Prevention of Double Taxation

Foreign Tax Credit
In accordance with Article 23 of the EITL, an enterprise is entitled to a tax credit for any tax paid overseas. For Chinese resident enterprises, the foreign tax is creditable up to the amount that would have been paid had the income been derived within China i.e. the credit cannot exceed the amount of tax that would have been paid in China and obviously it can also not exceed the amount that was actually paid overseas. For non-resident enterprises, the credit applies to taxable income from sources outside the PRC which is effectively connected with the establishment or place of business of such non-resident enterprise within China and therefore taxable under the EITL.

Application and Operation of Double Taxation Agreements
Article 58 of the EITL provides that the provisions of any double taxation agreements (“DTA’s”) between China and a foreign government will prevail in case of any inconsistency with the EITL. Accordingly, the operation of any DTA will obviously have a significant effect upon whether an enterprise is subject to taxation in China. There is obviously a difference in many of China’s DTAs which makes it difficult to analyse their affect on a broad level. However, here we examine the recent DTA signed between China and the Hong Kong Special Administrative Region. Despite the limitation mentioned above, the reason for examining the China-Hong Kong DTA is twofold; any examination and analysis of China’s international taxation regime that does not consider, to some extent, the effect of China’s DTAs would be deficient, and the China-Hong Kong DTA is most appropriate as Hong Kong is the leading source for investment in mainland China. From 1985 to 2006, approximately 40.5 per cent of all FDI in China originated from Hong Kong. The high level of investment originating from Hong Kong is primarily attributed to the fact that many foreign companies and local Chinese companies have utilised special purpose vehicles incorporated in Hong Kong for investing in China because of favourable tax advantages in both Hong Kong and China arising out of such an arrangement. It should be noted that the China-Hong Kong DTA is somewhat atypical to most of China’s DTAs. Accordingly, the following should not be relied upon as apply to all situations.

Under Article 4(3) of the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region of Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (the “DTA”), where an enterprise is a resident for the purposes of both Chinese and Hong Kong tax law, it will be deemed to be a resident only of the country in “which its place of effective management is situated.” The DTA provides that, where an enterprise is a resident of Hong Kong or China, the enterprises profits will be taxable by the country in which it is a resident i.e. the country in which its place of effective management is situated (Article 7(1)) The exception to this is that a non-resident enterprise will be liable to taxation to the extent that it has a permanent establishment in the other country. Under Article 21(1) a Chinese resident enterprise is entitled to a tax credit for any taxation paid in Hong Kong in respect of income derived from sources in Hong Kong.

As a Hong Kong resident company will only be liable to taxation in China on income attributable to a “permanent establishment”, the question of what is a “permanent establishment” of the purpose of the DTA is extremely important. Under Article 5(1) a “permanent establishment” is defined as a ‘fixed place of business through which the business of an enterprise is wholly or partly carried on’. Importantly, under Article 5(3) a foreign enterprise will be considered as having a permanent establishment in China if it has provided services, for the same or connected project, in China for more than 6 consecutive or cumulative months in any 12-month period.  The State Administration of Taxation clarified, in Circular No. 403 (Guo Shui Han [2007] No.403), that for the purpose of determining whether "6 consecutive or cumulative months in any 12-month period" test has been satisfied, the entire period starting from the first month that the first employee arrives in China till the last month when the last employee leaves China should be counted. Controversially, and in the contrast to the position of the Hong Kong Inland Revenue Department, the Circular further stated that if an employee is present for 1 day in a particular month, this will be regarded as being present for a full month for determining whether the enterprise satisfies the test of a permanent establishment. On 30 January 2008 the Second Protocol to the Arrangement Between the Mainland of China and the Hong Kong Special Administrative Region of Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income was signed (the “Second Protocol”). Under the Second Protocol, the six months requirement has been replaced with a requirement of “183 days”.

Under Article 10(2) of the DTA, the tax rate for dividends paid from a Chinese resident enterprise to a Hong Kong resident enterprise, of which the Chinese resident enterprise owns 25 per cent of the shares, is limited to 5 per cent. Further, the tax rate on interest re-payments and royalties paid from a Chinese resident enterprise to a Hong Kong resident enterprise is limited to 7 per cent.