China: Offshore SPV and tax optimization structures under fire

The Chinese State Administration of Taxation recently released the circular Guoshuihan [2009] No. 601 ("Circular"). The Circular defines the notion of “Beneficial owner” that may enjoy preferential tax rates for certain passive incomes under the relevant double taxation treaty (“DTT”) and “Conduit company” that cannot enjoy such DTT tax rates.

Beneficial owner:
Beneficial owner is an individual, a corporation or other organization that has the ownership and control over the income or the rights or assets that generates such income. A beneficial owner shall generally engage in substantive business activities such as manufacturing, trading and management activities, etc.

Conduit company:
Conduit company is a company set up solely for the purposes of avoiding/reducing tax or shifting/parking profits. Such a company is registered in a country with the mere intention of putting in place the necessary legal form without carrying on substantive business activities.

The Circular further sets forth the following seven unfavourable factors that would affect an applicant’s recognition as Beneficial owner:

(a) the applicant is obligated to pay or transfer all or most of (such as more than 60%) income to a resident of a third country or region in the stipulated time period (twelve months upon receipt of income for example);
(b) the applicant does not or barely engages in business activities except for holding the property or rights from which income is derived;
(c) the applicant, as an entity, its assets, operation scale and staff are relatively small and could not reasonably match its income;
(d) the applicant has little or no control or disposition rights over the income or its underlying assets or rights; the applicant bears little or no risk;
(e) the relevant income is not subject to or exempt from tax, or the actual tax rate is rather low in the applicant’s tax jurisdiction;
(f) in addition to a loan agreement in respect of which interest arises and is paid, there is another loan or deposit agreement concluded between the applicant and a third party whereby the amount, interest rate and conclusion date are similar to those of the original loan agreement
(g) in addition to copyright, patent, and technical know-how transfer agreements in respect of which royalties arise and are paid, there is another agreement concluded between the applicant and a third party whereby the use right or ownership of the copyright, patent, or technical know-how is transferred.

The Circular is a major change in respect of anti-tax avoidance actions. Currently, many international companies have established or are considering establishing special purpose vehicles in jurisdictions like Hong Kong or Singapore to enjoy preferential tax rates under the relevant DTTs for passive incomes (dividends, interests, royalties) derived from China. Chinese tax authorities may consider such vehicles as Conduit companies or non-Beneficial owners of the relevant China-sourced passive income. Companies may need to consider such risks when deciding their holding structures or take measures to minimise such risks by adding more business substance to such holding vehicles.