will be a growing concern given the close economic ties between Hong Kong and China. Furthermore, getting relief for any double taxation has become more important than ever with the increasing WHT enforcement in China, especially under the current economic conditions where managing cash flow is critical. While it is important to understand the tax exposures of these incomes in China, it is equally important to appreciate the reliefs that are available if such incomes are subject to tax both in Hong Kong and China. Finally, it should not be forgotten that good and proper documentation is always vital for obtaining both preferential treaty treatments in China and tax relief in Hong Kong.
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