How a Hong Kong Holding Company Can Benefit Foreign Enterprises Doing Business in China: Benefits to Seize and Pitfalls to Avoid
U.S. companies looking to expand internationally must consider complex legal and economic matters to ensure that the benefits of doing business in a foreign country are maximized. One of the primary concerns is to develop an investment structure that can minimize taxes not only on ongoing operations, but also on the repatriation of income to a domestic parent and the ultimate disposition of foreign operations in appropriate circumstances. Moreover, due to the complexity of the U.S. tax laws concerning foreign operations, including the foreign tax credit regime, and rules regarding controlled foreign corporations and personal foreign investment corporations, the choice of a particular legal and tax structure will depend on the specific characteristics of both the domestic company looking to expand overseas as well as the particular activities to be undertaken internationally. Given all of these considerations, we have nevertheless seen that an investment in mainland China is often best undertaken utilizing an intermediary holding company based in Hong Kong.
Long regarded as a financial hub and free trade center in Asia, Hong Kong is often chosen by foreign investors as a gateway to investing in China due to Hong Kong’s favorable tax relationship with China, along with its historical, geographical and cultural connections with the mainland.
The Importance of the China-Hong Kong Treaty
Many foreign-invested enterprises enjoyed preferential tax treatment before China enacted the Enterprise Income Tax Law (EITL) on March 16, 2007 (effective January 1, 2008). The EITL unified the taxation of domestic and foreign enterprises, eliminating many tax breaks for foreign investors.
Nonetheless, some of these tax breaks remain in place for certain structures which utilize a Hong Kong entity thanks to Hong Kong’s tax arrangement with mainland China - the Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion (the Treaty). The Treaty may enable some foreign investors to enjoy preferential tax treatment through the use of a Hong Kong holding company.
Providing a wide range of benefits, the Treaty covers not only direct income earned by businesses and individuals, such as operating profits and employment income, but also indirect income, such as dividends, interest and royalties. Further, Hong Kong allows a tax credit for any tax paid in mainland China. A few important benefits provided by the Treaty are summarized below.
Rates for Withholding Tax on Dividends
Before China enacted EITL, dividends paid by certain Chinese foreign investment enterprises to foreign investors were exempt from taxation in China. The EITL now generally requires 10% withholding on such dividends. Under the Treaty, however, the withholding rate on dividends received by a Hong Kong business is reduced to 5%, provided the Hong Kong entity holds at least 25% of the capital of the China enterprise paying the dividend.
Rates for Withholding Tax on Interest and Royalties
The Treaty reduces withholding rates on interest and royalties received by a Hong Kong business from mainland China from 10% to 7%.
Rates for Withholding Tax on Capital Gains - Direct and Indirect Transfers of Shares
Direct Transfer of Shares
With respect to a Hong Kong enterprise’s gains from the transfer of shares in a mainland enterprise, the Treaty allocates the taxing right exclusively to Hong Kong; on the mainland, the transfer is tax free. However, transactions may be taxed in both jurisdictions if the assets of the mainland enterprise are comprised mainly of immovable property situated in mainland China (i.e. at least 50% of the total assets, by value, are real property at any time within the 3-year period preceding the transaction), or if the recipient of the gains directly or indirectly owned at least 25% of the mainland enterprise at any time within the 12 months before the transaction.
Indirect Transfer of Shares
A typical investment structure involves an off-shore investment in a Hong Kong holding company that owns a China enterprise. An example of an indirect transfer would involve the foreign investor disposing of its ownership interest in the Hong Kong holding company. China’s State Administration of Taxation (SAT) has challenged certain indirect transfers, seeking to re-characterize the transactions as direct sales of interests in the China company. Income derived from a re-characterized transfer would be deemed China-sourced income, on which a 10% income tax would be levied under the EITL. To monitor such offshore indirect transfers, the Chinese tax authority imposes reporting obligations on the foreign investor through “Circular 698” (see below).
Anti-Treaty Shopping Provisions
Like tax authorities in the U.S. and elsewhere, Chinese tax authorities are sensitive to the use of particular investment structures that are undertaken solely to harness tax benefits that would not otherwise be realized by a taxpayer but which otherwise lack economic substance. As alluded to above, Chinese tax authorities have therefore issued a number of new rules to ensure that each particular investment structure utilized to make investments in mainland China has sufficient economic substance. The following is a brief summary of the primary tools available to Chinese tax authorities in their anti-treaty shopping efforts.
Taxation of Indirect Equity Transfers by Non-China Tax Resident Enterprises – Impact of Circular 698
On December 10, 2009, SAT issued the Notice on Strengthening the Management of Enterprise Income Tax Collection of Proceeds from Equity Transfers by Non-Resident Enterprises Guoshuihan  No. 698 (Circular 698), which represents a challenge to off-shore holding companies or special purpose vehicle structures in China. This Circular is impactful and controversial. It would seek to impose tax on certain indirect transfers of China Tax Resident Enterprises (TRE) by non-China Tax Resident Enterprises (non-TRE); in other words, it could apply to tax the transfer of interests in a Hong Kong holding company that owns a Chinese subsidiary.
Circular 698 is rather complex but, in short, it targets structures wherein the intermediate entity lacks a “reasonable commercial purpose.” SAT has not provided a clear definition of “reasonable commercial purpose,” nor has the focus of its application been precisely defined. The Implementing Regulations of the EITL, however, suggest that a potentially fatal weakness exists where the main purpose of a particular structure (more specifically, of the intermediate entity) is to reduce, avoid or defer tax.
Circular 698 imposes rigorous reporting and disclosure obligations on non-TRE transferors in connection with certain indirect transfers. In some cases, there may be a reporting obligation on the TRE subsidiary as well.
Structures in which investments in China are made through intermediate entities should be carefully established or examined, as the case may be, to ensure compliance with Circular 698. Intermediate entities should be chosen and structured carefully, and with Circular 698 in mind.
Criteria to Claim Benefit of Reduced Withholding Rate on Dividends – Circular 81
In order to enjoy the reduced withholding rate on dividends under the Treaty, a non-resident recipient of dividends must meet the criteria set forth in the Notice of the State Administration of Taxation on the Issues concerning the Application of the Dividend Clauses of Tax Treaties Guoshuihan  No. 81 (Circular 81), which was published by the SAT in February of 2009. Under Circular 81, the non-resident recipient must be a Hong Kong “tax resident” as well as the “beneficial owner” of the dividend (see below).
Definition of “Beneficial Owner” and the Principle of “Substance over Form” – Circular 601
Ultimately, to receive benefits under the Treaty, a company established in Hong Kong must be a “beneficial owner.” SAT treats this concept in the Notice of the State Administration of Taxation on How to Understand and Determine “Beneficial Owner” in Tax Treaties Guoshuihan  No. 601 (Circular 601), which essentially targets holding companies that lack substance. This dovetails with Circular 698.
Under Circular 601, the “beneficial owner” of income is the taxpayer who has the right to own and dispose of the income and the rights or properties generated from said income. The “beneficial owner” may be an individual, a company, or any other organization which is usually engaged in substantial business operations. It cannot, however, be an agent or a conduit company. Conduit companies are essentially those set up for the purpose of tax-avoidance and/or transferring or accumulating profits. Conduit companies barely satisfy the minimum organizational requirements in their home country and do not engage in substantial business operations.
Under Circular 601, a “substance over form” test may be employed in determining the “beneficial owner” of income; ultimately, the determination is fact-based. Some facts which may negatively affect the determination of a non-resident’s claim as “beneficial owner” include the following: (1) the resident of the treaty country is obligated to distribute the income (or a substantial part thereof) to residents of a third country or jurisdiction within a prescribed period of time, (2) the resident of the treaty country has minimal or no business activities other than the holding of the property and/or rights from which the income is derived, and (3) the treaty jurisdiction either imposes no tax, or imposes tax at an extremely low effective rate on the relevant income from China. This, of course, is a non-exhaustive list.
The China-Hong Kong tax treaty often provides an attractive backdrop to investing in China through an intermediate holding company formed in Hong Kong. Nonetheless, such structures must be carefully established so as not to run afoul of the numerous pronouncements recently issued by the Chinese taxing authorities. Investors must make certain that intermediate entities have sufficient commercial and economic substance; intermediate entities cannot merely be shells or conduits established for the purpose of receiving tax benefits under the China-Hong Kong treaty (or any other treaty). It is also critical that the investors verify that their own countries have not enacted measures against tax haven investment. If there are such measures, setting up a Hong Kong holding company may make less or no sense and a better choice for the investor might be to set up a wholly foreign owned enterprise in China directly.
Working in conjunction with a client’s other professional advisors, the attorneys in White and Williams’ China Business Practice Group can assist the client with selecting a structure for investing in mainland China that best meets their legal, business and tax objectives. For more information about the China Business Group, please contact Gary Biehn (215.864.7007; firstname.lastname@example.org). For more information regarding this alert, please contact Kevin Koscil (215.864.6827; email@example.com).
 A company is considered to be a resident of Hong Kong if it is incorporated in Hong Kong, or incorporated outside of Hong Kong, but managed and controlled from Hong Kong.