Tax Connect Flash | The United Kingdom and People’s Republic of China revise double taxation treaty

There has been good news last week for those investing between the People’s Republic of China (PRC) and the United Kingdom (UK), particularly those investing from the UK into PRC directly. The UK and PRC signed a new comprehensive Double Taxation Agreement (DTA) in London on 27 June 2011 during the visit of Chinese Premier Wen Jiabao.

There have been some important changes to the previous version of the DTA which was signed back in July 1984 and the last protocol signed in 1996. The headline change that will attract the most interest is the reduction in the rate of withholding tax on dividends down to 5% (from 10%). This reduced rate is only available where the investor holds at least 25% of the capital in the company paying the dividend. As UK domestic law does not impose any withholding tax on dividends paid by UK companies, this change is clearly of most benefit to UK investors which are currently holding, or are looking to hold, equity interests in Chinese companies.

The “technical fees” clause that existed in the previous version of the DTA has been deleted and replaced with the more standard permanent establishment (“PE”) clause. Prior to the implementation of the new DTA, provision of services by a UK company in PRC (including technical, supervision and management and consulting services) was subject to tax in PRC at 7%. By contract, most other DTAs to which PRC is a party state that the provision of such services for more than 6 months/183 days in any 12 month period constitutes a taxable PE. The new DTA corrects this anomoly and following its implementaion, the provision of services by an enterprise through employees or other personnel engaged by the enterprise for these purpose in excess of this qualifying period shall constitute a taxable PE, rather than simply subjecting such services to a 7% tax rate. This modification will result in UK companies who have dispatched their employees to China to provide services triggering a PE exposure in PRC.

The DTA also provides some welcome clarity on the taxation of capital gains on UK investors that hold assets in PRC. In particular, PRC can now only charge capital gains tax on a disposal of equity interests or shares in a Chinese company by a UK resident shareholder if the shareholder owns or has owned, directly or indirectly, at any time in the last 12 months, 25% of the capital of the Chinese company.

While the withholding tax on interest remains unchanged at 10%, there is a minimal change in the treatment of royalties. The rate of withholding tax applying to certain royalties has been reduced to 6% (down from 7%). However, this reduction is only in respect of royalties received as consideration for the use of, or the right to use, industrial, commercial or scientific equipment, which China usually considers as income from lease. Other royalties will continue to be subject to a withholding tax at 10% of the gross amount of the royalties.

The revised DTA may have a direct effect on the way that UK companies invest in China. This has historically been by way of investment through a Hong Kong company, aimed at reducing the withholding tax on dividends down to 5%. The case for interposing a Hong Kong company appears to be weakened to some extent following the reduced rates in the new DTA since PRC requires a Hong Kong company to prove its economic substance in Hong Kong in order to benefit from the 5% withholding tax (otherwise to be taxed at 10% according to Chinese domestic tax law), which appears to be more difficult than by using a UK company directly.

While there may be no benefit of including a Hong Kong holding company from a purely dividend witholding tax perpsective, corporate groups working in the region should still consider taking advantage of lower tax rates in a Hong Kong than China by warehousing certain operations in Hong Kong resident company. However, whether UK investors will dispense with the tried and tested investment structure is yet to be seen.

The new DTA will come into force once both countries have completed their respective legislative procedures, a process which could take several months. In PRC, the DTA will probably take effect from January 1 in the year following the completion of such procedures. In the UK, the DTA will take effect from 1 April (for corporation tax purposes) and 6 April (for income tax and capital gains tax purposes) following completion of such procedures. In both cases, this is expected to be in 2012.