China has double taxation agreements with more than one hundred countries. These treaties allocate taxing rights between China and the other contracting state and provide relief from double taxation through exemption, credit, or reduction methods. A foreign company operating a WFOE in China should understand which treaty benefits apply to its structure and how to claim them.
Too many foreign companies structure their China operations without considering the treaty dimension, and they leave money on the tax table. Here’s what the treaties offer and how to claim it.
Dividends
The standard withholding tax rate on dividends paid by a Chinese company to a foreign shareholder is 10% under Chinese domestic law. Most Chinese tax treaties reduce this rate, typically to 5% if the foreign shareholder holds at least 25% of the Chinese company’s capital — many newer treaties use a 10% or a 20% threshold — and to 1% in certain treaties with very high ownership thresholds.
The 5% treaty rate is the most common reduced rate. A UK parent company, a German parent company, a Singapore parent company, or a Hong Kong parent company holding at least 25% of the Chinese WFOE’s capital qualifies for the 5% rate on dividends. A US parent company qualifies for a 10% rate generally, reduced to 5% if the US company owns at least 10% of the voting stock of the Chinese company.
The treaty rate applies automatically under Chinese administrative practice if the treaty provides a dividend article and the foreign shareholder meets the ownership threshold. The Chinese company withholds tax at the treaty rate and reports the withholding on its withholding tax return. In some cases, the tax bureau may require the foreign shareholder to provide a certificate of tax residence from its home country’s tax authority to confirm that the treaty applies.
The real-world complication is that the Chinese tax authorities apply anti-treaty-shopping rules to deny treaty benefits to companies that are established in a treaty jurisdiction for the primary purpose of obtaining treaty benefits. A Hong Kong holding company with no substance — no office, no employees, no management in Hong Kong — that holds the Chinese WFOE and receives dividends that are immediately paid onward to a company in a non-treaty jurisdiction may not qualify for the Hong Kong treaty rate.
The foreign company’s structure must have commercial substance to benefit from the treaty. The holding company should have an office, employees, management, and business activities in the treaty jurisdiction, and the dividends received from the Chinese subsidiary should be retained and used by the holding company, not immediately passed through to a third jurisdiction. The substance requirement is enforced by the Chinese tax authorities and, increasingly, by the tax authorities in the treaty jurisdiction through their own anti-treaty-shopping rules.
Interest
The standard withholding tax rate on interest paid by a Chinese company to a foreign lender is 10%. The treaty rates are generally lower — 7% or 10% in older treaties, 5% or 7% in newer treaties, and 0% in treaties with specific provisions for interest paid to government-owned financial institutions or for export credit financing.
The interest article in Chinese tax treaties typically applies to interest on loans, bonds, and other debt instruments. It applies to interest paid by a Chinese company to a related-party lender — a parent company loan to a WFOE — and to interest paid to an unrelated bank. The treaty rate is the maximum rate that China can levy on interest payments to residents of the other contracting state.
The thin capitalization rules interact with the treaty rate. Chinese tax law limits the deductibility of interest paid to related parties to a debt-to-equity ratio of 2:1 for non-financial enterprises. Interest on related-party debt that exceeds this ratio is not deductible by the Chinese borrower and is recharacterized as a dividend for withholding tax purposes. The recharacterization may result in a higher withholding tax rate — the dividend rate rather than the interest rate — and the non-deductibility increases the borrower’s effective tax rate.
A foreign company that is capitalizing its Chinese WFOE with debt rather than equity should ensure that the debt-to-equity ratio is within the 2:1 limit and that the interest rate is at arm’s length. A related-party loan that bears an interest rate higher than the rate that an unrelated lender would charge is subject to transfer pricing adjustment, and the excess interest is recharacterized as a dividend.
Royalties
The standard withholding tax rate on royalties paid by a Chinese company to a foreign licensor is 10%. Treaty rates for royalties are generally 10% or lower — 7% or 6% in some treaties, and 10% in others. The Chinese treaty policy for royalties is less generous than for dividends and interest, reflecting China’s historical position as a net importer of technology and its interest in preserving taxation of royalty payments.
The royalty article in Chinese tax treaties applies to payments for the use of, or the right to use, copyrights, patents, trademarks, designs, models, plans, secret formulas or processes, industrial, commercial, or scientific equipment, and information concerning industrial, commercial, or scientific experience. It applies to royalty payments by a Chinese WFOE to its foreign parent for the use of the parent’s technology, trademarks, or other intellectual property.
The transfer pricing rules apply to royalty payments between related parties. The royalty rate must be at arm’s length, and the royalty agreement must reflect a genuine licensing arrangement with commercial substance. A royalty payment that’s not commensurate with the value of the licensed IP may be adjusted by the tax authorities.
A foreign company that’s licensing technology to its Chinese WFOE should have a written license agreement, should document the basis for the royalty rate, and should be prepared to demonstrate that the rate is consistent with the rates that would be agreed between unrelated parties for comparable technology. The documentation should be prepared before the royalty payments begin, not after the tax bureau raises a question.
Capital Gains
Chinese tax treaties generally provide that gains from the sale of shares in a Chinese company by a resident of the other contracting state are taxable only in the other state — that is, not taxable in China — unless the shares derive more than 50% of their value from immovable property in China or unless the seller held a specified percentage of the Chinese company’s shares during a specified period before the sale.
The capital gains treaty article is important for foreign companies that may sell their Chinese WFOE. A sale of the WFOE shares that’s exempt from Chinese tax under the treaty realizes the gain in the seller’s jurisdiction, where the tax rate may be lower or the gain may be exempt. A sale that’s not exempt under the treaty is subject to Chinese tax at 10% on the gain.
The indirect transfer rules complicate the treaty analysis. A sale of shares in a non-Chinese holding company that holds the Chinese WFOE may be treated as a deemed sale of the WFOE shares if the holding company is a tax-transparent entity or if the primary purpose of the holding company structure is to avoid Chinese tax. The Chinese tax authorities have taken an aggressive approach to indirect transfers in recent years, and a foreign company planning a sale of its China operations should obtain professional advice on whether the indirect transfer rules apply.
Claiming Treaty Benefits
Treaty benefits are not automatic — they must be claimed. The claim is made by filing a treaty benefit application with the tax bureau, together with a certificate of tax residence from the home country’s tax authority, the company’s constitutional documents, and evidence of the company’s business activities and substance in the home country.
The tax bureau reviews the application and determines whether the company qualifies for the treaty benefit. The review may involve questions about the company’s ownership structure, its management and control, its business activities, and the commercial rationale for the transaction for which treaty benefits are claimed. A company that’s resident in the treaty country only on paper and that’s managed from a third country is unlikely to satisfy the residence and beneficial ownership requirements.
The treaty benefit application should be submitted before the payment is made, or at the time the payment is made. A withholding tax return that claims treaty benefits without a supporting treaty benefit application may be rejected, and the company may be assessed for the full domestic withholding tax rate plus interest.
