Tax Tips (9) – New Beneficial Ownership Rules in China…LOB in Disguise

(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 9 April 2018: Forum 9)

[Tax Tips (7) and (8) are pre-reads of this article, which cover Treaty Shopping, Model Tax Convention, Multilateral Convention, Limitation-on-Benefits (“LOB”), Principal Purposes Test (“PPT”), Beneficial Ownership, Cir 601, PN30, Cir 165 and PN60.]


On 3 February 2018, the State Administration of Taxation (“SAT”) of Mainland China issued the Public Notice Relating to “Beneficial Owner” Under Tax Treaties” (Public Notice 2018 No.9, “PN9”) and its Explanatory Notes (“The Notes”) which is applicable to tax treaty benefit claims on tax obligations arising on or after 1 April 2018.  PN9 superseded Cir 601 and PN30, but is silent on Cir 165.  On the face of it, PN9 reduced the number of Unfavourable Factors compared with Cir 601 (there are now three Unfavourable Factors in relation to dividend income) and expanded the Safe-harbour Rules.  However, is it now easier or harder in obtaining benefit claims under Double Tax Treaties or Arrangements (collectively referred to as “DTA”)?  This Article first elaborates the key provisions of PN9 and the Notes, and then discusses how it will affect Hong Kong enterprises earning dividend income from investments in the Mainland.  The conclusion is: it will be very very hard to obtain treaty benefits in the Mainland.

1.     Key Provisions of PN9 and the Notes

1.1   PN9 Article 1 – Definition of Beneficial Owner

Article 1 of PN9 has retained Article 1 of Cir 601: “The term “Beneficial Owner” refers to a person who has both the ownership and right of control over the income or the assets or rights generating the income”, which is basically in-line with the OECD interpretation under the Model Tax Convention.  The requirement to consider “substance over form”, as stated in Article 2 of Cir 601, cannot be found in PN9.

1.2   PN9 Article 2 – Unfavourable Factors

Article 2 of PN9 sets out five factors, which, if matched with the circumstances of the applicant of DTA benefit claim (the “Applicant”), would be unfavourable to the determination of the Applicant’s qualification as the Beneficial Owner (hence they are called the “Unfavourable Factors”).  Three of these factors relate to dividend income:

1.2.1  Unfavourable Factor (1): “The Applicant has the obligation to pay more than 50% of the income within 12 months of receipt to a third-country (region) tax resident; “obligation” shall include contractual obligation as well as constructive obligation based on factual circumstances”.  The Notes provided a case study to demonstrate what is meant by “obligation”.  Please see Diagram 1 below for an illustration of the case:

The Notes pointed out that the fact pattern above matches with the provision that “the Applicant has the obligation to pay more than 50% of the income within 12 months of receipt to a third-country (region) tax resident”, and thus would be very unfavourable to the Applicant’s claim as the Beneficial Owner.  The Author suspects that the viewpoint expressed by the SAT is, to some extent, a result of the artificial nature of the arrangement for circumventing Unfavourable Factor No.1 of Cir 601, because:

  1. The arrangement of lending and repaying is not considered to be conducted at arm’s length
  2. The amount of dividend distributed by the Applicant is just under 60% of the dividend income, which is just below the threshold set out in Cir 601’s Unfavourable Factor No.1
  3. The Applicant may have been carrying out the same process on a recurring basis for some time

The Notes did not say whether the Applicant in the case had both the ownership and right of control over the income or the assets or rights generating the income.  If the Applicant had been actively reviewing the investment, had board meetings to decide the possible use of the funds received, and concluded that the best use of the funds was to lend to Parent Co for interest rate higher than leaving the cash idle in the bank, would the SAT’s view be different?  Since the Notes did not elaborate on the SAT’s thinking, in the future when a local tax bureau deal with a case with similar features, it is possible that the tax bureau may not review other facts and deem that the Applicant has the “obligation” simply because the Applicant has remitted more than 50% of its income to a third-country within 12 months, and deny the Beneficial Ownership status as a result.  

1.2.2  Unfavourable Factor (2): “The Applicant does not carry out substantive business activities.  Substantive business activities shall include activities such as substantive manufacturing, trading, management etc.  The assessment on substantiveness shall be made based on the risks assumed and functions performed by the Applicant. Substantive activities in investment holding management would also be regarded as substantive business activities; Applicants who are engaged in non-substantive investment holding activities and are carrying out other insignificant business activities at the same time would not be considered as carrying out substantive business activities”.  The Notes pointed out that in assessing the substantiveness of the Applicant’s business activities, attention should be paid to matters such as: whether the Applicant owns assets and has employees that match with the scale of its functions, and whether the Applicant bears the risks on the income and the assets or rights that generate the income.  These two points look similar to Cir 601 Unfavourable Factors (3) and (4), but by comparing the two documents carefully one would be able to spot the subtle and important differences which are advantageous to the Applicant. However, as these points are not standalone Unfavourable Factors, Applicants would unlikely be able to win their cases based on them alone.

PN9 has adopted the viewpoint in Cir 165 that “investment activities should be regarded as business activities”.  According to the Notes, in order to qualify as substantive business activities, the investment holding activities shall involve the actual performance of functions and assumption of risks, and include activities such as pre-investment feasibility studies, assessment and analysis, investment decision making, implementation of investment project and continuous investment management.  A number of case studies were set out in the Notes to explain what kind of investment activities would be regarded as substantive. A simple conclusion can be drawn: if the Applicant is an SPV (Special Purpose Vehicle – an entity set up for a specific project such as acting as holding company of a particular investment) it is unlikely that the investment activities would be considered substantive.   

In addition, some companies have in the past tried to circumvent Cir 601 Unfavourable Factor (2), “the Applicant does not or barely engages in other operating activities”, by adding functions to the holding company such as procurement or consulting services for other group companies.  The Notes used examples to clarify that if the Applicant is not able to substantiate the commercial reasons for such activities, and the income earned from such other business activities is “only 8%” of the total income (including income earned from Mainland China), the other business activities would be considered insignificant and thus would not constitute substantial business activities.

Lastly, the Notes did not elaborate whether the Applicants in the various examples had both ownership and right of control over the income or the assets or rights generating the income.

1.2.3  Unfavourable Factor (3): “The income is not taxable or is exempt from tax, or is taxable but subject to extremely low actual tax rate, in the Contracting State (Region)”.  PN9 retained the Unfavourable Factor (5) of Cir 601, and the Notes did not make any further elaboration on this item.  The factor itself is easy to understand and, unfortunately for Hong Kong taxpayers, is a factor that is almost certain for any Hong Kong companies to meet.  This Unfavourable Factor clearly has no relationship with ownership and right of control over the income or the assets or rights generating the income.

1.3    PN9 Article 3 – “Replacement Beneficial Owner”

Article 3 of PN9 provided two situations that would allow Applicants who would not be regarded as Beneficial Owner to be deemed as being qualified:

1.3.1  Situation One: Applicant is directly or indirectly 100% held by another person (Company A, “Co A”) which is a tax resident of the same country as the Applicant, and Co A is qualified as a Beneficial Owner under Article 2 (the Author names it “Replacement Beneficial Owner”).  The tax residencies of the intermediate companies between Co A and the Applicant is not relevant. The Notes provided Structures (4) and (5) to assist taxpayers’ understanding. Diagram 2 below is an attempt by the Author to illustrate the salient points:

Readers should note that, according to Article 8 of PN9, Co A and the Applicant are both required to provide their respective Tax Resident Certificates.

1.3.2  Situation Two: Applicant is directly or indirectly 100% held by another person (Company B, “Co B”) who meets the Beneficial Owner status (the “Replacement Beneficial Owner”) and Co B, as well as all intermediate companies in between, are tax residents of countries which, under the respective DTAs with the Mainland, would be entitled to benefits which are equivalent to, or more favourable than, benefits to be accorded to the DTA between the Applicant’s State and the Mainland.  The Notes provided Structure (6) as an example to illustrate the concept. Diagram 3 below is an attempt by the Author to illustrate the salient points:

It is important to note that, according to Article 8 of PN9, Co B, the Intermediate and the Applicant are all required to provide their respective Tax Resident Certificates.

1.4    PN9 Article 4 – Safe-harbour Rule

The Safe-harbour Rule is a combination of the relevant provisions in PN30 and Cir 165.  The difference with Article 3 is that provided the Applicant or the holding structure above it meets the prescribed criteria, the Applicant is deemed to be the Beneficial Owner, and no analysis under Article 2 is required.  The following kinds of Applicant would meet the Safe-harbour Rule:

(1) The Contracting Jurisdiction;

(2) A company that is a resident of the Contracting Jurisdiction and is listed on the stock exchange of that jurisdiction;

(3) An individual resident of the Contracting Jurisdiction;

(4) The Applicant is directly or indirectly 100% held by one or more of the persons listed in (1) to (3) above, and for indirect holding relationship, all intermediate holding companies are tax residents of the Mainland China or the Contracting Jurisdiction.

According to Article 8 of PN9, those who qualify under (4) above are required to provide the Tax Resident Certificates of all entities in the vertical holding chain.

The Notes provided sample structures (1), (2) and (3) to help taxpayers understand the concept.

1.5    PN9 Article 5 – Holding Period

This Article stated that the shareholding requirements in Article 3 and 4 refer to continuously meeting the shareholding percentage for 12 months prior to payment of dividend.

1.6    PN9 Article 10 – Anti-avoidance

This Article stated that even if the Applicant is qualified as the Beneficial Owner, the in-charge tax bureau may apply the relevant anti-avoidance rules if it is discovered that PPT under the DTA or domestic general anti-avoidance rules would be applicable.  

2.      Commentary

2.1    Unfavourable Factors

Article 1 of PN9 stated clearly that a Beneficial Owner is a person who has both the ownership and right of control over the income or the assets or rights generating the income.  According to the Para 12.3 of the Commentary to Article 10 Dividend of the Model Tax Convention, where the recipient of a dividend does have the right to use and enjoy the dividend unconstrained by a contractual or legal obligation to pass on the payment received to another person (thus having “the ownership and right of control over the income or the assets or rights generating the income”), the recipient is the “beneficial owner” of the dividend.  No guideline has been provided at all in the three Unfavourable Factors and the example provided in the Notes as to what constitute the evidence and characteristics of “ownership and right of control of dividend” to help tax bureaus and Applicants determine if the Applicant is the Beneficial Owner.

In the examples/cases provided in the Notes, the Applicants that are not considered to be the Beneficial Owner all possess the characteristics of the classic SPV.  Take Unfavourable Factor (1) as an example, it is normal commercial operations for an SPV to distribute the dividend income received from its subsidiary in the Mainland to its parent company (assume that it is located in a third jurisdiction) so that the funds can be deployed more efficiently.  If the SPV does not make distribution, cash will be sitting in the SPV’s bank account, which the tax bureau may argue to be an unfavourable fact because the example provided in the Notes on Unfavourable Factor (2) mentioned that “when income is idle in the account with no immediate plan for investment”, it would be viewed negatively in the Beneficial Ownership assessment.  Lastly, if the Applicant is a Hong Kong resident, since Hong Kong does not tax dividend, Unfavourable Factor (3) will be applicable.

Take a hypothetical case (refer to as “Case X”): A US Company (“US Co”) identified two Hong Kong individuals who are highly experienced in doing business in the Mainland and are experts in Industry X.  US Co invited them to participate in the investment in Industry X in the Mainland. US Co established a Hong Kong holding company (call it “X Holdco”) with $100 capital, and the board of directors of X Holdco consisted of the above-mentioned Hong Kong individuals, two Hong Kong senior executives working in US Co’s other operating business in Hong Kong (“H Co”), and two US technical experts of US Co (so the ratio of Hong Kong and US directors is 4:2).  X Holdco has a bank account in Hong Kong and pays H Co for the use of H Co’s office premises, equipment, employees and administrative support provided. X Holdco worked together with US Co in the pre-investment feasibility studies, assessment and analysis, investment decision etc. X Holdco’s board of director meets two times each year in Hong Kong to review the Mainland project and future development, and the two Hong Kong individuals visit the US once a year to report on the business.  The Mainland investment proved to be highly profitable, and each year dividend is remitted to X Holdco which, after allocating around 20% of it to pay the salaries of the two Hong Kong individuals and expenses to H Co, and with no new viable investment plan in the pipeline, the rest (80%) would be declared as dividend and paid to US Co. In this case, there are genuine reasons for setting up the Hong Kong holding company, which has the ownership and right of control over the dividend income, but the case also meets all three Unfavourable Factors and thus it is likely that X Holdco would not be regarded as Beneficial Owner.  On the other hand, the Group may have a good chance passing PPT because there is an overriding commercial reason for setting up X Holdco in Hong Kong. That, however, may be irrelevant in the eyes of the Mainland tax bureaus because the structure of PN9 is that if Beneficial Ownership is denied, no PPT analysis would be carried out to further assess if treaty benefits should be granted. If this is what will happen in practice, it may be against OECD’s intention.

It seems that if an Applicant does not qualify for the Safe-harbour Rule, it will have to be one of the two types of companies in order to qualify as the Beneficial Owner: (1) Active Operating Company, or (2) Group Holding Company with employees and holding multiple investments.  The question is: is it the view of the SAT that only these two kinds of companies “have the ownership and right of control on its dividend income”? There are commercial reasons, rather than tax reasons, for avoid using Active Operating Companies to be holding companies, and Group Holding Companies often use SPV to be the investing vehicle.  It seems that PN9 was purposefully designed, through the operations of the Unfavourable Factors, to only allow those who possess similar characteristics to the “Qualified Persons” in the LOB clauses to enjoy DTA benefits. More on “Qualified Persons” below.

2.2    “Replacement Beneficial Owner” and Safe-Harbour Rule

It appears that the “Replacement Beneficial Owner” and Safe-Harbour Rule would take care of the issue with SPV mentioned above.  Using Group Holding Company as an example, if the Company meets the conditions set out in Article 3 of PN9 and becomes the Replacement Beneficial Owner, then dividend earned by the SPV would enjoy treaty benefits.  Companies and tax representatives who have dealt with Cir 601 before may have tried to explore with local tax bureaus the possibility of “looking-through” the SPV structure under the principle of “substance over form” to identify if there is an entity above, resident in the same tax jurisdiction, which qualifies as a Beneficial Owner, in order to claim the treaty benefits on the basis that the structure was not “established for the purpose of avoidance or reduction of taxes or the transfer or accumulation of profits”.  However, as Cir 601 did not mention one could “look-through”, and if in the holding chain the equity interest is below 100%, would one apportion the DTA benefits proportionately? In principle, Beneficial Ownership cannot be apportioned: an entity either is or is not a Beneficial Owner. PN30 effectively disallowed it (it specified that one could “look-through” to the listed company with 100% shareholding). In practice, most tax bureaus would review if the Applicant meets the Unfavourable Factors in Cir 601, and review the upper holding structure from a “substance over form” perspective to see if there is evidence of treaty-abuse.  The “Replacement Beneficial Owner” provisions in PN9 has in effect provided the basis of “look-through”.

“Look-through” is not new in assessing the entitlement to treaty benefits; the Safe-harbour Rule in LOB clause allows tax bureaus to “look-through”.  Using the Simplified LOB clause in Para 8 to 13 of Article 7 of the Multilateral Convention as an example, Para 8 requires that the benefits be granted to the Qualified Person.  In order to be the Qualified Person, a resident of a Contracting Jurisdiction (the Applicant) shall meet one of the following conditions set out in Para 9 (simplified by the Author):

  1. An individual;
  2. The local authority or relevant organisation of the Contracting Jurisdiction;
  3. A company or entity, if the principal class of its shares is regularly traded on one or more recognised stock exchanges;
  4. A non-profit organisation, or an entity set up in the Contracting Jurisdiction to administer retirement benefits for individuals or for investment in funds for such benefits:
  5. Other than an individual, if, on at least half the days of a twelve-month period that includes the time when the benefit would otherwise be accorded, persons who are residents of that Contracting Jurisdiction and that are entitled to benefits of the Covered Tax Agreement under (1) to (4) above hold, directly or indirectly, at least 50% of the shares of the person.

Readers can easily see that the conditions for Qualified Person are very similar to, and more lenient than, the Safe-harbour Rule in PN9 Article 4.  A person (the Applicant) that is at least 50% held by a listed company on at least half the days of a twelve-month period that includes the time when the benefit would otherwise be accorded would be a Qualified Person.  By comparison, PN9 requires 100% direct or indirect shareholding for a continuous period of 12 months prior to obtaining the dividend, and if there are intermediate holding companies, they shall be resident of either the Mainland or the Contracting Jurisdiction.

LOB clause also has provisions similar to “Replacement Beneficial Owner”, called the “Equivalent Beneficiary”.  Para 11 of Article 7 of the Multilateral Convention stated:

A resident of a Contracting Jurisdiction to a Covered Tax Agreement that is not a qualified person shall also be entitled to a benefit that would otherwise be accorded by the Covered Tax Agreement with respect to an item of income if, on at least half of the days of any twelve-month period that includes the time when the benefit would otherwise be accorded, persons that are equivalent beneficiaries own, directly or indirectly, at least 75% of the beneficial interests of the resident.  

What is “Equivalent Beneficiary”?  Para 13(c) of Article 7 of the Multilateral Convention stated that (simplified by the Author): the term “Equivalent Beneficiary” means any person who would be entitled to benefits with respect to an income accorded by a Contracting Jurisdiction to a Covered Tax Agreement under the domestic law of that Contracting Jurisdiction, the Covered Tax Agreement or any other international instrument which are equivalent to, or more favourable than, benefits to be accorded to that item of income under the Covered Tax Agreement.  The provision of “Equivalent Beneficiary” is very similar to “Replacement Beneficial Owner” but more lenient: an equivalent beneficiary is only required to hold directly or indirectly at least 75% beneficial interests of the resident on at least half of the days of any twelve-month period that includes the time when the benefit would otherwise be accorded. By comparison, according to PN9 Article 3 and 5, a person would be directly regarded as the Beneficial Owner if the Replacement Beneficial Owner holds directly or indirectly 100% shares in that person for a continuous period of 12 months prior to obtaining the dividend.  

2.3    LOB’s Another Way Out for SPV

According to the Simplified LOB, if the Applicant is not a Qualified Person, DTA benefits would only be granted if the recipient is engaged in active conduct of business, and the income derived from the other Contracting Jurisdiction emanates from, or is incidental to, that business.  However, the articles provided a way out for SPV to be granted treaty benefit. Para 10(c) of Article 7 of the Multilateral Convention stated that: activities conducted by connected persons with respect to a resident of a Contracting Jurisdiction shall be deemed to be conducted by such resident.  Diagram 4 below is an attempt by the Author to illustrate the salient points:

PN9 has not provided the way out as illustrated in Diagram 4.  In other words, for a Hong Kong SPV which belongs to a group with Active Operating Companies or a Group Holding Company in Hong Kong, but such companies are not in the vertical holding structure of the SPV, these companies would not qualify as the Replacement Beneficial Owner, and would not be relevant to the SPV’s Beneficial Ownership assessment.

2.4    Tax Resident Certificate

Persons qualified under Situation Two of Replacement Beneficial Owner rule and Item 4 of Safe-harbour Rule are required to provide Tax Resident Certificates of all entities in the holding chain.  On the issuance of Tax Resident Certificates, many countries would require information such as nature of income and amount derived from the Contracting State, and the Certificate is issued based on the DTA signed with that Contracting State.  The issue is: the intermediate company receives dividend income from its immediate subsidiary, not from the bottom indirect subsidiary in the Mainland (e.g. the Intermediate company in Diagram 3 derived dividend income from Country A, not from the Mainland), and therefore in practice the Intermediate company may be refused by its in-charge tax authority the Tax Resident Certificate for dividend from the Mainland (in Diagram 3, Country C would only issue Tax Resident Certificate based on its DTA with Country A).

For Hong Kong, according to the Inland Revenue Department (“IRD”) webpage (, “a Certificate of Resident Status is a document issued by the Hong Kong competent authority to a Hong Kong resident who requires proof of resident status for the purposes of claiming tax benefits under the DTAs”.  The application form IR1313A requests for information regarding tax benefits to be claimed under the DTA with the Mainland.  Assuming the Applicant qualifies under Item 4 of Safe-Harbour Rule, in between the listed company and the Applicant there is an HK intermediate holding company which has no income from the Mainland, would the IRD issue the Certificate of Resident Status to this intermediate holding company?

When PN9 was first issued, many companies were pleased that they qualify under Situation Two of Replacement Beneficial Owner rule or Item 4 of Safe-harbour Rule, but they could be heading for disappointment if they are not able to obtain the Tax Resident Certificates for the intermediate holding companies.

2.5    Anti-Avoidance

Even if the Applicant passed the Beneficial Ownership tests, it may still be required by tax bureaus to provide information to substantiate whether one of the main purposes of the set up was to obtain DTA benefits (PPT) or if domestic General Anti-Avoidance Rules would apply.  Applicants who wish to obtain DTA benefits are indeed subject to multiple hurdles under PN9.

2.6    Conclusion

In conclusion, the SAT has effectively slipped in LOB provisions that are more stringent than the Simplified LOB via the assessment of Beneficial Ownership into all DTAs entered into by the Mainland, without the need of matching under the Multilateral Convention, which seems to be against the spirit behind the Model Tax Convention, BEPS and the Multilateral Convention (the Mainland, like many other Tax Jurisdictions, did not opt for LOB).  According to Para 1 of Article 31 (General Rule of Interpretation) of the Vienna Convention on the Law of Treaties, which applies to treaties concluded between states, including DTAs concluded by Mainland China with other States, “A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose”.  The term “Beneficial Owner” should be interpreted accordingly.  Therefore, although the SAT has the right to define the term “Beneficial Owner”, DTA partners would expect that the definition to be aligned with the ordinary meaning of the term and the Commentary of the Model Tax Convention, and they may challenge this much-narrowed definition of Beneficial Ownership.  In practice, the most affected DTA partner will likely be Hong Kong. For Hong Kong enterprises, since the DTA between the Mainland and Hong Kong is not a treaty between states, Hong Kong enterprises would not be able to apply the Vienna Convention directly in negotiation but may add this as a supporting point.  In case of dispute, it remains to be seen if the IRD would initiate discussions with the SAT for Hong Kong taxpayers for a fair and acceptable outcome.

To avoid disputes, the Author recommends that the SAT replaces the Beneficial Ownership Guidelines with PPT guidelines, and return to the basic for Beneficial Ownership assessment, i.e. determine if the person has both the ownership and right of control over the income or the assets or rights generating the income, so that DTA benefits would be rightly granted to companies that are not conduits, and structures that are not set up with obtaining DTA benefits as one of the main purposes (such as the X Holdco in Case X above).  

3.     Tax Tips:

From now on, unless qualified under the Replacement Beneficial Owner or Safe-harbour Rule (and able to obtain the Tax Resident Certificates where applicable), Hong Kong enterprise would find it harder than before in obtaining benefits under the Mainland-Hong Kong DTA.  What can HK enterprises do? If Readers have followed the “tips” in the last issue of Tax Tips to read the new rules (PN9) in detail, and then study this article, one should be able to assess the potential impact on oneself and determine preliminary action proposals. Next is to discuss with tax advisors who are familiar with PN9 to confirm the step plan.  On the face of it, Hong Kong enterprises may change the holding structure to improve the chance of qualifying as the Beneficial Owner.

However, all restructuring carry tax risks, especially when involving indirect transfer of equity interests in Mainland enterprises, which may be subject to the “Public Notice on Certain Issues on Enterprise Income Tax Relating to Indirect Transfer of Properties by Non-Resident Enterprises” issued by the SAT (Public Notice 2015 No.7).  Taxpayers are advised to consult tax consultants to avoid being exposed to higher tax risks than expected.  Further, if an arrangement or restructuring is carried out mainly for obtaining tax benefits, it may attract tax bureau’s attention and could lead to denial of DTA benefits.  Lastly, even if the restructuring is successfully completed, the Applicant may need to wait for twelve-month before the Beneficial Ownership qualification can be granted.

From now on businesses should also consider the position to take in the PN60 reporting for DTA benefit claims, and, in the case of merger and acquisition involving Mainland enterprises, assess the potential additional tax liabilities that may be created by PN9.  

In conclusion, PN9 has a profound impact on Hong Kong enterprises with investments in the Mainland, and its implications should be assessed carefully and immediately so that appropriate responses can be determined and implemented.  


Author: Edwin Bin


2018 Notice 9:

2018 Notice 9 Explanatory Notes:

Multilateral Convention:

2015 Notice 7:

Vienna Convention: