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By Mr. Qian Junliang1
1. Case Facts and Questions
1.1 Facts
1.1.1 H Co. is a limited liability company incorporated under the Chinese Company Law and its registered office domicile is in China2 .
1.1.2 H Co. has a 50% share in S Co. which is incorporated in a foreign country in accordance with the laws and regulations of that foreign country. In addition, H Co. has a 1% share in Y Co. which is incorporated in said foreign country or another foreign country in accordance with the laws and regulations of that foreign country.
1.1.3 H Co. has fulfilled the all appropriate approval and or recordation proceedings with the competent Chinese authorities3.
1.2 Questions
1.2.1 Is there any avoidance of double taxation under Chinese taxation rules of the dividends received by H Co.?
1.2.2 How shall the dividends received by H Co. be taxed?
1.2.3 Provided that both S Co. and Y Co. are both Chinese legal persons, how would the dividends be taxed?
2. Brief introduction of Chinese Enterprise Income Tax Law regarding the tax of dividends4.
The Enterprise Income Tax Law of the People’s Republic of China (hereinafter referred to as “EITL”) was promulgated by the National People's Congress on March 16, 2007 to "establish a unified tax system for enterprises of all types" and came into force on January 1, 2008. Before that, taxation of enterprise income in China had two parallel systems for domestic investment enterprises and foreign investment enterprises, which were regulated respectively by the Tentative Regulations of the People's Republic of China on Enterprise Income Tax (hereinafter referred to as “TREIT”) and the Income Tax Law of the People's Republic of China on Foreign-invested Enterprises and Foreign Enterprises (hereinafter referred to as “FEITL”). In order to implement the EITL, the State Council of the People’s Republic of China promulgated The Release of Regulations on the Implementation of Enterprise Income Tax Law of the People's Republic of China by the State Council (hereinafter referred as “IEITL”). Therefore, currently the EITL and IEITL are the two main applicable regulations on enterprise income tax5 . Of course, administrative rules issued by the Ministry of Treasure and State Administration of Taxation are usually applied to tax cases. Unlike the situation in European countries and the United States, in practice tax cases are seldom brought to the courts in China, although legally speaking Chinese courts have the competence to hear a tax case against a tax authority brought by a taxpayer or some person who has interest in it.
“In order to carry out the "going out" strategy and raise the competitiveness of Chinese enterprises, the existing tax credit measures applicable to taxes directly levied on overseas incomes are retained in the New Enterprise Income Tax Law. Meanwhile, the New Enterprise Income Tax Law also adopts tax credit measures to deal with taxes indirectly levied on dividends. In international practice, a resident enterprise's holding of certain shares of a foreign company is the precondition for applying for indirect tax credit. For example, it is regulated in the United States, Canada, Britain, Australia and Mexico that domestic companies shall directly or indirectly hold more than 10% of a foreign company's voting shares; the minimum shareholding set in Japan and Spain is 25%. Since the New Enterprise Income Tax Law introduces the concept of indirect tax credit for the first time, we may be less experienced. Therefore, in order to implement strict tax administration, the Implementation Rules provide that domestic companies shall directly or indirectly hold more than 20% of the foreign company's voting shares for the purpose of indirect tax credit. Different countries have different rules on the hierarchy of a parent company and subsidiaries involved in indirect tax credit. There is a two-level hierarchy in Germany and Japan, while the hierarchy in Spain is 3-level, that in America is 6-level, and that in England is indefinite. In consideration of the situation of overseas investment and the level of tax administration, we only set a general rule on indirect tax credit in the Implementation Rules. Detailed regulations of the level of hierarchy and the method of calculation will be set forth in the administrative regulations set by relevant departments or regulatory documents6.”
“Regarding the tax levied on dividend income between resident enterprises, according to the preceding tax laws, the difference in tax rate shall be made up by enterprises enjoying low tax rates when they distribute dividends to enterprises subject to high tax rates. Tax exemption of dividends distributed to or received from a resident enterprise by another resident enterprise is generally adopted by other countries in order to prevent double taxation. Such practice is also adopted in the New Enterprise Income Tax Law. To show the government's purpose of granting preferential tax policies and to ensure the benefits brought by the Western Development Project as well as low tax rate granted to high-tech enterprises and low-profit small enterprises, it is expressly sated in the Implementation Rules that no making up of tax rate difference will be required. However, the aim of short-term (less than 12 months) share investment is to benefit from share transfers in the secondary market instead of obtaining dividends. Such share transfer is of high frequency and is hard for tax administration. Therefore, the Implementation Rules regulate that dividend income from shareholding of less than 12 months shall not be tax free while dividend income from shareholding of over 12 months shall be tax free7.”
3. Analysis of the questions
3.1 China adopts a tax credit measure to avoid double tax levied on dividends received by H Co.
a) Direct tax credit principle.
The income tax that has been paid overseas8 on taxable income originating outside China earned by resident enterprises, or on taxable income incurred outside China that is earned by institutions or establishments which have an actual relationship with non-resident enterprises set up in China, may be credited from the payable tax of the current period9.
However, the credit amount has a limit, namely the payable tax calculated in accordance with the EITL with respect to the income of such item. The portion in excess of the offset limit may be made up by the balance of the offset amount of the current year out of the annual credit limit within the subsequent five years10.
The limit of tax credit = the total domestic and overseas tax payable calculated in accordance with the EITL × the taxable income sourced from a country (region) /the total domestic and overseas incomes combined.
The limit of tax credit shall be calculated per country (region) without being itemized unless otherwise stipulated by relevant laws or regulations.
Hence, provided that the dividends received by H Co. have been taxed by foreign tax authorities, within the limit, they can be credited when calculating the tax payable according to the EITL. Mostly, the tax levied on dividends overseas is withheld by S Co. and Y Co. in accordance with relevant income tax regulations.
b) Indirect tax credit principle.
Where income from equity investment such as dividends and bonuses originating outside the territory of China is shared by foreign enterprises directly11 or controlled indirectly12 by resident enterprises, the portion undertaken by foreign enterprises of the income tax actually paid outside the territory may be credited in the credit limit prescribed in Article 23 of the EITL as income tax that may be credited outside the territory by such resident enterprises.
Hence, in order to avoid the double tax levied on dividends, since the shares in S Co. held by H Co. are more than 20%, the portion undertaken by H Co. of the income tax paid by S Co. in the foreign country can be credited when calculating the tax payable within the credit limit. The method of calculation of the indirect credit limit is the same as that of the direct credit limit.
3.2 Example
a) Tax Credit of dividends distributed by S Co.
i) The pre-withholding tax dividend distributed by S Co. to H Co. = 900/(1-10%) = 1,000
ii) The withholding tax of dividend distributed by S Co. to H co. = 1,000 * 10% = 100
iii) Income tax payable by S Co. in Country A = 5,000 * 20% = 1,000
iv) The after-tax profit of S Co. = 5,000 – 1,000 = 4,000
v) The portion of income tax payable by S Co. undertaken by H Co. = 1,000 * (1,000/4,000) = 250
vi) The pre-tax dividend distributed by S Co. to H Co. = 1,000 + 250 = 1,250
vii) The pre-tax dividend distributed by Y Co. to H Co. = 60/(1-20%) = 75
viii) The withholding tax of dividend distributed by S Co. to H co. = 75 * 20% = 15
ix) The total domestic and overseas tax payable calculated in accordance with EITL = (10,000 + 1,250 + 75 ) * 25% = 2,831.25
x) The taxable income sourced from Country A = 1,250
xi) The total domestic and overseas incomes combined = 10,000 + 1,250 + 75 = 11,325
xii) The limit of tax credit from Country A = 2,831.25 * (1,250/11,325) = 312.5
xiii) The total tax payable actually paid by H Co. in Country A = 100 + 250 = 350
b) Tax Credit of dividends distributed by Y Co.
i) The taxable income sourced from Country B = 75
ii) The limit of tax credit from Country B = 2,831.25 * (75/11325) = 18.75
iii) The total tax payable actually paid by H Co. in Country A = 15
c) The tax payable of H Co. paid in China
i) The tax payable of H Co. = 2,831.25 – 312.5 – 15 = 2503.75
d) Controversy relating to the calculation method of indirect tax credit under the EITL
It can be seen from 3.2 a) xii) that the limit of indirect tax credit is calculated in combination with the limit of direct tax credit. It seems that such calculation method is in accordance with Article 24 of the EITL, which requires the indirect tax credit to be calculated within the limit prescribed in Article 23. Meanwhile, according to Article 78 of the IEITL, the limit of tax credit shall be calculated per country without being itemized. It can be interpreted that the dividend distributed from S Co. is sourced in one country so that the limit of tax credit shall be calculated in combination irrespective of whether it is a direct or indirect tax credit. However, there is still a distinction between direct tax credit and indirect tax credit in that a direct tax credit is allowed to be brought forward to the subsequent five years, whereas an indirect tax credit can not be brought forward. In case of combined calculation of direct and indirect tax credit, the limit of indirect tax credit can not be distinguished. Since the indirect tax credit is a new tax rule prescribed in the EITL, the details of its implementation shall be regulated in administration rules by the Ministry of Treasure and the State Administration of Taxation. But up to now, the stipulation of the aforesaid tax administration rules is still in process.
3.3 Provided that S Co. and Y Co. are both Chinese residents, the tax structure will be:
i) By registering in some special areas or industries in China, the enterprise can enjoy a different tax rate with a reduction. In the above figure, S Co. enjoys a 15% tax rate with a reduction.
ii) According to paragraph 2, Article 26 of the EITL, since both S Co. and Y Co. are resident enterprises in China, the dividends distributed to H Co. are tax-exempt.
iii) Such tax-exemption is a new rule in the EITL. In the old abated TREIT, the dividends distributed by S Co. to H Co. shall be taxed from H Co. on a basis of the tax rate distinction between 25% and 15%. That is to say, H Co. would have paid 117.6513 of income tax for the dividend.
4. Conclusion
The new EITL, after coming into force on January 1, 2008, adopted some international practices to avoid double taxation on dividends. In terms of dividends sourced from overseas, the EITL has direct and indirect tax credit rules. On the other hand, the EITL exempts the tax levied on dividends between resident enterprises in China. Notwithstanding, due to the fact that the indirect tax credit is a new tax rule in China, China has less experience in this aspect. The competent authorities shall speed up the stipulation of administrative rules to clarify the calculation method and the definition of “indirect control”.
Legislature used for reference:
1. The Enterprise Income Tax Law of the People’s Republic of China.
2. The Release of Regulations on the Implementation of Enterprise Income Tax Law of the People's Republic of China by the State Council.
3. Circular of the State Administration of Taxation on the Issuance of the Outlines for Promotion of the New Enterprise Income Tax Law.
2.China, herein and hereafter, refers to the mainland of the People’s Republic of China excluding Hong Kong, Macau and Taiwan.
3.In accordance with relevant Chinese laws, any overseas investment should be approved or recorded by the competent commercial authorities, administration of foreign exchange bureaus, tax bureaus and relevant authorities.
4.In this article only Chinese national tax law is considered. Since the tax treaties between China and other states could have some conflicts with the national tax law, these treaties are not discussed herein. With respect to Art. 58 of “the Law of the People’s Republic of China on Enterprise Income Tax”, where agreements on taxation concluded by the People’s Republic of China and a foreign government contain different provisions, such agreements shall prevail.
5.In China, the taxpayers of enterprise income tax are enterprises and other organizations that obtain income within China, excluding, however, individual proprietorship enterprises and partnership enterprises. Art. 1 of EITL and Art. 2 of IEITL.
6.Paragraph 19 of Circular of the State Administration of Taxation on the Issuance of the Outlines for Promotion of the New Enterprise Income Tax Law.
7.Paragraph 24 of Circular of the State Administration of Taxation on the Issuance of the Outlines for Promotion of the New Enterprise Income Tax Law.
8.Art. 77 of IEITL, "The income tax paid overseas" as referred to in Article 23 of the Enterprise Income Tax Law is the enterprise income tax payable and paid for the income sourced outside the territory of China pursuant to Foreign Enterprise Income Tax Laws and pertinent regulations.
9.Art. 23 of EITL.
10.Art. 79 of IEITL, "The subsequent five years" as referred to in Article 23 of the Enterprise Income Tax Law are the five consecutive years subsequent to the year when the income tax paid overseas on overseas incomes exceeds the limit of the tax deduction.
11.Paragraph 1, Art. 80 of IEITL, The direct control mentioned in Article 24 of the Enterprise Income Tax Law means that the resident enterprise directly holds over 20% share in the foreign enterprise.
12.Paragraph 2, Art. 80 of IEITL, The indirect control mentioned in Article 24 of the Enterprise Income Tax Law means that the resident enterprise indirectly holds over 20% share in the foreign enterprise. The specific method for identifying "indirect control" shall be separately prescribed by the competent finance and taxation departments under the state council.
13.(1,000/(1 - 15%)) * (25% - 15%) = 117.65
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