China Tax/Business News Flash 

CCCFC is defined in Circular 82 as an enterprise established in accordance with the laws of foreign counties (regions) with Chinese enterprises or corporate groups as the main shareholding investors.

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Circular 82 sets out the following four criteria for the determination of Chinese TRE status for a CCCFC:

1. The places where the senior management personnel execute the daily management and operation of the CCCFC are mainly located within China;
2. The decisions for the CCCFC in terms of finance and personnel matters are made by or subject to the approval of organization(s) or individual(s) in China;
3. The main properties, accounting ledger, corporate seal, minutes of the board meetings and shareholders' meetings, etc. of the CCCFC are situated or kept in China; and
4. 50% or more of directors with voting rights or senior management personnel of the CCCFC ordinarily reside in China.

The above criteria need to be satisfied simultaneously in order to qualify as Chinese TRE.  Meanwhile, the principle of "substance over form" should be applied in determining whether the above four criteria are met.

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CCCFCs that are qualified as Chinese TRE ("Qualified CCCFC") shall be subject to CIT on worldwide income according to the CIT Law.  In addition, Circular 82 spells out the CIT implications in respect of dividends derived by and from Qualified CCCFCs respectively as follows (please refer to the following Chart):

1. Dividend from the Chinese operating investee (TRE) to Qualified CCCFC (1st-layer dividend) is considered as dividend distribution between two Chinese TREs and thus may be exempt from CIT according to the relevant provisions in the CIT Law [note1] and DIR.
     
2. Dividend from Qualified CCCFC to its investors (2nd-layer dividend) is considered as sourced from China and thus:
     
   B.1 if the investor of the Qualified CCCFC is also a Chinese TRE, then the principle in Point A above may apply and the dividend may be exempt from CIT;
     
   B.2 if the investor of the Qualified CCCFC is not a Chinese TRE, then the 2nd-layer dividend is subject to CIT in the form of withholding tax ("WHT").
        
   

This is commonly known as a "China > Foreign (CCCFC) > China" structure and is a common structure used by "Red Chips" in their overseas listings.  We will have more discussions on the significant impact of Circular 82 on the "Red Chips" arrangement below.

[note1]: Article 26(2) of CIT Law provides that qualified dividend distribution from equity investment between TREs which meet certain prescribed criteria shall be tax-exempt income.  Article 83 of DIR further elaborates that the prescribed criteria are referred to dividends derived by a TRE from the direct investment in other TREs excluding investment income from circulating stocks issued publicly by TREs and traded on stock exchanges where the holding period is less than 12 months.

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• The Foreign Investment Enterprise ("FIE") status of enterprises set up by Qualified CCCFC in China should remain unchanged for China tax purposes.  This is important for the purpose of enjoying grandfathering treatment available to FIEs under the CIT regime.
• The CCCFC which is deemed to be a TRE shall not be classified as Controlled Foreign Corporation ("CFC") [note2].  Meanwhile, the foreign enterprises that are controlled by Qualified CCCFC shall still be subject to the CFC rules.
• Where the CCCFC which is deemed as TRE has dual tax residency, one in the place of its registration and the other in China, the relevant clauses of the double tax agreement shall apply.

[note2]: Article 45 of CIT Law provides that where a TRE controls a foreign enterprise in countries (regions) whose effective tax burden is substantially lower than the statutory tax rate of 25%, that foreign enterprise shall be treated as CFC.  If the profit of the CFC is not distributed or is under-distributed not for reasonable operational needs, the portion of the aforesaid profit which is attributable to the TRE shall be deemed as distributed income to the TRE in the current period.

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A CCCFC may lodge the application to the in-charge tax bureau at where the "effective management" is located (or where the main Chinese investor resides).  If the CCCFC does not lodge the application, the tax bureau in charge of the main Chinese investor of the CCCFC may initiate the assessment of TRE status of the CCCFC.  In both cases, the final approval lies with the SAT.

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• Circular 82 applies to foreign enterprises with Chinese enterprises or corporate groups as their main shareholding investors, but it is silent on what is meant by "main shareholding".  We believe that "main shareholding" refers to "relative majority holding" as opposed to "absolute majority holding".
• It appears that Circular 82 does not apply to foreign enterprises owned / controlled by foreign-registered investors with foreign capitals, regardless of where the effective management of that foreign enterprise is located.  However, please see more of our insights in the section of "Implications and recommendations to non-CCCFC" in the last part of this News Flash.

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• Some phrases in the four criteria for determining China TRE status, such as "mainly located" in the 1st criteria, "main properties" in the 3rd criteria and "ordinarily reside" in the 4th one, etc., are vague and difficult to measure.
• In the meantime, it is important to note that Circular 82 provides that the principle of "substance over form" should be applied in determining the TRE status.  The CIT Law has actually put emphasis on "substance" when introducing the TRE concept.  However, the interpretation of this principle may still be vague as there is no further explanation stated in the CIT Law, its DIR or Circular 82, and the implementation of this principle is still immature in practice.  Nevertheless, the objective of adopting this principle is obviously to supplement the vague phrases in the criteria and counter any abusive use of the 4 criteria.  More importantly, this is not the first time that we have seen the Chinese tax authorities use the principle of "substance over form" in its circulars recently.  It signifies that the Chinese tax authorities are more and more inclined to use this principle in administering CIT.

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As mentioned above, if the investor of Qualified CCCFC is also a Chinese TRE (i.e. "China > Foreign (CCCFC) > China"), both layers of dividends could be exempt from CIT.  It seems that the CIT treatment provided in Circular 82 only addresses one layer of foreign enterprise.  However, in some Chinese-capital / controlled "Red Chips" [note3] structure, there is generally more than one layer of foreign enterprise in between the Chinese investors and the Chinese operating company (e.g. "China > Foreign Co. 2 > Foreign Co. 1 > China OpCo").
      
Assuming that Foreign Co.1 and Foreign Co.2 are both qualified as Chinese TREs, the dividends received by Foreign Co.1 and Foreign Co.2 (1st and 2nd-layer dividend) would qualify for the CIT implications under Point A and B.1 respectively mentioned above.  But the literal meaning of Circular 82 seems to imply that the dividend received by the investors of Foreign Co.2 (i.e. China HoldCo.) from Foreign Co.2 (3rd-layer dividend) may not qualify for the tax exemption treatment.  If this is true, it could have negative impact on the CIT consequence of this common "Red Chips" structure, which does not seem to be the intention of Circular 82.  It remains to be seen whether the Chinese tax authorities would provide further clarification in this respect.

[note3]: The designation of "Chinese-capital/controlled Red Chips" is commonly referred to a non-Chinese company which is formed, owned and controlled by the Chinese investors, and mainly used as a listing vehicle in overseas stock markets, e.g. Hong Kong.  The major assets of the "Red Chips" are the shareholding of the Chinese operating investee companies.

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• It is imperative to note that, as reflected in Circular 82, the SAT has taken the position that the dividend derived by the foreign investor of Qualified CCCFC should be considered as China sourced income and thus subject to China WHT.
    
• Circular 82 is silent on the taxation of capital gain derived by a foreign investor on the disposal of shares in a Qualified CCCFC.  However, if the same SAT's position on "source of dividends" is applied to "source of capital gain", then the capital gain would be regarded as China-sourced and the foreign investor would be subject to CIT on such gain, subject to treaty application.  However, up to now, the SAT has not made clear how to handle this issue.

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• While a CCCFC may lodge the application for Chinese TRE status, Circular 82 also empowers the in-charge tax bureau to initiate the investigation on a CCCFC to determine whether it should be regarded as a Chinese TRE.  Regardless of whether the SAT has a plan to go after such CCCFCs and challenge them as Chinese TREs, Circular 82 provides the legal basis if the SAT chooses to do so.
• Unfortunately, Circular 82 has only addressed how a CCCFC lodges an application for Chinese TRE, but it provides no clues on the administrative procedures on monitoring the maintenance of such Chinese TRE status or even the case of "disqualification" (turning from TRE to non-TRE).
• Since dividend derived by foreign investors of Qualified CCCFC would be China sourced income and thus subject to WHT, there may be an implementation problem on the administration and collection of WHT by the Chinese tax authorities.  We would expect the Chinese tax authorities to provide further clarification in this respect.
• Circular 82 is retrospective to 1 January 2008, same as the effective date of the CIT Law and its DIR.  In the situation whereby a Qualified CCCFC has paid interim dividends in the middle of 2008 before obtaining the approval of the TRE status, it is uncertain whether the Chinese tax bureaus would re-open the cases and assess the Qualified CCCFC as a TRE and then impose WHT on the interim dividends already paid to foreign investors.   

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In May 2009, soon after the issuance of Circular 82, a few "Red Chips" companies in Hong Kong have released public announcements in relation to the withholding of China WHT in respect of dividends for year 2008.  They announced that they will withhold WHT on dividends to be distributed to non-individual shareholders whose names appear on the company's shareholders' registry.  In cases where such shareholders could provide evidence to support that it is a Chinese TRE, i.e. a Chinese-incorporated company or a foreign-incorporated company with its effective management located in China, then the "Red Chips" companies will not withhold the WHT from the dividends to be paid.
       
As mentioned above, the "China > Foreign (CCCFC)> China" structure has commonly been used by "Chinese-capital / controlled Red Chips" for overseas listing purposes.  This structure, however, is not tax efficient to the Chinese investors groups.  Now, in light of Circular 82, it is obvious that the overall tax efficiency of the Chinese investors groups could be improved significantly if the "Chinese-capital / controlled Red Chips" is considered to be a Chinese TRE.  In addition, from an accounting perspective, the Chinese-capital / controlled "Red Chips" also does not have to provide deferred tax on the post-2007 retained earnings of the Chinese operating investee companies if it is considered to be a TRE, which will result in an increase in its consolidated after tax profits.

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Before the CIT regime, Non-individual foreign investors of CCCFC were not subject to China tax at all because the CCCFC was regarded as non-Chinese TRE and thus the dividend from CCCFC was not sourced in China.  However, in light of Circular 82, once the CCCFC becomes Chinese TRE, these foreign investors of Qualified CCCFC would be subject to China WHT on the dividend derived from Qualified CCCFC.  Of course, it does not necessarily translate into lower after-tax profits because there will also be CIT exemption for dividends from the Chinese operating investee companies to the Qualified CCCFC which means that Qualified CCCFC may have more after-tax profits to distribute to foreign investors.  These foreign investors should compare the overall tax liabilities pre- and post-qualification of the CCCFC as Chinese TRE in order to assess the actual returns on investments.

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"Chinese-capital / controlled Red Chips" should review their status using the four criteria mentioned above and, where applicable, lodge the application for the Chinese TRE status in order to enjoy the CIT benefits provided by Circular 82.  However, they should also be mindful of the associated tax consequences of being subject to CIT on their worldwide income if they are qualified as Chinese TRE.

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While Circular 82 enables "Chinese-capital / controlled Red Chips" to enjoy CIT exemption on dividend from TRE to TRE, it also allows the Chinese tax authorities to more aggressively attack the "round-tripping structure".  Some Chinese-entrepreneur groups may have adopted a "round-tripping structure" whereby the CCCFC may not be purely an investment holding of the Chinese operating company but having its own overseas business and non-China source income.  Such CCCFC may have the risk of being regarded as Chinese TRE and subject to CIT on its worldwide income.
      
It is important for these CCCFCs to study the four criteria mentioned above and assess what actions / arrangements they should take to manage the risks of being assessed as Chinese TRE.  No matter whether the Chinese tax authorities have a concrete plan to check on all such CCCFCs, these CCCFCs should get prepared as soon as possible in light of Circular 82.

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Technically Circular 82 only applies to CCCFC and the criteria stated therein should only apply to determine the TRE status of CCCFC.  Having said that, if the SAT is going to issue a separate set of rules to determine the TRE status of non-CCCFC, it seems unlikely for the SAT to adopt a very different set of criteria for that purpose.  Although the SAT has not come up with clear intention / policy at this stage, we believe that the four criteria should serve as a good reference for non-CCCFCs in assessing and managing the risk of being regarded as Chinese TREs.

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