On 9 February 2018, the State Administration of Taxation (SAT) issued the Bulletin on Certain Issues Relating to Implementation of Tax Treaties (Bulletin 11),1 which revises and supplements China's existing treaty interpretation rules under Circular 752 with respect to permanent establishments (PE), international shipping and air transport, artists and athletes, and partnerships. Bulletin 11 took effect on 1 April 2018.
In this article, we will discuss the key provisions of Bulletin 11 and their potential implications for multinational companies (MNCs) doing business in China.
1. Summary of Key Provisions
1.1 Permanent establishment
Bulletin 11 introduces two noteworthy directives for assessing a non-resident enterprise’s PE exposure in China.
First, Bulletin 11 provides that a foreign entity which operates a non-legal person joint educational institution or a joint educational program with a Chinese partner in China should be treated as having a PE in China. This provision addresses a long-standing area of uncertainty that has led to tax disputes for foreign universities with operations in China. This new provision in Bulletin 11 appears to close the door for a foreign entity to argue that its joint educational institution or joint educational program in China is not a PE.
Second, Bulletin 11 provides that the "six-month" threshold for a non-resident enterprise to have a service PE should be interpreted to mean a “183-day” threshold. Most of China’s tax treaties provide that a foreign enterprise will have a PE in China if its employees or other personnel stay in China for more than a certain amount of time during a 12-month period in connection with a service project or connected service projects. In some of China’s treaties, the threshold is “six-months”, while in other treaties, particularly more recent treaties, the threshold is “183-days”. Prior to 2011, China had a rule under Notice 4033 for applying the "six-month" service PE threshold that was often referred to as the “one day equals one month” rule. Under this rule, a nonresident enterprise was treated as having personnel in China for an entire month where at least one person was present for at least one day during a calendar month. One month could be deducted only where no personnel were present in China for 30 consecutive days. This interpretation could result in the creation of a PE where the enterprise had personnel in China for as few as seven days if the days were spread over seven months. Although this “one day equals one month” rule was removed from Notice 403 in 2011, it was uncertain whether the SAT had changed the interpretation, and some Chinese tax bureaus continued to apply the rule. With the clarification provided under Bulletin 11, a foreign enterprise from a treaty jurisdiction with the "six-month" service PE threshold can now accurately manage the presence of personnel in China to avoid crossing the threshold for creating a service PE.
1.2 International shipping and air transport
Bulletin 11 replaces the provisions in Circular 75 on the interpretation of the international shipping and air transport clauses in China’s tax treaties.
Bulletin 11 adopts the internationally accepted principle that income derived from the time or voyage charter of ships or the wet lease of aircraft should be characterized as income from international transportation, i.e., as income derived from the operation of ships or aircraft in international traffic. Circular 75 excluded such income from the scope of international transportation income, unless it was merely incidental to the operation of an international transportation business.
Bulletin 11 retains the Circular 75 interpretation that bare boat charters, dry leases of aircraft and leases of containers are not within the scope of international transportation business unless they are incidental to the operation of an international transportation business. However, the definition of “incidental” is more stringent under Bulletin 11 than under Circular 75.
Like Circular 75, Bulletin 11 defines “incidental” to mean (i) that the enterprise’s business registration or other relevant documents demonstrate that its core business is international transportation, and (ii) that the enterprise’s revenue from the “incidental” business does not exceed 10% of its total international transportation revenue within a fiscal year. However, Bulletin 11 further provides that an “incidental business” must be closely connected with the enterprise’s international transportation business and cannot be considered as a separate business or a separate income source. This additional condition is subjective, and it remains to be seen how the Chinese tax authorities will interpret it. Another uncertainty that is not clarified in Bulletin 11 is whether the 10% revenue test is based on the non-resident enterprise’s worldwide revenue or only its China-sourced revenue.
In other aspects, Bulletin 11 is basically consistent with Circular 75 with respect to international transportation.
Bulletin 11 marks the first time the SAT has issued official rules about a partnership’s eligibility for treaty benefits. Bulletin 11 covers not only partnership but also “other entities with a similar nature” (collectively Partnership). Bulletin 11 does not define the term “entities with a similar nature”, and it is not clear whether, for example, a US limited liability company with look-through treatment under US federal tax rules may fall within this category.
Bulletin 11 provides different tax treatments for a Partnership depending on whether it is formed under Chinese or foreign laws. Under Chinese tax rules, a Chinese Partnership is a tax transparent entity and the partners are liable to pay tax in China on their respective income shares. For a Chinese Partnership, Bulletin 11 allows its foreign partner to claim treaty benefits if the partner is taxed on its respective share of the partnership income in the partner’s country of residence.
In contrast, Bulletin 11 generally views a foreign Partnership as an independent non-resident taxpayer. Bulletin 11 does not allow a foreign partner of a foreign Partnership to directly claim treaty benefits in China with respect to income derived by the Partnership unless permitted under an applicable tax treaty. Instead, the foreign Partnership itself must establish its eligibility for treaty benefits. In order to do so, the foreign Partnership must, as a minimum requirement, submit a tax residency certificate supporting that the foreign Partnership is liable to pay income tax in its country of residence based on its domicile, residence, place of establishment, place of management or other criteria of a similar nature.
2. Analysis and recommendations
Although not an OECD member country, China has adopted many concepts and principles from the OECD’s commentaries on the Model Tax Convention to interpret its treaties. Bulletin 11 has further incorporated OECD principles with its guidance on the service PE threshold and international transportation income.
Interpreting “six months” to have the same meaning as “183 days” will effectively raise the service PE threshold for MNCs from certain treaty partner jurisdictions such as the US, Canada, Australia, Spain, Norway, Malaysia and South Korea and therefore is good news for MNCs in these countries. MNCs may also benefit from the expanded scope of international transportation income to cover income derived from time or voyage charters of ships and wet leases of aircraft because the treaty-based tax exemption for such income is no longer subject to the incidental business requirement.
However, the provision that Sino-foreign cooperative education activities constitute PEs represents a divergence from OECD principles and may be inconsistent with China’s tax treaties. As treaties should prevail over domestic tax rules in a conflict, taxpayers may consider challenging such PE assertions based on treaty PE principles and resort to mutual agreement procedure where necessary.In terms of treaty benefits for foreign Partnerships, most of China’s tax treaties do not expressly allow look-through of a Partnership for tax purposes, and thus Bulletin 11 will apply in most treaties (the China-France treaty is a notable exception).
This no look-through treatment could create issues for an MNC that invests into China where a foreign partnership or an entity of a similar nature is in the chain of ownership above China. As an example, suppose that a closed Dutch CV has two Dutch tax resident companies as its partners and indirectly owns 20% of a Chinese company. The Dutch CV indirectly transfers shares of the Chinese company. Bulletin 74 provides a “treaty safe harbor” under which the indirect transfer of a Chinese company is not subject to tax in China where the indirect transfer would have been exempted from tax in China under an applicable tax treaty if the non-resident transferor directly transferred the Chinese company. In this example, if the Dutch CV does not pay income tax in The Netherlands and is unable to obtain a Dutch tax residency certificate, it would be unable to establish its eligibility for the capital gains exemption under Article 13 of the China-Netherlands income tax treaty. As a result, the Dutch CV would be prevented from claiming the treaty safe harbor. Furthermore, the two partners of the Dutch CV would also be unable to claim the treaty safe harbor, as Bulletin 11 does not allow a look-through of the Dutch CV in the absence of explicit provision in the China-Netherlands income tax treaty. As this example illustrates, MNCs with investments in China that are directly or indirectly under a foreign Partnership must carefully assess the potential impact of Bulletin 11 and plan their investments and transactions accordingly to reduce tax risk.
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1 State Administration of Taxation Bulletin on Several Issues Relating to the Implementation of Tax Treaties, SAT Bulletin  No. 11, dated 9 February 2018, effective from 1 April 2018.
2 Notice of the State Administration of Taxation on the Interpretation of the Agreement Between the Government of the People's Republic of China and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion With Respect to Taxes on Income and the Protocols Thereof, Guo Shui Fa  No. 75, dated 26 July 2010.
3 Notice of the State Administration of Taxation on the Interpretation and Implementation of Some Clauses in the Arrangement between the Mainland of China and Hong Kong Special Administrative Region on the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income, Guo Shui Han  No. 403, issued by the SAT on 4 April 2007.
4 State Administration of Taxation Bulletin on Several Issues of Enterprise Income Tax on Income Arising from Indirect Transfers of Property by Non-resident Enterprises, SAT Bulletin  No. 7, dated February 3, 2015, effective as of the same date. For a detailed discussion of Bulletin 7, please refer to the February 2015 issue of our Client Alert.