Double Taxation Agreements and Your China Investment Strategy

July 15, 2013 Posted by China Briefing Reading Time: 9 minutes

By Chris Devonshire-Ellis, Dezan Shira & Associates

Jul. 15 – Double taxation has been dubbed “one of the most visible obstacles to cross border investment,” leaving room for a significant amount of money to be saved under the almost 3,000 double taxation avoidance agreements (DTAs or DTAAs) signed between nations across the globe. To combat such obstacles, DTAs aim to prevent the same income from being taxed by two or more states, while also eliminating tax evasion and encouraging cross-border trade efficiency.

DTAs are mostly of a bilateral nature and, while DTA-signing countries are not all members of the Organization for Economic Cooperation and Development (OECD), DTAs are generally based on model conventions developed by the OECD or (less commonly) the United Nations. And while about 75 percent of the actual words of any given DTA are identical with the words of any other DTA, the applicability and specific provisions of each treaty can vary substantially.

From an investor’s perspective, confusion about international taxation can arise when investors are subject to two different and potentially conflicting tax systems. For example, Hong Kong and Singapore adopt a “territorial source” principle of taxation, which means that only profits sourced locally are taxable. Meanwhile, other countries such as China and the United States are on the worldwide tax system, and resident enterprises can be required to pay tax on income sourced both inside and outside of the country. DTAs not only provide certainty to investors regarding their potential tax liabilities, but also act as a tool to create tax-efficient international investments.

China’s International Spread of Double Tax Agreements

DTAs apply to individuals and companies of the countries or jurisdictions who are parties to the agreement, with the aim to prevent double taxation by allowing the tax paid in one of the two countries to be offset against the taxes payable in the other country, and/or by providing exemptions or reduced tax rates for specific income types such as royalties, interest, and dividends.

Withholding Tax and Profit Repatriation

DTAs also affect the repatriation of profits and earnings, as the location of profit taking and distribution can be manipulated favorably under the correct circumstances. This means that profits may be permitted to be taken in a lower cost jurisdiction than would normally be the case and distributed from there back to the overseas headquarters. This makes complete sense when developing a business in Asia, as capital injections and investments can then be made from the lower tax jurisdiction.

The distribution of dividends back to the home domicile can also be arranged in a beneficial and less tax burdensome manner than would otherwise be possible. Many preferred holding company jurisdictions maintain DTAs that limit or eliminate the level of withholding taxes payable on dividends coming from subsidiary countries and going to parent companies. For example, Hong Kong has a DTA in place with China that lowers dividend withholding taxes from the general rate of 10 percent down to just 5 percent (provided certain capital holding requirements are met).

What this means for foreign businesses is that they have the option to create a corporate structure such that profits from a China subsidiary may be remitted to a Hong Kong holding company at a 5 percent withholding tax rate on dividends, before then being passed on to the overseas parent company with no additional tax obligations. In contrast, if the China subsidiary were to remit directly to the parent company in a country that does not hold a DTA with China, it may be taxed at a withholding tax rate of 10 percent. Such reductions can represent significant tax savings over a period of time, being realized instead as additional profits.

Permanent Establishments

DTAs also exist to define areas where companies may not be considered to be generating taxable income in one or the other country. Within these, a key area is the concept of permanent establishment (PE) status.

There are three general types of PEs that are recognized throughout the world: fixed place PEs, agency PEs, and service PEs. These are typically defined as follows:

Triggering PE status is an issue of great importance as it defines the taxable status of particular legal structures and trade. A typical DTA, for example, contains clauses related to the PE concept and this can favorably impact on the total investment needed to enter the target market. It can also impact upon the type of legal vehicle actually required to be incorporated and, in some cases, does away with the need for one altogether.

The concept of PE is primarily used to determine a specific state’s right to impose tax on the business activities of foreign companies operating in that country. Where a resident of a country carries on business in another country with which the resident’s country has a DTA, the profits derived will not be subject to tax in the other country unless the business is carried on through a PE. Once an enterprise triggers PE status in a country, that enterprise will be subject to the host country’s relevant business taxes, and any qualifying staff will be subject to individual income tax in the country as well. As such, it is critical for foreign businesses operating within Asia in any capacity to stay on top of their PE applicability and the relevant tax rates in the region.

With further regards to PE qualifications, the OECD Model Income Tax Treaty defines a PE as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” However, while most DTAs do use the OECD definition, countries are allowed to define what constitutes a PE independently. We discuss the impact of PE upon China in a recent issue of China Briefing Magazine.

This can have highly beneficial results. For example, a well-structured incorporation can carry out effective services for its parent company – in some cases to the extent of billing local companies on their behalf – without triggering tax exposure in the secondary country. It depends upon how the PE issue is addressed within the specific DTA. Singapore, for example, has favorable DTAs with many other countries, including with China, which when properly structured at the local incorporation level, do away with any profits tax liability altogether, even while maintaining an office in the country. Such tax structuring and usage of DTAs is becoming more common, and precise evaluation of how a PE is determined under the terms of each treaty becomes important to understand.

Case Study: Using DTAs to Offset Profits Tax and Eliminate PE Liabilities

A recent study carried out by Dezan Shira & Associates Singapore involved extensive use of the Singapore-Spain DTA for a company based in Madrid looking to set up a service office as a limited liability company in Singapore. The Spanish company’s Singapore entity was charged with operating as a regional hub for promotional activities and conducting invoicing on behalf of the Spanish entity’s significant online business. A detailed study of the DTA’s PE clauses resulted in the following conclusions concerning the use of the DTA in avoiding profits tax in Singapore:

Consulting fees received should not be taxable in Singapore since the service activities are conducted outside Singapore at a fixed place of business in Spain. As such, the income should not be considered to be accruing in Singapore.
The income will not be deemed to be derived in Singapore under Section 12(7) as no services pertaining to this income are being performed in Singapore. As a result, no withholding tax should be due on such payments made by the clients in Singapore.
On this basis, the income would be considered foreign sourced income. However, there is a risk that such income could be considered remitted into Singapore if either the fees are paid into a Singapore bank or used to satisfy trade or business debts in Singapore (such as your own company subsidiary in Singapore). To alleviate this risk, the income received should not be paid or used in this manner.

This business case and use of the Spain-Singapore DTA was enough to permit the client to establish operations without the risk of incurring double taxation in Singapore, and was an integral part of the client’s expansion into Asia. Without the DTA, the business model would not have been viable.

Although this model was built around the Singapore-Spain DTA, similar cases could be made for companies based in Hong Kong (which also has a DTA with Singapore) and China itself as well as in many other similar jurisdictions.

Conclusion

In addition to the abovementioned taxation implications, DTAs lay out the ground rules for many other bilateral tax agreements. The nature of these differ significantly depending upon each individual treaty, however each should be studied in detail to ascertain both the required legal structure and the scope of trade. International businesses intending to trade with China and/or establish a physical presence would be wise to examine the applicable treaties and seek professional advice over the legal and financial implications prior to contemplating the legal structure itself.

Chris Devonshire-Ellis is the Founding Partner of Dezan Shira & Associates and is based out of the firms Singapore offices. He previously managed the firms China practice for 16 years. For information concerning tax treaties and China, please email china@dezshira.com. For Asian treaties, please contact asia@dezshira.com.

Portions of this article came from the July 2013 issue of Asia Briefing Magazine, titled “An Introduction to Tax Treaties Throughout Asia,” which is available as a complimentary PDF download on the Asia Briefing Bookstore until the end of August. In this issue of Asia Briefing Magazine, we take a look at the various types of trade and tax treaties that exist between Asian nations. These include bilateral investment treaties (BITs) and also the meatier double tax treaties (DTAs) and free trade agreements (FTAs) that directly affect businesses operating in Asia.

Dezan Shira & Associates is a specialist foreign direct investment practice, providing corporate establishment, business advisory, tax advisory and compliance, accounting, payroll, due diligence and financial review services to multinationals investing in emerging Asia. Since its establishment in 1992, the firm has grown into one of Asia’s most versatile full-service consultancies with operational offices across China, Hong Kong, India, Singapore and Vietnam as well as liaison offices in Italy and the United States.

For further details or to contact the firm, please email china@dezshira.com, visit www.dezshira.com, or download the company brochure.

You can stay up to date with the latest business and investment trends across Asia by subscribing to Asia Briefing’s complimentary update service featuring news, commentary, guides, and multimedia resources.

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