SAT Sets First Criteria to Enforce Anti-Tax Treaty Shopping Legislation: Holding Company Structures to be Denied Tax Treaty Benefits

November 5, 2009


Many investments into China are typically structured with the use of offshore holding companies located in countries or territories that have tax treaties with China.  Popular holding company jurisdictions for China include Hong Kong, Macau, Singapore, Barbados, Cyprus,  Ireland, Luxembourg, Mauritius, and Seychelles.  Benefits of using a holding company structure include the reduction of PRC taxes with respect to PRC source income generated by the investment.  This includes dividends, capital gains, interest, royalties, and other income.  China generally taxes such income at a rate of 10% under domestic law.  With the right holding company structure, however, this tax may be reduced or even avoided entirely. 

Gradually, the SAT has upgraded its domestic tax law to combat perceived abuses in connection with tax treaty planning.  This began with a general anti-abuse provision in Article 47 of the Enterprise Income Tax Law, effective January 1, 2008 and was followed up by the SAT's Implementation Regulations for Special Tax Adjustments rules on January 8, 2009 which specifically targets tax treaty shopping for anti-abuse sanctions.  Subsequent developments included a number of striking cases in late 2008 where local State Tax Bureaus in Chongqing and Xinjiang actually denied tax treaty benefits using different means (ignoring the holding company in Chongqing and denying treaty residence for Xinjiang).  More recently, the SAT issued procedural rules on August 24, 2009 which took effect from October 1, 2009 (i.e., Administrative Measure on Treaty Benefit Application for Non-resident Enterprises [Trial]) regarding applications for tax treaty benefits.  Under this guidance, holding companies seeking benefits must produce residency certifications and follow other formalities relating to the analysis of their bona fide residency status.  However, until today, no further guidance had been offered on how to conduct such an analysis regarding the tax authorities’ use of the 2008 anti-abuse provision in a tax treaty context. 

The Notice on the Interpretation and Recognition of “Beneficial Ownership” under Tax Treaties (“Circular 601”), issued on October 27, 2009 and released on November 5, 2009 now addresses this issue.  A summary of this major international tax development is set out below.

Beneficial Owner” Concept is Defined

  • The “beneficial owner” entitled to benefits under an income tax treaty is defined as any person who owns or has control and dominion over the income or the rights or assets which may give rise to such income. 
  • A beneficial owner must be engaged in "substantive" business activities (e.g., manufacturing, distribution or management) in the form of “individuals, cooperation or other forms.”  A pure "conduit" company or shell company that is formed merely to fulfill legal registration obligations in a foreign jurisdiction does not qualify for treaty benefit as a beneficial owner.  Conduit companies refer to companies incorporated for the purposes of the “evasion or reduction of tax, the transfer or the accumulation of income.”
  • The PRC tax authorities will evaluate and determine beneficial ownership based on their “substance-over-the-form” concept. 

Identification of Typical Conduit/Shell Company Structures

Circular 601 sets out the following as negative factors which could determine unfavorable tax benefit treaty status for the applicant:

  • the applicant has the obligation to pay or distribute all or a substantial part of its income (e.g., more than 60%) to a third country resident within a prescribed time (e.g., within 12 months after receiving such income);
  • the applicant has no or almost has no other business activities other than holding the assets or interests pursuant to which such incomes are derived;
  • the applicant’s nature is such that its assets, size, and personnel is relatively small and not commensurate with the income it derives;
  • the applicant has no or almost has no rights of control or disposal with respect to the income, assets, or rights based on which income is derived, and the applicant does not assume any risks or rarely assume risks;
  • certain income is not taxable or otherwise exempt from tax in the treaty country, or taxed at a very low effective rate;
  • there exists a back-to-back loan through the applicant with terms similar to those for the loan agreement with respect to which is relevant to treaty benefits; and
  • there exists back-to-back royalties through the applicant with terms similar to those for the IP license agreements which are relevant to treaty benefits such as for copyrights, patents, and technology transfer agreements.

In addition, in order to qualify as a “beneficial owner” entitled to tax treaty benefits, the burden will fall upon the applicant to provide supporting documentation showing that it does not fall within any of these factors typical of a conduit/shell company structure.


Circular 601 is a major development in connection with the structuring of investments into China and will have significant implications for existing structures.  Firms will need to re-evaluate the efficacy of certain holding company structures in the first instance, restructure existing structures which may have been based on earlier assumptions, and consider how longer term planning with respect to creating more substance and re-deployment features into holding companies can be used to maintain beneficial treatment.