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1. HCo is a Host Country corporation that is part of a multinational group of corporations. FCo, a Country X affiliate of HCo, seconds Exec, an individual Country X tax resident, to HCo to work in HCo's Host Country offices for the four-month period from September 1-December 31 of Year 1.
• What are HCo's income tax withholding and reporting obligations to Host Country with respect to compensation it pays to Exec during this period?
• Do those obligations differ depending on whether Host Country has an income tax treaty with Country X?
2. HCo's ultimate parent company, FHoldco, which is a tax resident of a country with which Host Country does not have an income tax treaty, licenses worldwide rights to certain valuable intellectual property to SisterCo, a tax resident of Country X, which has an income tax treaty with Host Country that exempts royalties paid to Country X residents from Host Country tax. Under the license agreement, SisterCo is obligated to pay FHoldco 95 percent of any royalties that SisterCo receives from sublicensing of the intellectual property. SisterCo in turn sublicenses the Host Country rights to the intellectual property to HCo for a royalty based on HCo's sales associated with such intellectual property.
• What are HCo's income tax withholding and reporting obligations with respect to its payment of royalties to SisterCo with respect to the sublicense?
• What are SisterCo's Host Country income tax withholding and reporting obligations -- if any -- with respect to any royalties it pays to FHoldco attributable to HCo's Host Country exploitation of the intellectual property?
3. HFund is a partnership organised and having offices in Host Country that is engaged in investing and trading in stocks and securities issued by Host Country corporations on behalf of its partners, who consist of investors some of whom are residents of Host Country and some of whom are residents of foreign countries. HFund borrows funds from Lender for a below-market fixed interest rate along with an “equity kicker” tied to HFund's performance. Lender is a partnership organised and managed from Country Z, a country with which Host Country does not have an income tax treaty, whose members consist of ten extremely wealthy individuals with prior business or social connections, three of whom are Host Country tax residents and the rest of whom are foreign (non-Country Z) tax residents. Lender is an investment partnership that makes strategic customised debt and equity investments throughout the world.
• What are HFund's Host Country income (and other) tax withholding and reporting obligations with respect to its payments to Lender?
Peng Tao and Richard Tan
Under the tax rules of the People's Republic of China (“PRC”), tax reporting obligations are the concern of both taxpayers and withholding agents. For withholding agents, the tax withholding and reporting obligations are, so to speak, two sides of the same coin.
Under the PRC Individual Income Tax Law (the “IIT Law”), the payor of income has the withholding obligation.1 Under the PRC Enterprise Income Tax Law (the “EIT Law”), a nonresident enterprise deriving passive income from China will be subject to withholding at source, the payor of the income acting as the withholding agent.2 At the same time, where a nonresident enterprise derives active engineering or service income from China, the payor of the income may also be designated by the PRC tax authorities as a withholding agent.3 Thus, in the case of cross-border payments, tax withholding may apply to both passive income and active income.
To fulfill its tax withholding obligation, a withholding agent is required to submit tax withholding returns and pay to the tax authorities the taxes withheld on behalf of the taxpayer.
In addition, depending on the subject of a cross-border payment, the PRC value added tax (“VAT”) or business tax may also apply and have to be withheld before the payment can be remitted. However, this paper will deal only with the income tax issues and will not address VAT or business tax issues.
Though the facts do not provide details of the secondment arrangement, it seems that HCo is to pay the compensation to Exec. Thus, it is assumed that when Exec works in China, he will be working only for the benefit of HCo and will be the de facto employee of HCo during the secondment period.
Because Exec performs the employment services in China, the compensation paid to Exec for the services will be regarded as Chinese-source income and will be subject to PRC IIT. As Exec's de factoemployer, HCo will have an obligation to withhold IIT at progressive rates (which range from 3 percent to 45 percent) on behalf of Exec on a monthly basis. HCo will need to file a withholding return with the PRC tax authorities and pay over the IIT withheld on behalf of Exec.
The PRC IIT consequences, as set out above, will be the same regardless of whether there is or is not a tax treaty between China and Country X (i.e., Exec's country of residence), since it is assumed that HCo will bear the compensation paid to Exec. If Exec's compensation was borne not by HCo but by FCo, the existence of a tax treaty between China and Country X would make a difference to the PRC IIT consequences. Under one of its tax treaties, China will not tax the compensation paid to an individual employee resident in a treaty partner jurisdiction if:
• the individual stays in China for no more than 183 days in a calendar year (or any 12 months depending on the wording of the treaty concerned); and
• the individual's compensation is not paid or borne by a PRC company or by the permanent establishment (PE) in China of a foreign company.
Thus, it would be possible for Exec to be exempted from PRC IIT if he were to satisfy the above conditions.
In theory, there should be no EIT consequences for FCo, since Exec is working in China only for the benefit of HCo, the argument for this position being strengthened if the relevant compensation is paid by HCo directly to Exec. If the compensation is paid to FCo rather than to Exec (perhaps, for example, because FCo first pays Exec and then asks for reimbursement from HCo), the position would become much less favourable for FCo, since FCo could potentially be regarded as performing services in China through its own employees. This in turn would mean that FCo could potentially be regarded as having an establishment/PE in China.
Under the PRC domestic rules, an establishment may be deemed to exist if the activities of a foreign enterprise in China last for three months. However, under China's tax treaties, the threshold for a service PE is six months (or 183 days depending on the particular treaty) in any 12-month period. Thus, if China has a tax treaty with Country X, FCo's PE risk should be minimal, since Exec will stay in China for only four months.
That being said, in practice, if a foreign company is regarded as performing services in China, when a Chinese company pays service fees to the foreign company, the Chinese tax authorities will mostly likely wish to adopt a deemed PE approach in order to be able to tax the service fees. Because a PE determination is very much fact oriented, it may be difficult for a foreign company to prove that it has no PE in China.
Once they have deemed a foreign company to have a PE in China, the PRC tax authorities may use a deemed profit method to determine the profits attributable to the PE. The deemed profit rates range from 15 percent to 50 percent, with the tendency among local tax authorities being to apply a higher deemed profit rate in order to maximise their income tax revenue.
In these circumstances, the applicable EIT, which would be 25 percent of the deemed profits attributable to the PE, will have to be withheld by the PRC payor -- in the present case, HCo, if HCo remits payment for Exec's services to FCo.
The facts indicate that the direct recipient of the royalties from China is SisterCo, which is a resident of Country X, which has a tax treaty with China.
First, under the PRC domestic rules, the royalties paid by HCo will be regarded as Chinese-source income and will be subject to a 10 percent withholding income tax. The key question will then be whether SisterCo is able to claim the benefit of a treaty exemption from PRC withholding income tax under Country X's tax treaty with China (in reality, China's tax treaties provide not for an exemption from source country taxation of royalties but, at most, for a reduced rate of withholding tax).
To be able to claim treaty benefits, a recipient of royalties must qualify as the beneficial owner of the royalties. In this respect, it is worth noting that China has been intensifying its examination of the beneficial owner status of persons claiming treaty benefits.4 It would seem that certain facts here could be an obstacle to SisterCo's ability to secure beneficial owner status, for example, the fact that SisterCo is obliged to pay FHoldCo, a company resident in a non-treaty partner jurisdiction, 95 percent of any royalties that SisterCo receives from sublicensing the intellectual property to HCo. That being said, the relevant PRC tax rules also require local tax authorities to adopt a comprehensive approach that takes all the relevant elements into account when determining an applicant's beneficial owner status. Thus, other facts -- if indeed there are other such facts -- could be more persuasive for the determination of whether SisterCo is able to qualify as the beneficial owner of the royalties received from HCo.
If SisterCo fails the beneficial owner test, it will not be entitled to the treaty exemption from withholding tax on royalties, but will be subject to the 10 percent PRC withholding income tax, which will have to be withheld by HCo when it pays the royalties to SisterCo.
Whether SisterCo will have any PRC income tax withholding and reporting obligations with respect to the royalties it pays to FHoldCo that are attributable to HCo's (PRC) exploitation of the intellectual property is essentially beyond the scope of this paper. However, if SisterCo were located in China, China would impose a 10 percent withholding income tax on its payment of royalties to FHoldCo, which would have to be withheld by SisterCo.
The fact pattern as it pertains to interest would not be possible under the current Chinese legal regime because stock and security trading is a business subject to foreign investment restrictions. As a foreign-invested partnership -- some of HFund's partners are nonresidents -- HFund cannot be approved for engaging in investing and trading in stocks and securities issued by Chinese corporations.
Solely for discussion purposes, assuming HFund were able to carry on such business or some other legitimate business, it would still need to overcome the foreign exchange control barrier. Under the PRC foreign exchange rules, all foreign debts (i.e., debts that arise from borrowing from offshore lenders) are subject to foreign debt registration. As a partnership and, in particular, a foreign-invested partnership is not a commonly used investment vehicle, the authors would certainly anticipate that the barrier would have to be overcome before the foreign debt could be duly registered.
If, again solely for discussion purposes, it is assumed that HFund's debt to Lender has been duly registered, under PRC domestic tax rules, the interest paid by HFund, a PRC enterprise, will be regarded as PRC-source income and hence subject to 10 percent PRC withholding income tax, to be withheld by HFund upon remittance of the interest. This will be the case regardless of whether or not Lender is an incorporated entity.
1 IIT Law, as amended June 30, 2011, Art. 8.
2 EIT Law, effective Jan. 1, 2008, Art. 37.
3 EIT Law, Art. 38.
4 See Guo Shui Han  No. 601 for the various criteria for determining beneficial owner status.
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