A recent protocol to the Barbados-China double tax agreement (DTA) concluded 10 February 2010, entered into force 9 June 2010, and will apply starting 1 January 2011. The protocol is important for companies using, or planning to use, intermediary holding companies in Barbados for investment in China.
Set forth below is a brief overview of some of the key features of the protocol.
Prior to amendment by the protocol, the Barbados-China DTA of 15 May 2000, provided particularly favorable tax treatment for foreign companies investing in China through Barbados in regards to Chinese taxation of dividends and capital gains. Dividends were generally subject to a 5 per cent withholding tax, while most capital gains (including capital gains from dispositions of shares in Chinese resident companies that own real estate in China) were exempt from taxation. Thus, Barbados became an attractive gateway for foreign companies seeking to invest in China. However, with the growth of tax anti-avoidance legislation in the last two years, Chinese tax authorities have begun to focus on abusive uses of tax-treaty networks (or what is known as ‘treaty shopping’).
Key Amendments Introduced by the Protocol
The protocol amends the definition of ‘resident’ and the income tax treatment of dividends and capital gains, revises provisions relating to the elimination of double taxation and the exchange of information, and adds a clause on the application of domestic anti-avoidance laws.
Definition of ‘Resident’
In keeping with the expanded concept of tax residency introduced by the Chinese Enterprise Income Tax Law of 2007, pursuant to which, in certain circumstances, enterprises established outside China whose actual management or control is located in China can be considered China-resident enterprises, the criteria for determining tax residency for the purposes of the DTA was expanded by the protocol to include the place of effective management of an entity. If a company is resident in both jurisdictions there is no ‘tie-breaker’ rule; rather, the matter is to be resolved through the Competent Authority process.
The protocol provides two key amendments relating to tax on capital gains.
One key amendment gives either contracting country the right to tax capital gains derived by a resident of the other contracting country ‘from the alienation of shares, participations, or other rights in the capital of a company resident’ in the first mentioned country ‘if the recipient of the gains, at any time during the 12-month period preceding the alienation, had a direct or indirect shareholding or participation of at least 25 per cent in the capital of [the] company’.
- For example, from a Chinese tax perspective, a Barbados-tax resident who owns 25 per cent or more of the shares in a Chinese-resident company will not be subject to income tax in China on capital gains arising from a share transfer prior to 2011. However, capital gains from such a transfer will be subject to income tax in China beginning 1 January 2011 due to the protocol.
Another key amendment of the protocol gives either contracting country the right to tax capital gains derived by a resident of the other contracting country ‘from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from real estate situated ‘ in the first country.
- For example, from a Chinese tax perspective, beginning 1 January 2011, a Barbados-tax resident who transfers shares in a land-holding Chinese company (i.e., a Chinese-resident company that holds real estate in China where the real estate assets are valued at more that 50 per cent of the Chinese company’s total assets) may be subject to income tax in China on the gains realized on the disposition, regardless of its percentage ownership of the Chinese company.
Amended Withholding Tax
Also of importance, the protocol amends the 5 per cent withholding tax rate on dividends such that it is now available only when the beneficial owner is a company that owns 25 per cent or more of the equity interest of the company paying the dividend. If the 25 per cent ownership requirement is not met, a 10 per cent withholding tax rate may apply.
Addition of Anti-Avoidance Rule
Finally, although it does not affect any direct revisions to the DTA, Section 4 of the protocol provides that the DTA ‘shall in no case prevent a Contracting State from the application of the provisions of its domestic laws aiming at the prevention of fiscal evasion and avoidance, provided that the taxation in that State on the income concerned is not contrary to the [DTA]’.
Recent tax legislation and administrative practice indicate that the State Administration of Taxation and the Chinese tax authorities generally are increasing their scrutiny of both the tax-treaty residency status of foreign intermediary entities that own equity interests in China resident companies and indirect transfers of equity interests in China-resident companies accomplished via dispositions of interests in intermediary entities.
Foreign investors who have an existing Barbados-China investment structure or who plan to invest in China via a Barbados company should consider the following:
- Status of a tax resident of Barbados: Pursuant to Chinese tax law, a Barbados company must officially register with or obtain approval from the Chinese tax authorities in order to enjoy the benefits of the Barbados-China DTA. This process involves filing certain statutory forms providing comprehensive shareholder information and supporting documents, pursuant to China tax Circular Guoshuifa  No. 124, China tax Circular Guoshuifa  No. 601 (regarding the beneficial ownership test under the dividends provision of the DTA) and other applicable circulars and regulations.
If a Barbados company cannot provide valid or sufficient information of tax residency in Barbados, its residency for tax-treaty purposes could be challenged by the Chinese tax authorities. There have been at least two recent cases in which the Chinese tax authorities denied tax-treaty benefits to Barbados companies with regard to capital gains (exempt under the DTA until the protocol takes effect) and instead assessed the normal Chinese withholding tax on such gains on the basis that the companies in question were not Barbados residents for purposes of the DTA.
- Indirect Transfer of Equity in a Chinese Company: Generally, capital gains derived from the transfer of equity interests in a non-Chinese resident company are not subject to Chinese tax. However, China tax Circular Guoshuifa  698, which upon issuance in December 2009 took retroactive effect as of 1 January 2008, specifically addresses equity transfers undertaken by foreign companies outside China which result in the indirect transfer of ownership of a Chinese company. It aims to counteract the avoidance of tax on capital gains from dispositions of equity by means of offshore special purpose vehicles.
Pursuant to Circular 698, if a transferred foreign holding company (e.g., an intermediary entity holding shares in a Chinese company) is situated in a jurisdiction that has an effective tax rate of less than 12.5 per cent or that does not tax its residents on foreign-source income, the transferor must report the disposition to the relevant Chinese tax authorities. The required documents generally must indicate the commercial purpose of the transaction as well as information pertaining to the transferor and the transferred foreign holding company. The transaction may be challenged by the Chinese tax authorities if it is deemed to be a transaction without a reasonable commercial purpose and, in substance, a tax-avoidance transaction. If such a determination is made, the transferor may be required to pay a 10 per cent tax on the capital gains derived from the offshore transfer. There is currently no clear definitional guidance under Chinese tax law with respect to the key concepts of ‘substance’ and ‘reasonable commercial purpose’.
Multinational companies with existing Barbados-China structures or plans to implement such an arrangement should take extra care and remain alert to Chinese tax developments in these areas. Given the current uncertainties with regard to the new protocol, engaging in informal dialogue (preferably on a ‘no-name’ basis) with the Chinese tax authorities may also be a wise precaution prior to restructuring existing Barbados-China structures or implementing new structures.If you would be interested in discussing details of these new developments or any other aspect of Chinese tax law or procedures, please do not hesitate to contact any member of our integrated U.S.-China tax service team.