by michael g. velten, yeoh lian chuan, adelene sung-pei · pdf file02-09-2009 · 22...

September 200922 TaxViewsAsia

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I. IntroductionThis article considers recent developments in the taxation of foreign equity investment in Asia1.

Foreign equity investment can be in shares in a listed or unlisted company and may be in the form of foreign direct investment (FDI) or private equity or portfolio investment by foreign institutional and private investors.

The return to an investor may be a dividend and/or a gain on the sale of the shares.

Domestic tax law will dictate whether and if so how dividends and gains that are earned by a foreign investor are to be taxed.

The operation of domestic tax law may be subject to a tax treaty.

The application of a tax treaty will be subject to certain conditions, most notably that (i) the investor be “tax resident” in the jurisdiction with which the tax treaty has been entered and (ii) in the case of dividends, that the investor be the “beneficial owner” of that income.

Procedures may be prescribed for investors wishing to claim the benefit of a

2. The possible application of domestic tax rules to tax an “offshore” gain on the sale of shares. Recent court cases in India have brought this to light, particularly where that the share sale gain has a “business connection” with India.

3. Continued refinements for taxing non-resident capital gains and dividends. Australia, China, Japan and South Korea have all amended rules that affect particularly portfolio investment by non-residents.

4. “General” or “special” tax treatment of restructurings in China is now available provided certain conditions are met.

5. Tax planning for investments in China must take account of not only

tax treaty to exempt or reduce a domestic dividend withholding tax or capital gains tax (CGT).

Prevailing attitudes both internationally and in each jurisdiction towards tax treaty “abuse”2 must be understood.

How foreign equity investors are taxed is one of the more interesting current issues in Asia taxation.

This article seeks to identify themes, distil trends and draw conclusions based on key developments that can be seen across Asia in this area.

II. Observations on the taxation of foreign equity investors in AsiaThere are a number of interesting developments in the taxation of foreign investors in Asia. The themes arising from these developments are broadly as follows.1. Evolving tax regimes with respect

to fund managers, particularly in Singapore where favourable tax treatment of funds’ investors are being widened and in Australia where there are hopes to establish an Asia regional fund management centre.

Taxation of Foreign Equity Investors in Asia

By Michael G. Velten, Yeoh Lian Chuan, Adelene Sung-Pei Wee and

Penelope Wong

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1 This article reflects developments known to the authors as at 14 August 2009. Notwithstanding that this article is not intended to, and does not, constitute legal advice, please note that under the existing law of the People‘s Republic of China (PRC), the authors are not permitted to render opinions in respect of, or to advise on, PRC law. In this regard, the contents of this article will, in so far as the laws and regulations of the PRC are concerned, necessarily be based on the authors’ own research and experience.

2 The improper use of tax treaties is discussed in paragraphs seven to 26 of the Organisation for Economic Co-operation and Development (OECD) Commentary on Article 1 of the Model Convention and in greater details in two OECD reports issued in 1987 entitled Double Taxation Convention and the Use of Base Companies and Double Taxation Conventions and the Use of Conduit Companies.


September 2009 TaxViewsAsia 23

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recent tax developments such as the introduction of thin capitalisation and transfer pricing rules, but also regulatory developments that impact profit repatriation strategies.

6. Greater sharing of information through exchange of information (EOI) initiatives for both OECD Member States and non-OECD countries.

7. The trend towards substance. China and South Korea are moving towards the substance over form doctrine. This is not necessarily the case in Thailand and the Philippines.

8. Increasing guidance on the meaning of “beneficial ownership”. Beneficial ownership is a key concept in being able to access double tax treaties. Although this is not clearly defined in international tax law, the concept has been tested in the courts in Indonesia and outside the region with implications for structuring investments into Asia.

These broad themes are discussed in more detail below.

III. Evolving tax regimes impacting fund managersHong Kong, Japan and Singapore have exemptions from tax for foreign investors or offshore funds managed locally. Singapore, in particular, has been liberalising its tax regime for exempting non-resident funds managed in Singapore from tax. Meanwhile, Australia continues to see further policy discussions regarding the tax implications of foreign fund managers.

A. SingaporeOver the years, Singapore has progressively liberalised its tax regime for exempting non-resident funds managed in Singapore from tax. For many years, the exemption was based on the so-called “80:20” rule whereby at least 80% of the investors in the fund had to be outside Singapore.

In 2007, this was substantially altered to grant favourable tax treatment to “qualifying funds” whose investors were “qualifying investors”. To be a “qualifying fund”, the fund had to be a non-resident/non-citizen individual or a non-resident

Australian resident is generally exempt from Australian CGT, assuming that the non-Australian resident is trading on capital account; the exceptions being where the company is “land rich” for CGT purposes and, broadly, the non-Australian resident held 10% or more of the company7.

The consequence is that foreign investors in shares of Australian-listed companies should not need to concern themselves with the availability of a CGT exemption under an applicable tax treaty.

This does not mean that listed share sale gains cannot be taxed in Australia.

Notwithstanding the domestic CGT exemption for most transactions in most Australian-listed securities, a gain on revenue account that has an Australian source will form part of assessable income and may be subject to Australian ordinary income tax unless a treaty exemption is available.

Whether a gain is on revenue account and has a source in Australia is a question of fact.

Whether there is a source in Australia may depend where the contract was concluded.

The Australian Taxation Office (ATO) believes this may be in Australia if a local Australian broker has been used. This is borne out in ATO Interpretative Decision ATO ID 2004/904.

company or trust not 100% owned by citizens or residents of Singapore. Qualifying investors included individuals, bona-fide non-resident persons not carrying on business in Singapore or using income from Singapore to invest in the funds and persons who had less than 30% (or in some cases 50%) interest in the fund. These reforms substantially widened the scope for Singapore resident investors to participate in the offshore funds regime.

In the 2009 Singapore Budget, the regime was further liberalised by the introduction of an “Enhanced Tier” scheme. This allows Singapore resident entities to be used as fund vehicles and removes restrictions on the category of investors who could participate in the funds. The scheme also improved the treatment for limited partnership funds managed from Singapore, which was previously problematic. Singapore has also granted partial Goods and Services Tax (GST) input tax recovery for certain locally constituted funds managed from Singapore3.

B. AustraliaAustralia is focused on the future of its tax system and in particular developing its position as an Asia regional fund management centre4.

In Australia, however, there are a number of tax issues that concern the Australian Financial Centre Forum (AFCF)5. Such issues include whether a foreign fund or a foreign entity may be deemed to have a permanent establishment (PE) in Australia or “Australian residency”, and hence be subject to Australian income tax merely as a result of having an investment advisory, discretionary funds management or other similar presence in Australia6.

To be a fund management hub, we believe that Australia needs to consider an exemption similar to those in Singapore and Hong Kong.

Another issue in Australia relates to the domestic taxation of foreign investors acting on revenue account.

Broadly speaking, the sale of shares in an Australian company by a non-

3 See “Budget Seminar: Questions on Budget 2009 Changes and Inland Revenue Authority of Singapore (IRAS) Response”, 20 February 2009, page eight at http://www.iras.gov.sg/irasHome/uploadedFiles/Questions%20and%20IRAS%20Responses%20-%20Budget%20Seminar%202009.pdf (accessed 2 August 2009).

4 The Hon Chris Bowen, MP, “Promoting Australia as a Financial Services Hub - Progress of the Australian Financial Centre Forum”, Statement by the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs, 27 May 2009; Greg Reinhardt and Mishra Seema, “Making Australia the Financial Services Hub of Asia”, Taxation in Australia, Volume 44/1, July 2009, page 18.

5 The AFCF is charged with preparing a policy blueprint for promoting Australia as a leading financial services centre. See Letter from the Australian Financial Centre Forum to the Australia’s Future Tax System Review, dated 11 May 2009.

6 If the foreign fund is deemed to have a PE in Australia, or a foreign entity is deemed to be an Australian resident, this would have two consequences: first, it would mean that where the fund or entity transacts on capital account, the CGT exemption for non-residents no longer applies; and secondly, if the fund or entity transacts on revenue account then the gains will be taxed as domestic income.

7 Mallesons Stephen Jaques, “New Changes to Capital Gains Tax for Foreign Residents”, Client Alert, 8 December 2006, http://www.mallesons.com/publicat ions/2006/Dec/8723065w.htm (accessed 25 July 2009).



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This appears similar to the position taken in Hong Kong under the Hang Seng8 and ING Barings9 cases, whereas for instance the Singapore tax authorities appear to take a different view of “source”, favouring a broader “operations test” as the general test for “source” of ordinary business income10.

In the absence of a clear cut definition of “source”, due to revenue integrity concerns on the part of the ATO, arguably there is a lack of certainty as to tax treatment from trading Australian-listed securities for certain foreign investors.

IV. The possible application of domestic tax rules to tax an “offshore” share sale gain A. India: The Mauritius route A large proportion of foreign equity investment in Indian companies is usually made by a Mauritian company11. Under the India-Mauritius tax treaty (Treaty) there is no Indian CGT on the sale of the shares of the Indian company by a Mauritian company. Such gains are also exempt from Mauritius tax.

A tax residency certificate issued to a Mauritian company is sufficient evidence for the India tax authorities to accept the status of residence as well as beneficial ownership according to Circular 789 and Union of India vs. Azadi Bachao Andolan [2003] SOL 619.

The benefits of the Treaty would apply even when a Mauritian entity is established primarily for investment into India. Singapore has a similar CGT exemption in its revised treaty with India (introduced in 2005), but with a “limitation of benefits” provision.

India has over the years given indications that it would like to introduce a similar “limitation of benefits” provision in its treaty with Mauritius12. However, changing a treaty is neither easy nor quick. In the meantime, the Indian tax authorities have been giving greater scrutiny to cross border transactions. The ongoing E*Trade case13 bears this out. This case is concerned with the applicability of withholding tax on the sale of shares in an Indian company from one Mauritian

it to withhold tax on the acquisition. It also questioned the constitutionality of a retrospective change to the Indian tax law in May 2008 that would allow the government to take action against companies that do not withhold taxes when making a transaction19.

The Bombay High Court dismissed Vodafone’s petition. Although Vodafone had argued that the transaction occurred overseas, the Court decided that the assets were largely based in India, therefore taxes should be paid in accordance with Indian laws20.

Vodafone then appealed to the Supreme Court.

The primary question that Vodafone requested the Supreme Court to answer was whether the Indian tax authorities have the jurisdiction to tax a transaction that

company to another. A writ petition was filed by E*Trade Mauritius Limited before the Bombay High Court challenging the withholding tax certificate issued by the Tax Department to pay capital gain tax on the consideration it received from HSBC Violet Investments (Mauritius) Limited. The Bombay High Court disposed of the writ petition filed and directed the matter back to the Tax Department for revision proceedings.

B: India: “Business connection” Generally, the use of the “Mauritius route” should mean that the possible application of India domestic tax law to a share sale gain does not need to be considered.

This, however, may not be the case if shares in a Mauritian company, which in turn has invested in an Indian company, are sold at a gain.

The question is whether that share sale gain has a “business connection” with India and therefore taxable under section 9(1) of the India Income Tax Act, 196114.

If so, a requirement on the purchaser of the shares to withhold tax for remittance to the India tax authority arises under section 195 of the India Income Tax Act, 1961.

This issue arose in the Vodafone15 case.Vodafone Group Plc paid US$11.1

billion to a unit of Hong Kong’s Hutchison Whampoa for a controlling stake in an Indian mobile operator16.

Vodafone International Holdings BV (Vodafone), a company registered in the Netherlands, acquired the entire share capital of CGP Investments (Holdings) Ltd (CGP); a Cayman Islands based company, from Hutchison International (HTIL). CGP, itself, owns 52% stakes in Hutchison India17.

Vodafone received a tax bill from the India Income Tax Department, which said that Vodafone was liable to pay CGT as most of the assets it bought were based in India18.

Vodafone challenged the charge, arguing that the transaction occurred overseas and was not a transfer of capital asset situated in India and that the Indian law at the time did not require

8 CIR v Hang Seng Bank Ltd [1990] 3 HKTC 351.

9 ING Baring Securities (Hong Kong) Limited v The Commissioner of Inland Revenue (FACV No. 19 of 2006).

10 Inland Revenue Authority of Singapore, Income Tax Guide on E-Commerce, Reference Number 2001/EC/1.

11 Mauritius accounted for 43% of cumulative foreign fund inflow. Of the total USD81 billion FDI that has come into India since April 2000, USD35.18 billion was routed through the Mauritius route, according to figures available with the Department of Industrial Policy and Promotion, “India gets 43% FDI through Mauritius route”, Press Trust of India, 20 April 2009.

12 Eg “India to Amend Indo-Mauritius Tax Treaty”, India Express, 4 August, 2009; “India Working on Anti-abuse Provisions in Tax Treaties” Economic Times, 9 August, 2009; “Tail Twisting of Mauritius Tax Treaty is Unnecessary” Business Standard 10 August, 2009.

13 E-Trade Mauritius Limited - Writ petition No. 2136 of 2008 order dated 26 September 2008 – Unreported; E-Trade Mauritius Limited - Writ petition No. 2134 of 2008 order dated 23 March 2009 – Unreported. See Nishith Desai & Associates, “E*Trade and the Mauritius Route: Much Ado About Nothing?” VC Circle, 20 April 2009, http://www.vccircle.com/500/news/etrade-and-the-mauritius-route-much-ado-about-nothing (accessed 22 July 2009).

14 Section 9(1) of the India Income Tax Act states: “The following incomes shall be deemed to accrue or arise in India: - (i) All income accruing or arising, whether directly or indirectly, through or from any business connection in India, or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India”.

15 Vodafone International Holdings BV v Union of India, (2008) 220 CTR 649 (Bombay High Court), 175 Taxmann 399 (Bombay High Court); Vodafone International Holdings BV v Union of India & Anr (2009) 221 CTR 617 (SC) / 311 ITR 46 (SC).

16 “Vodafone Loses India Tax Case, to Appeal”, Reuters, 3 December 2008; “Vodafone Loses USD2 billion Indian Tax Case”, cellular-news, 3 December 2008.

17 Ibid.

18 Ibid.

19 Ibid.

20 Vodafone’s refusal to disclose this to the Bombay High Court was one of the factors that led to the Court dismissing the company’s petition.


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occurred outside India between parties that do not have a presence in India21.

Interestingly, the Supreme Court did not directly rule on this22.

Instead, the Supreme Court asked the Indian tax authority to decide, as a preliminary issue only, whether it has jurisdiction to proceed against Vodafone23.

Should Vodafone be aggrieved by the order of the tax authority’s preliminary adjudication on jurisdiction, Vodafone has been permitted to directly approach the High Court24.

India’s new Income Tax Code25

On 12 August 2009 the Finance Minister released a draft of the Direct Tax Code and a Discussion Paper for public comment. The new Code aims to replace current Income-Tax Act, 1961 and Wealth Tax Act, 1957.

Under section 5(1) (d) of the Direct Tax Code, “Income shall be deemed to accrue in India, if it accrues, whether directly or indirectly, through or from transfer, directly or indirectly, a capital asset situate in India”26.

This provision supports Indian Tax Department’s stand that if profit has been generated in India, tax has also to be paid in India27.

The new Direct Tax Code is to introduce provisions to prevent the misuse of tax treaties28.

A general anti-avoidance rule (GAAR) is to be introduced29.

Importantly, the Direct Tax Code will override tax treaties which India has entered.

The Direct Tax Code provides that: “For the purposes of determining the relationship between a provision of a treaty and this code neither the treaty nor the code shall have a preferential status by reason of its being a treaty or law; and the provision which is later in time shall prevail”30.

The proposed Direct Tax Code is expected to become law in 2011.

V. Continued refinements for taxing non-resident capital gains and dividendsA. AustraliaAustralia has moved to reduce the

PRC-sourced dividends and interest received by QFIIs are subject to a 10% withholding tax. The Notice clarifies that the QFII is the taxpayer, and moreover, the QFII is eligible for a reduced withholding tax rate under an applicable tax treaty provided approval is granted by the relevant PRC tax authorities37.

Notice 47 is silent on the withholding tax treatment on capital gains38.

withholding tax on the distribution to non-residents by Australian Managed Investment Trusts (MITs)31.

On 1 July 2009, the relevant withholding tax rate was reduced to 15%.

The new 15% withholding tax rate is applicable to a distribution by a MIT of the “fund payment component”32 to eligible non-residents.

An eligible non-resident is a beneficiary that resides in a country that has an effective EOI agreement with Australia.

Fund payments to beneficiaries that are not residents in an EOI country remain liable to tax at 30%.

On 1 July 2010, it will reduce to 7.5%.

B: China1. Treatment of “H-share” dividends33

On 6 November 2008, the State Administration of Taxation (SAT) issued Guoshuihan [2008] No. 897 (Notice 897), which relates to withholding tax by the People’s Republic of China (PRC) resident enterprises on distributing H-share dividends to overseas non-resident enterprise shareholders.

“H-shares” are shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange.

According to Notice 897, when a PRC resident enterprise pays dividends for 2008 and any subsequent year to an overseas H-share non-resident enterprise shareholder, a 10% tax must be withheld on the dividends paid.

The dividend recipient can thereafter apply to the relevant tax authorities for a tax refund in accordance with an applicable tax treaty, if any.

2. Treatment of Qualified Foreign Institutional Investors34 (QFIIs)On 23 January 2009, the SAT issued Guoshuihan [2009] No. 47 (Notice 47)35. Notice 47 clarifies the payment of PRC withholding tax on dividends and interest received by QFIIs from PRC entities36.

In Notice 47, the SAT confirms that

21 Ibid.

22 “SC Declines to Intervene in Vodafone Tax Plea”, Business Standard, 24 January 2009; see also “Vodafone Tax Case Back to Square One”, livemint.com, 24 June 2009, http://www.livemint.com/2009/01/23234920/Vodafone-tax-case-back-to-squa.html (accessed 14 August, 2009).

23 It has been reported that a show cause notice is to be issued to Vodafone by the Income Tax Department: “India Likely to Send Tax Notice to Vodafone Unit –Official” Wall Street Journal Online 11 August 2009 http://online.wsj.com/article/BT-CO-20090811-705438.htm (accessed 13 August 2009).

24 Ibid.

25 “India Unveils Draft Code to Replace Tax Laws” Wall Street Journal Online 12 August, 2009. http://online.wsj.com/article/SB125007834416325551.html (accessed 14 August 2009); “No More Riding on Tax Treaties” Economic Times 13 August 2009; “MNCs May Not Get to Challenge I-T Dept” Economic Times 14 August, 2009; “Indian Tax Law Set to Come of Age” Livemint .com 13 August 2009, http://www.livemint.com/2009/08/12234540/Indian-tax-law-set-to-come-of.html?h=B (accessed 14 August 2009).

26 Ibid.

27 Ibid.

28 Ibid.

29 Ibid.

30 The new provisions is in line with US tax laws, which states that domestic tax law, passed by the Senate shall override any pre-existing treaty.

31 The Hon Chris Bowen MP Assistant Treasurer Minister for Competition Policy and Consumer Affairs, “Establishing Australia as a Regional Financial Hub”, Press Release, 13 May 2008.

32 The fund payment component is broadly a payment that represents a distribution of Australian source net income (other than dividends, interest and royalties) of the trust. This income component is commonly known as Sundry Other Income – or “SOI”.

33 Stephen Nelson, “China: Levying Withholding Tax on H-share Dividends”, International Tax Review, February 2009.

34 The QFII program (合格的境外机构投构者) was launched in 2002 to allow licensed foreign investors to buy and sell yuan-denominated “A” shares in China’s mainland stock exchanges (in Shanghai and Shenzhen). Chinese mainland stock exchanges were previously closed off to foreign investors due to China’s capital controls. As of February 2009, a total of 79 foreign institutional investors had been approved under the QFII program. Foreign access to China’s yuan-denominated “A” stocks is still limited, with an overall quota placed under the QFII program amounting to USD30 billion: “China Further Loosens its Capital Controls - International Herald Tribune”, August 20, 2007

35 Baker & McKenzie, “Additional Guidance Issues on the Taxation of QFIIs in China”, Client Alert, March 2009.

36 Ibid.

37 Ibid.

38 Ibid.


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3. Tax resident statusOn 22 April 2009, the SAT issued Guoshuifa [2009] No. 82 (Notice 82)39. Notice 82 provides guidance on the determination of tax residence status of Chinese-controlled offshore companies under the place of effective management and control rule in the new Enterprise Income Tax Law (EIT Law).

Notice 82 may have a significant impact on Chinese companies listed on a foreign stock exchange.

Chinese tax residents pay EIT on worldwide income.

Notice 82 sets out detailed rules for determining whether a Chinese controlled offshore incorporated enterprise (OIE) is a tax resident of China describes the tax implications of such an enterprise being regarded as a tax resident40 and sets out the procedures for an assessment of the tax residence of OIEs by a relevant local tax bureau.

The provisions of Notice 82 apply retroactively from 1 January 2008.

4. Guoshuihan [2009] No. 39441

In Guoshuihan [2009] No. 394, issued to a local tax authority on 30 July 2009, the SAT confirmed42 (effective 1 January 2008) that tax at 10% should be withheld on dividends paid to non-resident company shareholders by Chinese resident companies whose shares (i.e., “A”43 shares, “B”44 shares and other overseas shares) are publicly traded and listed on domestic or overseas stock exchanges.

Non-resident company shareholders may apply for tax treaty benefits or a tax reclaim.

5. Guoshuihan [2009] No. 395On 24 July 2009, the SAT issued Guoshuihian [2009] No. 395 (Circular 395)45.

To facilitate the implementation of tax treaties, the SAT has collected samples of tax resident certificates (TRCs) from jurisdictions that have signed tax treaties with China (Contract Jurisdictions)46.

Circular 395 provides TRC samples from 42 Contract Jurisdictions, including the United States, Germany, Singapore, Hong Kong, Macau and Belgium47.

2. Exemption from creating a PE in Japan52

Similar to the capital gains measures discussed above, certain partners investing into Japan through special partnerships are now deemed not to have a PE in Japan.

This should create significant comfort for a large number of passive investors, who currently face the risk that any income and gains on their Japanese investments may be subject to Japanese corporate taxation.

3. South Korea: Application of CGT exemption53

For listed stock that is sold through the South Korean stock exchange, tax treaty protection is not required and CGT is not imposed if a foreign seller (without a PE in South Korea) and its related party owned less than 25% of the shares in, or the capital of, the South Korean

The SAT also specifies that as several countries, such as Japan, the Netherlands, Australia, Switzerland, Luxembourg and Ireland, do not have an official uniform sample for their TRC, the competent tax authorities in such countries may instead issue letters to provide TRC information upon request48.

Circular 395 indicates that in cases where a local tax authority has suspicions regarding TRCs it has received, or experiences difficulties in verifying them, it may request confirmation from the competent tax authorities in the specific jurisdiction through the SAT49.

According to Circular 395, the SAT will provide samples of TRCs for other Contract Jurisdictions in separate circulars50.

C. Japan1. Exemption from taxation of capital gains51

Japan’s tax reform for 2009 amended the rules that subject foreign investors owning shares in Japanese companies (except for those whose holding period is less than one year or those in certain distressed financial institutions) to Japanese taxation on capital gains on the disposal of such shares (the so-called “25/5” rule).

Previously, investors in a fund structured as a partnership were required to aggregate their shareholdings with those of their related parties and of any partners with whom they hold their investments in determining whether they have met the 25% ownership, or 5% disposition threshold.

Investors investing through certain types of partnerships are now no longer required to aggregate their shareholdings with those of their partners in determining their position with regard to the thresholds.

This move had been actively lobbied for by the private equity funds industry in particular, to encourage investment into Japan.

The amendments are however limited to certain partners only.

39 Deloitte Chinese Services Group, “China’s Tax Authority Issues Guidance on Tax Resident Status of Chinese: Controlled Offshore Companies”, China Tax Law Commentary, May 2009.

40 Article 4 of Notice 82 provides that dividends paid by a Chinese tax resident are exempt from income tax in the hands of an offshore incorporated Chinese tax resident or OIE.

However dividends distributed by an OIE are deemed to be China-source income. Accordingly to Notice 82, dividends received by a foreign shareholder of the OIE would be subject to Chinese withholding tax.

Notice 82 is silent on how capital gains derived by a foreign shareholder from the disposition of shares in the OIE should be taxed.

41 Ernst & Young, China Tax & Investment Express, 2009017.

42 Guoshuihan [2009] No. 394 was posted on the SAT Website on 31 July 2009.

43 Shares traded on the two mainland Chinese stock exchanges in Renminbi are called “A” shares.

44 “B” shares are traded in foreign currencies on the Shanghai and Shenzhen stock exchanges. In Shanghai “B” shares are traded in US dollars, whereas in Shenzhen, they are traded in Hong Kong dollars.

45 Ernst & Young, China Tax & Investment Express, 2009018.

46 Ibid.47 Ibid.48 Ibid.49 Ibid.50 Ibid.51 Deloitte, “Tax Reform Proposals 2009”, Jonathan Stuart

Smith, Yang-Ho Kim and Nicholas Walters, Japan Tax Alert, 19 December 2008.

52 “Tax Reforms to Encourage Foreign Investments Through Funds”, Jetro, 8 June 2009, http://www.jetro.go.jp/en/invest/newsroom/detail/o2009006.html (accessed 22 July 2009).

53 Jay Shim, “South Korea Foreign Investors Face New National Tax Rules”, Mondaq Banking and Financial, 12 June 2007, http://www.mondaq.com/article.asp?articleid=49114 (accessed 24 July 2009); See also Samil PricewaterhouseCoopers, “2007 Korean Tax Law Changes”, Client Alert, 16 February 2007.


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company during the year of the sale and the five preceding years.

Following an amendment to the Enforcement Decree under the Corporate Income Tax Act (which had been announced by South Korea’s Ministry of Strategy and Finance on 17 January 2007), when a foreign partnership owns Korean-listed company shares and transfers such shares, the determination of the ownership ratio under the 25% exception would be made at partnership level.

Thus, even if an investor in the partnership indirectly owned less than 25%, the investor would not be allowed to claim that the 25% exception is applicable on the grounds that the foreign partnership was a pass-through entity and the ownership ratio should be tested at the level of the investor in the partnership.

VI: The tax rules for corporate restructurings in China have been introducedOn 30 April 2009, the PRC Ministry of Finance (MOF) and SAT jointly issued Notice of Some Issues Associated with Income Tax Treatment of Enterprise Restructuring (Cai Shui [2009] No. 59) (Notice 59) relating to China’s tax treatment of certain corporate restructuring transaction54.

The rules introduced in Notice 59 have retrospective effect from 1 January 2008.

A. The pre-1 January 2008 positionPrior to Notice 59, the SAT had issued Guo Shui Fa [1997] No. 71 (Circular 71) and Guo Shui Han Fa [1997] No. 207 (Notice 207).

Circular 71 set forth detailed guidelines on the tax treatment of enterprise restructuring transactions. Notice 207 permitted foreign investors to transfer their equity interests in a Chinese enterprise to a 100% related enterprise at cost, provided a commercial-purpose test was satisfied.

A key issue for foreign investors in China had been the position of Circular 71 and Notice 207 under the new EIT Law and Implementation Rules to the Enterprise Income Tax Law (the Rules) that took effect on 1 January 2008.

In principle, however, the favourable tax treatment granted under Circular 71 and Notice 207 terminated once the EIT Law became effective on 1 January 2008, unless further regulations were issued by SAT and MOF to maintain it.

B. The position post-1 January 2008Article 75 of the Rules requires an enterprise that undergoes a corporate restructuring to realise gain or loss on the transfer of related assets at the time the transaction is conducted and requires the corresponding tax basis to be determined in accordance with the transaction price.

Notice 59 defines “enterprise restructuring” and lists six specific types – namely, an equity acquisition, asset acquisition, merger, spin-off, change in legal form and debt restructuring.

It provides that either the “general”55 or “special”56 tax treatment can be elected for such enterprise restructurings.

Restructurings may be done free of EIT provided the conditions imposed for “special tax treatment” are satisfied57.

Notice 59 is more stringent than Circular 71 and Notice 20758.

It has been observed that “new investments should preferably use the most tax efficient structure rather than having to face a possible restructuring need later, given the new conditions”59.

VII. China investment planning and profit repatriation strategiesIn China, foreign investment is subject to relevant investment laws and regulation (such as exchange controls, foreign ownership limits and investment restrictions).

The operation of these laws calls for the formulation of profit repatriation strategies both in the context of a wholly foreign-owned investment or joint venture (together, foreign-invested enterprises or FIEs).

Typically profits are repatriated from China in the form of interest, royalties and service fees (in addition to dividends).

Approval is required from the State Administration of Foreign Exchange (SAFE) for the repatriation of these

54 Raymond Tan, “Taxation of Corporate Restructuring”, CN Blawg, 22 May 2009, http://www.cblawg.com/index.php?option=com_content&view=article&id=3737&catid=140&Itemid=1162 (accessed 24 July 2009).

55 The general treatment is the basic tax recognition rule provided under Article 75 of the Rules.

56 If certain criteria are met, a party to a restructuring can elect a special non-recognition tax treatment. Below are the basic requirements for both foreign and domestic investors to elect special tax treatment:

• Therestructuringtransactionmustaccomplishreasonablecommercial purposes, and cannot be conducted primarily to decrease, avoid or defer tax payments.

• For equity acquisitions, no less than 75% of the totalequity of the target company must be acquired; and for asset acquisitions, no less than 75% of the total assets of the target company must be acquired.

• Within the12months following the restructuring, therecan be no change in the original business operation of the target company, and there can be no re-transfer of the acquired stock.

• At least 85% of the total consideration received by thetransferor must consist of the acquirer’s stock.

• The shareholderswho receive equity in the restructuringmust continue to hold such equity for a period of one year following the restructuring.

Special tax treatment is also available for the following specific types of cross-border restructurings that otherwise satisfy the above five criteria.

• Transferbyanon-residententerpriseofitsequityinterestin a resident enterprise to another resident enterprise that is wholly-owned by the transferring non-resident transferor.

• Investmentbyaresidententerpriseofitsassetsorequityina wholly-owned non-resident enterprise. The gain resulting from such a transfer must be amortised into taxable income over the 10 year period following the transfer.

• Transferbyanon-residententerpriseof itsequity interestin a resident enterprise to another non-resident enterprise that is wholly-owned by the non-resident transferor. Such transfer will not result in any change to the withholding tax burden of the non-resident transferee relating to any capital gains arising out of a subsequent transfer of the entity interest in the resident enterprise. However, the non-resident transferor must not transfer its equity interest in the wholly-owned transferee within three years after the transfer.

• OthertransactionsapprovedbyMOFandSAT. Notice 59 allows restructurings that occur in multiple steps

to be considered as one restructuring, provided all steps are completed within a 12-month period. The special non-recognition treatment will only apply with respect to the equity consideration received on the restructuring.

If a resident enterprise undergoing a restructuring satisfies all of the above requirements and intends to elect special tax treatment, it must submit written information to its local tax bureau, along with its annual income tax filing, showing that the requirements were satisfied.

Taxable gain or loss will still be recognised on the receipt of any “boot” consideration (including cash, receivables and other assets).

57 See footnote above.

58 Loyens & Loeff, Asia Newsletter, Summer 2009.

59 Ibid.

60 This includes the Hong Kong Special Administrative Region, the Macau Special Administrative Region and Taiwan.

61 Total investment refers to the “total amount of funds required for establishing the foreign-invested enterprise, ie, the total amount of the capital required in basic construction in accordance with the production scale of the enterprise and the total working capital for the production”: Article 19 of the Rules for the Implementation of the Law of the People’s Republic of China on Foreign-funded Enterprises (2001 Revision, Order No. 301 of the State Council of the People’s Republic of China).

payments. The amount that may be paid may also be subject to regulatory approval. For instance the rate of interest payable on a shareholder loan is subject to SAFE approval.


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and cooperation is a growing trend in China.

By way of example, SAFE and SAT require a single payment of more than US$30,000 to a foreign service provider to be accompanied by a tax clearance certificate (without which banks will refuse to sell foreign currency to the FIE for payment)68.

b) Information sharingAn investment in China lays a substantial paper trail for both the FIE and the investor; from the initial Feasibility Study Report69, contractual documentation setting out payment rates for foreign services, licenses or loans to be provided to the FIE, to ongoing compliance requirements during the operational life of the FIE.

Numerous information-gathering methods on businesses are now available to China’s regulatory authorities as a whole70.

This, and greater joint enforcement efforts between different regulatory authorities, suggest that investors should seek to ensure consistency of information provided to different authorities in different contexts71.

2. Tax developmentsa) Transfer pricingThe Implementation Regulations for Special Tax Adjustments (Guoshuifa [2009] No. 2) (Circular No. 2) introduced detailed transfer pricing rules that require related party interest, royalty and service fee payments to meet the arms-length standard.

The transfer pricing rules are supported by detailed tax disclosure and contemporaneous documentation requirements72.

b) Business tax on shareholder loansThe 2008 revision of the Implementation Rules of the Interim Regulations of the People’s Republic of China on Business Tax (Order No. 52 of MOF and SAT) provides that from 1 January 2009, business tax will be imposed on interest paid on foreign shareholders’ loans73.

Tax considerations (such as withholding tax and business tax) are relevant here.

There have been a number of recent tax and regulatory developments in China that impact China profit repatriation strategies.

A. Some background: The regulatory framework for foreign investment in ChinaAn investment in China that is made by an entity located in a country or territory outside of mainland China60 is foreign investment in China.

Approval is required in China for foreign investment.

The total investment amount61 and registered capital62 is prescribed by the relevant regulatory authority63.

The total amount of foreign debt which an FIE is permitted to incur is restricted to the difference between the FIE’s total investment amount and registered capital. (China’s new thin capitalisation rules are now relevant here.64)

B. Recent regulatory and tax developments in China1. Regulatory developments There have been a number of recent regulatory developments in China.

Of note are the Notice of the State Administration of Foreign Exchange on Relevant Issues Concerning Foreign Exchange Administration for Domestic Residents to Engage in Financing and Round-trip Investments via Overseas Special Purpose Companies65 and the Interim Provisions on the Takeover of Domestic Enterprises by Foreign Investors66.

Some developments impact the repatriation of profits from China. For instance, additional restrictions to the ratio of registered capital to total investment have been introduced in certain sectors of investment67. These restrictions reduce the amount of foreign debt financing which an FIE may obtain and thus act to limit the amount of interest that may be repatriated.

a) Cross-departmental cooperationCloser cross-departmental enforcement

62 Established rules exist in this regard. See Article 3 of the Provisional Regulations on the Proportion of Registered Capital to Total Investment of Sino-Foreign Joint Ventures promulgated by the State Administration of Industry and Commerce on 1 March 1987 (applicable also to wholly foreign-owned enterprises – or “WFOEs”).

63 Regulatory approval must be obtained to adjust the total investment and registered capital amounts. In planning an investment in China, there is thus a need to “get it right”.

• If the total investment amount is too low, cash-flowproblems may be experienced.

• Anoverlyhighregisteredcapitalamountmayresultinthetying-up of idle cash, which could be better allocated to another group company.

• Ifthetotalinvestmentamountiscalculatedonanoverlyaggressive basis, limits on foreign debt may mean that the FIE has less flexibility in obtaining additional financing, if required.

64 On 8 January 2009, the SAT issued the Implementation Regulations for Special Tax Adjustments Guoshuifa [2009] No. 2. (Circular No. 2). Circular No. 2 sets out the formula for calculating non-deductible interest expense.

65 Hui Fa [2005] No. 75. Promulgated by SAFE on 21 October 2005 and effective on 1 November 2005.

66 Order No. 10 of the Ministry of Commerce, State-owned Assets Supervision and Administration Commission, China Securities Regulatory Commission, State Administration of Taxation, State Administration of Industry and Commerce, State Administration of Foreign Exchange. Promulgated on 8 August 2006 and effective on 9 August 2006.

67 An example is the measures promulgated to regulate foreign investment in China’s real estate market in 2006, ie, Opinions Governing the Market Access and Administration of Foreign Investment in Chinese Real Estate Market (Jian Zhu Fang [2006] No. 171) (Circular 171) and Notices Governing Further Strengthening and Regulating Approvals and Supervision of Direct Foreign Investment in Real Estate Sector (Shang Zi Han [2007] No. 50) (Circular 50).

Notwithstanding the ratios of registered capital to the FIE’s total investment set out in the Provisional Regulations on the Proportion of Registered Capital to Total Investment of Sino-Foreign Joint Ventures, a foreign-invested FIE set up for the purpose of investment in real estate has a higher registered capital requirement, namely, for a total investment amount of USD3million and above, registered capital must be at least 50% of total investment.

Prior to this change, single-property-holding FIEs were financed as to 70% by way of shareholder’s loan.

Both Circulars 50 and 171 further provide that if the FIE is a Sino-foreign joint venture, the joint venture parties may not guarantee direct or indirect fixed returns to any party in their investment or joint venture documentation.

68 See Notice on the Relevant Issues concerning Submitting Tax Certificates for Foreign Payments under Trade in Services and Other Items (Hui Fa [2008] No. 64), which was jointly issued by SAFE and SAT on 25 November 2008 and effective from 1 January 2009.

69 A Feasibility Study Report is part of the documentation required to be submitted in an investor’s application to establish an FIE. Such a report generally includes information on the proposed business model, financing and background information on the investor. Regulatory authorities have been known to argue that rates of payment should be adjusted based on background information on the investor. For instance, Customs authorities have been known to adjust import values of goods on the basis that the royalty component of the import price should be higher on a well-known brand or trademark.

70 Another regulatory framework through which extensive information may be obtained on investors (or potential investors) is China’s antitrust regime. The PRC Anti-Monopoly Law (Order No. 68 of the President of the People’s Republic of China) came into effect on 1 August 2008, but prior to that the Guidelines on Anti-Monopoly Filing for Mergers and Acquisitions of Domestic Enterprises by Foreign Investors (promulgated by the Ministry of Commerce and effective on 8 March 2007) already created an onerous burden for foreign inbound mergers and acquisitions.


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A withholding tax of up to 10% (on top of a 5% withholding for business tax) may be imposed.

The service fee will be subject to tax disclosures and possible contemporaneous documentation requirements.

Individual Income Tax law considerations will arise for all staff rendering services in China for a period beyond the prescribed domestic law or tax treaty-based limits.

VIII. Greater exchange of infor-mation to be expectedIn an international context, recent months have seen intense efforts by Governments in OECD countries to improve the EOI between tax authorities. Nonetheless, the situation at present is that in order to secure entry into the “white-list” of countries that have substantially enacted the “internationally agreed standard” for EOI, a State must have at least 12 EOI arrangements that meet the new standard.

In order to meet this benchmark, it is likely that a State need only enter into EOI arrangements with OECD countries. It remains to be seen how this trend towards enhanced EOI provisions will translate into tax treaty practice amongst countries in Asia outside the OECD.

It is likely that Hong Kong, as a result of the EOI initiatives, will become a jurisdiction with a material number of tax treaties. This will likely have substantial implications for the use of Hong Kong in international tax planning. A country like Singapore, which has never had a tax treaty with the United States due to EOI concerns, is likely also to wish to negotiate a comprehensive double tax treaty with America.

IX. The trend towards substanceA. ChinaIn China, the doctrines of economic substance and business purpose embedded in the general anti-avoidance rules of the new EIT Law are now a part of administrative practice in China.

In two recent tax cases – Chongqing Case and Xinjiang Case, China’s tax

c) Impact on profit repatriation strategiesPRC profit repatriation planning often sees approval being sought for interest on shareholders loans (from SAFE) and royalties (from the Ministry of Science and Technology) at the maximum rate that the relevant approving authority will accept.

In China interest and royalty payments are approved by SAFE for remittance.

Both payments are subject to withholding tax at the 10% rate under the EIT Law (in addition to a 5% business tax).

Like royalties and interest, service fees are often used as a profit repatriation tool in China.

1. Impact of transfer pricing rules and tax disclosuresAn FIE paying interest, a royalty or service fees to a “related” party is now required to file extensive tax disclosures as part of its annual tax filing and possibly required to prepare contemporaneous documentation.

A transfer pricing review/expense adjustment may result.

An adjustment to a relevant expense will not result in a refund of PRC withholding tax imposed on amounts remitted abroad.

If there is an inability to fully credit the withholding taxes and/or the absence of a correlative adjustment following a PRC transfer pricing adjustment, the after tax return from the investment will be impacted.

2. “Fly in rules”In the case of service fees, the Interim Measures on for the Administration of Taxation of Non-Residents for Contracting Engineering Projects and the Provision of Services (Guo Jia Shui Wu Zong Ju Ling [2009] No. 19) (Order 19) or the “fly in rules” must be mentioned.

Order 19 requires the registration of Service Fee Agreements with the tax authorities.

A de facto PE determination will then be made and the extent of PRC sourced income of the service provider ascertained.

71 A hypothetical situation may be where a Feasibility Study Report is viewed by an investor as a marketing document, in which an extensive description of the FIE’s function within the investor’s group of companies is included. This information in the hands of the SAT may trigger a transfer pricing audit, particularly if circumstances necessitate an actual change in the FIE’s role within the group and the expected related party transactions are not reported to SAT.

72 Detailed reporting forms on related party transactions must now be submitted with annual tax returns: Notice Containing Related Party Transaction Annual Reporting Forms (Guoshuifa (2008) No. 114.

Contemporaneous transfer pricing documentation must also be maintained and submitted upon request by the tax authorities, except where:

• theFIEhasanannualamountofrelatedpartybuying-and-selling transactions below RMB 200 million, and an annual amount of all other types of related party transactions (for related party financing arrangements, the interest paid and received to be used for this calculation) below RMB 40 million (not including transaction amounts covered under cost-sharing arrangements or advance pricing arrangements implemented during the same tax year);

• therelatedpartytransactionsarecoveredbyadvancepricingarrangements; or

• theforeignshareholdingoftheFIEisbelow50%andtheFIE only transacts with domestic related parties: Circular 2.

73 Financial services are included as services subject to business tax pursuant to Article 2 of the Implementation Rules of the Interim Regulations of the People’s Republic of China on Business Tax. Article 4 of the Implementation Rules further clarified that as long as an entity accepting the service subject to business tax was in China, the service will be deemed to be provided in China.

74 The tax authorities will consider the following factors based on the “substance over form” principle in determining whether a transaction is arranged for tax avoidance purposes:

• Formandsubstanceofthearrangement;• Conclusiontimeandexecutionperiodofthearrangement;• Connectionbetweeneachsteporpartofthearrangement;• Changesoffinancial statusofeachparty involved in the

arrangement; and• Taxconsequenceofthearrangement.

authorities either disregarded or denied treaty benefits to an offshore special purpose vehicle (SPV) – which were found to lack substance.

Although not specifically stated in the cases, tax practitioners generally believe that the general anti-abuse clause in the new EIT law (i.e., Article 47) was the underlying rationale and legal basis in deciding these two cases.

1. Anti-abuse clarificationCircular No. 2 to clarify the general anti-abuse clause.

Among other things, it provides that the tax authorities may initiate a general anti-avoidance investigation to enterprises with the following tax avoidance arrangements: (i) abuse of tax incentives; (ii) abuse of tax treaties; (iii) abuse of a company’s legal form; (iv) tax avoidance through a tax haven; and (v) other arrangements without bona fide business purpose74.

Article 94 of Circular 2 specifically permits the tax authorities to disregard


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directors of the Barbados SPV were US citizens.

The Xinjiang tax bureau said that a consularised document from the PRC embassy in Barbados showed only that the Barbados company was registered in Barbados, but was insufficient proof of tax residency. Instead, the tax bureau relied on the EOI procedure under the tax treaty to obtain information from the Barbados authorities and concluded that the Barbados company was not a resident in Barbados for tax purposes.

On this basis, the tax bureau denied the tax exemption under the treaty.

As the transactions took place in 2006 and 2007, the anti-avoidance principles in China’s new EIT Law, which became effective on January 1 2008, technically did not apply to the case84.

Nonetheless, the tax bureau took the opportunity to comment in some detail on the potential tax avoidance and treaty abuse aspects of the transactions85.

B. South KoreaIn South Korea, there is a focus on “substance over form” in an international anti-avoidance and in particular a concern to address “tax treaty shopping”.

company. However, Chongqing tax authorities looked beyond the legal form of the transaction and decided that this transaction was a transfer of Chinese onshore stock through the SPV in substance and therefore the SPV should be disregarded for tax purposes.

Consequently, the Singapore parent had to pay income tax in China at a 10% rate on the capital gain from the sale, as if it had sold the PRC subsidiary directly.

Two key factors cited by the Chongqing tax bureau were that the Singapore subsidiary (i) had a very small amount of capital and (ii) did not carry on any business activity other than owning the shares of the PRC subsidiary80. Hence, the Singapore subsidiary lacked economic substance81.

Although the Chongqing case was reported by the municipal tax bureau in Chongqing, it is understood that the SAT reviewed and approved the case82.

4. Xinjiang Case83

A Barbados-based SPV, established by a US company, derived capital gains from the sale of its equity interests in a Chinese company located in Xinjiang.

In general, such capital gains are protected by the China/Barbados income tax treaty and should not be taxed in China.

However, in this case, PRC tax authorities denied the benefits of the Barbados income tax treaty and imposed tax on the SPV because the tax authorities found that the purported seller had no substance in Barbados.

The following facts were identified by the tax authorities as suspicious: the Barbados SPV purchased the equity interest in the Chinese company only after one month of its formation and sold the equity interest after approximately one year from the date of the purchase; the SPV’s return on its investment in the Chinese company was 36%, which was not achieved by business operation of the Chinese company but instead was based on a pre-arranged contractual arrangement as if the SPV had made a disguised loan rather than an equity contribution and all

the existence of an enterprise that lacks economic substance, particularly one established in a tax haven, and thereby to prevent tax avoidance by both related and unrelated parties of the enterprise.

2. Denial of treaty benefits for arrangements that seek favourable dividend treatment On 20 February 2009, the SAT issued the Notice on Issues Relevant to the Implementation of Dividend Provisions in Tax Treaties (Notice 81)75. Notice 81 addresses the situation where the withholding tax rate on dividends under a tax treaty is lower than the 10% rate under domestic law in China76.

Article 4 of Notice 81 empowers the tax bureaus in China to investigate and to deny treaty benefits where the main purpose of a transaction or an arrangement is to obtain more favourable treatment of dividends under a tax treaty77.

Notice 81 reflects the implementation of the emerging anti-avoidance principle in China that poses new challenges to the effective use of a SPV78.

3. Chongqing Case79The Chongqing Yuzhong district-level State Tax Bureau published a tax case in late November 2008 in which the PRC tax authorities looked beyond the legal form of a transaction and disregarded a Singapore SPV (with results similar to that in the Vodafone case).

According to the published case, the Chongqing tax authority imposed a withholding tax on capital gains derived by a Singapore holding company from the sale of its shares in a wholly-owned Singapore subsidiary (ie, the SPV) to a Chinese buyer.

The SPV held a 31.6% equity interest in the Chinese target company. The Chongqing tax authority found that the SPV had no real business other than holding the 31.6% equity interest in the Chinese target company and the total capital of the SPV was only S$100.

Based strictly on the legal form of the transaction, China did not have tax jurisdiction over the Singapore holding

75 Baker & McKenzie, “New Challenges to Special Purpose Vehicles for Investing in China”, Client Alert, March 2009.

The following conditions must be met for the recipient of the dividend to enjoy the treaty benefit:

• Therecipientofthedividendmustbeataxresidentoftheother treaty jurisdiction;

• The recipient of the dividend must be the beneficialowner of the dividend;

• Thedividendmustqualifyasadividendunderthetaxlawof China; and

• OtherconditionsthattheSATmayimpose. Under Notice 81 the SAT will now require the non-

resident taxpayer or the withholding agent to provide documentary evidence to prove that the recipient of the dividend meets these requirements.

76 Ibid.

77 Ibid.

78 Ibid.

79 A summary of the Chongqing case was kindly provided to the authors by Larry Sussman, Managing Partner, O’Melveny & Myers, Beijing.

80 See footnote 75.

81 Ibid.

82 Ibid.

83 A summary of the Xinjiang case was kindly provided to the authors by Larry Sussman, Managing Partner, O’Melveny & Myers, Beijing.

84 See footnote 75.85 Ibid.


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sale of shares in a Korean company. The National Taxation Service (NTS)

had denied the application of the tax treaty and assessed capital gains tax to the foreign private equity funds arguing that the investment holding company should not be respected as beneficial owner of the gain. Rather, the NTS said that the foreign investors in each investment holding company should be viewed as the beneficial owner in substance of the capital gains through an application of the substance over form principle under Korean domestic law.

The Seoul Administrative Court held that the Korean substance over form principle could apply in the context of a tax treaty (even in the absence of an express beneficial ownership requirement in that tax treaty with respect to capital gains). The share sale gains in question could thus be taxed in Korea on the basis that the CGT exemption in the Korea–Malaysia tax treaty was not applicable in these cases.

a) Lone Star caseIn July 2007, Korea’s National Tax Tribunal ruled against Lone Star with respect to its sale of the landmark 45-story Gangnam Finance Tower (formerly Star Tower) in Seoul.

In 2001, Star Tower Corp. bought Gangnam Finance Tower in Seoul for KRW 700 billion. The shares in Star Tower Corp. were owned by a Belgium holding company called “Star Holdings”. In 2004, the shares in Star Tower Corp. were sold by Star Holdings to Government of Singapore Investment Corp. (GIC) for KRW 900 billion, at a profit of KRW 280 billion90.

The NTS subsequently audited the Star Tower sale91.

Lone Star argued that the transaction should be tax free in Korea because the company that bought and sold shares in Star Tower Corp. was tax resident in Belgium. The NTS disagreed, saying Lone Star had a “permanent establishment’’ in Korea and owed taxes totalling KRW 101.7 billion on the sale of the building92.

In a press release, Korea’s National Tax Tribunal (NTT) said, “The Belgian company, Star Holdings, was founded only to evade taxes and has no operational activity. It is a conduit company, and does not exercise real ownership and management rights.” The Tribunal said the company was “treaty shopping” to avoid taxes, and because of that, it was liable to pay taxes under domestic Korean law. “The company’s current country of residence, which is Belgium, is excluded,” the tribunal said, “thus taxing the real owner, Lone Star Funds, is in line with the law”93.

On 16 February 2009, the Seoul Administrative Court issued its ruling in Case No: 2007-37650 Annulment of Income tax.

A copy of the decision of the Seoul Administrative Court is available on the Korean Supreme Court website.

In a 16 February 2009 press release entitled “Annulment of Lone Star Fund capital gain tax: Seoul Administrative Court orders to pay corporate tax instead”, Maeil Business Newspaper reported:

This is evident when one looks at a range of recent developments in Korean taxation over the past few years.

An international substance over form principle has been introduced into Korean tax law, together with a special withholding tax regime and procedures for asserting tax treaty claims.

South Korea is also working to re-negotiate several of its tax treaties to include a limitation of benefits article86.

There have been recent decisions made by the Seoul Administrative Court of note.

These developments are discussed in further detail below.

1. Codification of “substance over form” doctrine in international transactionsOn 24 May 2006, the Law for the Coordination of International Tax Affairs (LCITA) governing international transactions were revised to include the codification of the “substance over form” principle and beneficial ownership requirement87.

2. Special withholding procedures for profitsAn amendment to the LCITA, passed by the National Assembly in May 2006, instituted a new provision (effective 1 July 2006) that allows the Ministry of Strategy and Finance to list certain countries and jurisdictions as tax havens and to seek a standard withholding tax on profits before repatriation to those destinations.

The Ministry issued a notice in June 2006 designating Labuan, an island territory of Malaysia, as the first and only offshore jurisdiction subject to the special withholding tax88.

3. Recent court decisions89

In South Korea, the Seoul Administrative Court recently issued judgments in two cases in which private equity funds had established an investment holding company in Labuan and claimed the benefit of the Korea–Malaysia tax treaty with respect to the gain that arose on the

86 “S. Korea Wants to Rewrite its Tax Treaties”, The Hankyoreh, 10 July 2007, http://english.hani.co.kr/arti/english_edition/e_business/221456.html (accessed 30 July 2009).

87 “Special Withholding Procedure Applicable to Foreign Companies or Funds Taking Effect on July 1, 2006” Ministry of Strategy and Finance Press Release 14 March, 2006; “Answers to FAQs on the Special Withholding Procedure applicable to Foreign Companies or Funds”, 14 March 2006, International Tax Division Ministry of Finance and Economy, Press Release; “Designation of Subject Territory under Special Withholding Procedure”, Ministry of Strategy and Finance, Press Release 30 June 2006; Korea Economic Institute and Korea Institute for International Economic Policy, Henry An and David Jin-Young Lee, “Tax Issues Affecting Foreign-Invested Companies and Foreign Investors”, Korea’s Economy: 2008, Volume 24, http://www.keia.org/Publications/KoreasEconomy/2008/Lee1.pdf (accessed July 30 2009).

88 Ibid.89 Kim & Chang, Client Alert, June 2009.90 “South Korea Upholds USD110 milion Tax on Lone

Star Deal”, Reuters, 5 July 2007; “S. Korea Rejects Lone Star’s Tax Appeals”, Yonhap, 5 July, 2007; “Tribunal rejects Lone Star’s tax-exempt appeal”, Joongang Daily, 6 July 6, 2007.

91 Song Jung-A and Anna Fifield, “South Korean Tax Probe into Foreign Private Equity Funds”, Financial Times, 15 April 2005, http://www.mail-archive.com/[email protected]/msg05072.html (accessed 30 July 2009).

92 See footnote 75.

93 Ibid. Lone Star Funds’ chairman John Grayken said, “Lone Star respects the National Tax Tribunal’s view, but is disappointed in this decision and will appeal it to the Korean courts. Lone Star remains convinced the courts will determine that, under the applicable treaty and international standards, Lone Star’s affiliate in Belgium that sold the shares in Star Tower Corp. is not obliged to pay taxes in Korea”.


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This decision confirms a trend in Indonesia where the tax authority is denying tax treaty benefits.

While Circular Letter No. SE-03/PJ.03/2008 does not specifically exclude “conduits”; the Tax Court seems to consider conduits not to be ‘beneficial owners’ for tax treaty purposes.

B. Overseas court decisionsThe Swiss Supreme Court has denied treaty benefits in a treaty shopping case, applying an anti-abuse rule inherent to tax treaties and based on the Vienna Convention on the Law of Treaties99.

Germany introduced a domestic anti-treaty shopping rule and tested it in Court100.

France won in a major treaty shopping case at the highest Court (le Conseil d’État) based on the notion of “fraude à la loi”101.

must withhold tax due in accordance with the income tax law.

For the domestic taxpayer to withhold at a lower treaty rate, it must be certain that:• The non-resident recipient of the

income is a resident of the other contracting state, as evidenced by a valid certificate of domicile; and

• Thenon-residentistheactualownerof the income and the one entitled to directly enjoy the benefits of the income as mentioned in the treaty.

Unless both requirements are met, the domestic taxpayer must withhold tax at a rate of 20%.

The new Circular is silent on SPVs and their status as beneficial owners. It does state, however, that another circular will be issued to provide guidance and set out procedures for applying the provisions of a tax treaty. That Circular is expected to clarify the procedures and documentation required to support a claim of beneficial owner status.

The new Circular revokes Circular Letters No. SE-04/PJ.34/2005 and No. SE-02/PJ.3/2006.

2. Indonesia Tax Court decisionIt has been reported96 that a recently released decision by Indonesia’s Tax Court has held that an Indonesian company incorrectly applied the lower withholding tax rates available under the Indonesia-Mauritius tax treaty for interest payments it made to a wholly-owned subsidiary that is a tax resident of Mauritius.

The Court was unconvinced that the recipient was the “beneficial owner”97 of the interest payments.

The Tax Court considered the recipient to be a “conduit”98.

In reaching that conclusion, the Court’s judges referred to the definition of beneficial owner made by tax scholar Klaus Vogel. The reason the term cannot be interpreted by reference to the domestic law of the State applying the treaty is that none of the national tax systems in question offer a precise definition of the term ‘‘beneficial owner”.

“The Court ruled that the capital gain tax levied on Lone Star Fund should be annulled. Yet this ruling does not state that the tax levied is unfair but that it should pay a different tax and interests are now turned toward what the higher court’s rulings will be.

Lone Star Fund III, a Bermudan LP and Lone Star Fund III, a US LP filed a lawsuit against Yeoksam Tax Office requesting an annulment of capital gain taxes. On the 16th, the Seoul Administrative Court ruled that “the 100bn won levied by the Yeoksam Tax Office in 2005 should be annulled.” Yet the Court stated that a “Limited Partnership” is an entity that exists only under the Anglo-American Law and it is therefore not liable to pay capital gain taxes which should be levied to individuals. It is more appropriate to levy corporate taxes”

The decision of the Seoul Administrative Court in Case No: 2007-37650 Annulment of Income Tax does not appear to say that corporate tax should be paid.

Detailed commentary of the decision of the Seoul Administrative Court is awaited.

In a related development the Seoul High Court has confirmed that Star Tower Corp. was not a newly established entity for purposes of the Korean heavy registration tax94.

X. The meaning of “beneficial ownership”Beneficial ownership is a key concept in being able to access double tax treaties. There have been a number of recent developments of note.

A. Indonesia1. Circular Letter No. SE-03/PJ.03/200895

Circular Letter No. SE-03/PJ.03/2008 defines a beneficial owner as the actual owner of dividend, interest or royalty income, and the person entitled to directly enjoy the benefits of such income. Where a domestic taxpayer pays dividend, interest or royalties to a non-resident, the domestic taxpayer

94 “Court Sides with Lone Star”, The Korea Times, 2 August 2009.

95 Loyens & Loeff, Asia Newsletter, Autumn 2008.

96 Loyens & Loeff, Asia Newsletter, Autumn 2008.

97 The Court had found that the term ‘‘beneficial owner’’ is based on a substance over form doctrine and an economic approach. Thus, a beneficial owner of income is the party that substantially and obviously owns the income and can freely enjoy the income in its resident country, where the income is taxed: ABNR Legal Brief, July 2009.

The Court found: • theinterestrecipientimmediatelyforwardedallinterestit

earned to the other party;• theinterestrateactuallypaidbythetaxpayeristheinterest

rate of the notes issued by the issuer and not the interest rate based on the loan agreement entered by the taxpayer with the issuer;

• the bank account of the interest recipient is only anintermediate bank account because it does not have any genesis other than the interest payments; and

• thebalanceofthebankaccountoftheinterestrecipientis very small and demonstrates no economical activity substance.

98 The Court based its conclusion on the following facts:• the audited financial statement of the interest recipient

states the interest recipient is 100% owned by the taxpayer;

• variousinformationwasgatheredfromthedocumentsofthe interest recipients, including the facts that two shares were issued at USD1 each; the purpose of the interest recipient was ‘‘to borrow or raise money’’; and three of the five members of the board of directors of the interest recipient are also directors of the taxpayer;

• thereisnosalaryexpensebornebytheinterestrecipient;and• thebiggestassetoftheinterestrecipientisthereceivable

against the taxpayer. Source: ABNR Legal Brief, July 2009.

99 Swiss Supreme Court decision, 2A.239/2005.100 The so called “Hilversum jurisprudence”, concluded by

the German Federal Tax Court‘s Hilversum II decision (31May 2005), and followed by a legislative amendment in 2007 to tighten the anti-treaty shopping rule.

101 Decision of the Conseil d’État Bank of Scotland (CE Dec. 20, 2006, No. 283314).


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The Canadian tax authorities had taken the position that the beneficial owner of the dividends was not BV, but rather the UK and Swedish shareholders of the BV. As such, they argued that tax should have been withheld at the higher rates under Canada’s tax treaties with Sweden and the UK, rather than at the 5% rate under the Canada-Netherlands treaty107.

The sole issue before the Court of Appeal was the meaning of the term “beneficial owner” in the Canada-Netherlands treaty. The Tax Court had concluded that the beneficial owner of a dividend is the person who assumes and enjoys all attributes of ownership of the dividend, including control of the dividend received. The Court of appeal affirmed the Tax Court’s interpretation and upheld its finding that the BV was the beneficial owner of the dividends108.

The Federal Court of Appeal rejected the Crown’s argument that a beneficial owner should be the person who ultimately benefits from the dividend, stating that such a pejorative view of holding companies had not been adopted under Canadian law or by the international community. Furthermore, the Court of Appeal affirmed the appropriateness of looking to amendments to OECD Commentary on the Model Convention released subsequent to the taxation year in question, as well the OECD report on “Double Taxation Conventions and the Use of Conduit Companies”109.

C. A contrast in Thailand and the Philippines1. Thailand: A focus on the registered legal owner of listed securitiesCapital gains on the sale of Thai securities (including securities listed in the Thai Stock Exchange) are subject to withholding tax at the rate of 15%110.

In Thailand, the Revenue Department looks to the legal registered owner of a listed security in ascertaining the application of a tax treaty business profits or CGT exemption claim. Absent a tax treaty exemption foreign investors are

subject to a 15% withholding tax on the sale of listed Thai securities.

Investors in Thai-listed securities often use the services of a securities brokerage firm established in a country that has a tax treaty with Thailand that exempts capital gains such as the United Kingdom, Hong Kong and Singapore.

The securities brokerage firm acts as the custodian of the Thai-listed securities

Three recent common law court cases are summarised below.

1. IndofoodThe UK Court of Appeal, in Indofood International Finance Ltd. v. JP Morgan Chase Bank N.A., London Branch [2006] EWCA CV 158, has ruled that a Dutch SPV could not be the beneficial owner of loan interest paid to a Mauritian subsidiary by its Indonesian parent, and that the Mauritian subsidiary could terminate its bonds early under a redemption agreement.

In Beneficial Ownership: After Indofood102, Philip Baker QC examines the Indofood case and the meaning of beneficial ownership in the context of tax treaties103.

2. MIL (Investments) On 13 June 2007, a three-judge panel of the Federal Court of Appeal unanimously upheld the Tax Court of Canada’s August 2006 decision in MIL (Investments) S.A.V.R.

This was the first treaty-shopping case to be litigated in Canada104.

At the Tax Court level, the Canadian tax authorities argued that treaty benefits otherwise available to a taxpayer under the Canada-Luxembourg treaty should be denied by virtue of Canada’s domestic GAAR or an inherent treaty anti-abuse rule. The Tax Court rejected these arguments on the facts of the case. In the course of its decision, the Court stated that the “shopping or selection of a treaty to minimise tax on its own cannot be viewed as abusive.”

3. Prévost CarOn 26 February 2009, the Federal Court of Appeal upheld the decision of the Tax Court of Canada in Prévost Car Inc v The Queen105.

The case concerned whether a Dutch holding company (Besloten Vennootschap – or “BV”, a private limited liability company) was the beneficial owner of dividends paid by its Canadian subsidiary for purposes of the Canada-Netherlands income tax convention106.

102 See http://www.taxationweb.co.uk/international-tax/general/beneficial-ownership-after-indofood.html (accessed 24 July 2009). The article was first published in GITC Review, Vol. VI, No.1.

103 Baker concludes: “If one draws back for a moment, however, and looks at the

facts of the case, can one really be surprised at the outcome? Recall: the Mauritian company borrowed the identical amount that it on-lent, at the same interest at which it on-lent, and the Court of Appeal found as a fact that the Mauritian company could do nothing with the interest it received but use it to pay the identical amount of interest that it had to pay on. In this type of egregious circumstance, is there any real surprise that the Dutch company which was proposed to take the place of the Mauritian company would not have been the beneficial owner? If beneficial ownership had any meaning at all, surely it would exclude the type of interposed entity which had no function whatsoever but to receive income and pay on the identical amount of income: in fact, it had so little function that, according to the Court of Appeal, the actual flows of money missed it out completely.

The biggest difficulty with the case is not that it confirms that the proposed Dutch company would not have been the beneficial owner. The real difficulty is how far the judgment extends: what other arrangements would be held to fall foul of the Beneficial Ownership (BO) limitation?

In principle, ... the case itself should have had a relatively limited impact”.

104 Jeffrey Shafe and Bryan Bailey, “Canada: Treaty Shopping – The Next Chapter”, International Tax Review, September 2007.

105 Sarah Davidson Ladly and Chris Van Loan, “Canada: Tax Authorities Lose Appeal in Beneficial Ownership case”, International Tax Review, May 2009.

106 Ibid.107 Ibid.108 Ibid.109 Ibid.110 See http://www.set.or.th/en/regulations/tax/tax_p1.html

(accessed 30 July 2009).111 For a tax treaty that does not provide for a CGT exemption

(such as the Thailand – United States tax treaty), it is possible for certain investors to seek an exemption from Thai CGT under the “business” profits” article of the tax treaty.

Listed Thai securities are accepted to be inventory of a foreign investor and thus “business profits” if the foreign investor has a securities trading licence in its home country. The securities trading licence becomes the decisive factor in determining whether or not capital gains from a sale of Thai listed securities may be treated as “business profits” for purposes of an applicable tax treaty.

The Thai Revenue Department has confirmed in private rulings that the “business profits” exemption in the US – Thailand tax treaty may be asserted by a US broker – dealer.

A broker-dealer is a company or other organisation that trades securities for its own account or on behalf of its customers. When executing trade orders on behalf of a customer, the institution is said to be acting as a broker. When executing trades for its own account, the institution is said to be acting as a “dealer.” Securities bought from clients or other firms in the capacity of dealer may be sold to clients or other firms acting again in the capacity of dealer, or they may become a part of the firm’s holdings.


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corporations and the reduced 15% tax. The Philippine tax law thus encourages

the use of “tax haven” holding companies in order to obtain reduced dividend withholding.

A similar benefit is not however available in the case of share sale gains116.

XI. Some concluding thoughtsAsia’s “developed” OECD member countries such as Australia, Korea and Japan have long had sophisticated (and often times aggressive) tax authorities.

However, in other countries, tax authorities have at times been constrained by lack of resources, knowledge and information to examine beyond the surface of tax arrangements that have at times been relatively simplistic.

Clearly, this situation is changing. The tax authorities of Asia’s twin “giants” of China and India are clearly becoming increasingly sophisticated and have already demonstrated their willingness to adopt sophisticated analyses and cutting edge (and sometimes novel) interpretations in difficult areas such as “beneficial ownership” and “source of income”. This trend is also perceptible in other large Asian countries, such as Indonesia.

As a result, taxpayers should expect to devote more care and attention to ensure that planning arrangements in Asia are structured in a robust and technically defensible manner, from the outset of implementation. This should entail a greater degree of focus on the substance of the planning whether this be with respect to legal interpretation, capital, location of personnel or business rationale justifying a structure

Given the recent developments, the near- to medium-term may prove interesting as regards to the use of holding companies in offshore tax havens, which can be prevalent amongst many taxpayers in or investing into Asian countries. We anticipate that tax authorities will, in line with the trends noted in this paper, scrutinise the substance of tax haven SPVs more closely. .

for the client; and hence is the legal registered owner of the securities.

The Thai Revenue Department has confirmed in private tax rulings that the person and entity with their names registered as the legal owner of securities is entitled to an exemption of the withholding tax on any capital gains on the sale of the securities111.

If the Thai Revenue Department were to change its view, the expectation is that any new practice would be applied on a prospective basis.

Possible trends need however to be anticipated.

The fact that a favourable administrative practice might exist today with respect to, for instance, tax treaty claims does not mean that will always be the case. To mitigate the risk of a change in administrative practice (on a retrospective basis) obtaining a ruling confirming the tax treatment being applied is recommended112.

Of course, from the perspective of providing complete certainty to foreign investors exempting foreign investors from Thai CGT on the sale of listed securities is optimal.

2. Philippines: “Tax haven” dividendsUnder the Philippine Tax Code, cash dividends paid by a domestic corporation113 to a corporation are not subject to tax if the recipient is either another domestic corporation or a resident foreign corporation.

If the recipient is a non-resident foreign corporation, the cash dividends will generally be subject to a final withholding tax of 30%114, subject to applicable tax treaties.

The dividends withholding tax rate may be reduced to 15% if the country in which the non-resident foreign corporation is domiciled (i) imposes no taxes on foreign-sourced dividends or (ii) allows a credit against the tax due from the non-resident foreign corporation for taxes deemed to have been paid in the Philippines equivalent to 15%115, which represents the difference between the regular income tax of 30% on

112 While unique to its facts, the “tax-free Shin sale” is an interesting case study in how a transaction may be viewed after its completion and the anticipated tax treatment not found to apply: See for example, “Paying the Shin Tax”, Asia Sentinel, 10 November, 2006; “Thaksin’s Children Owe THB21 billion in Tax, Thai panel says”, New York Times, 24 April 2007; “Thaksin’s Children Ordered to Pay USD360 million Tax”, Reuters, 29 June 2007.

Originally, the Thai Revenue Department had said that Thaksin’s children did not have to pay tax on their sale of shares in Shin Corp.

The department’s Director-General, Sirote Swasdipanich, subsequently focused on the purchase of 329.2 million shares in Shin Corp by Panthongtae and Pinthongta from Ample Rich, an offshore family company. The pair bought the shares from Ample Rich for one baht each share and sold them a few days later to Temasek for 49 baht.

113 A domestic corporation is a corporation organised under the laws of the Republic of the Philippines.

114 From 1 January 2009, the final withholding tax rate was reduced to 30% under the provisions of Republic Act No. 9337.

115 The rate was reduced to 15% beginning January 1 2009, in view of the reduced regular income tax rate that is applicable from that date.

116 The tax on sale or other disposition of shares of stock in a domestic corporation will depend on whether or not the shares are listed and traded through the Philippine Stock Exchange (PSE).

A sale or other disposition of shares of stock that are listed and traded through the PSE by a resident or non-resident holder, other than a dealer in securities, is, unless an applicable tax treaty exempts such sale from tax, subject to a stock transaction tax at the rate of 1/2 of 1% of the gross selling price of the shares of stock sold or otherwise disposed which shall be paid by the seller or transferor. Securities listed on the PSE can only be traded through PSE through a duly licensed and registered broker. A 12% value added tax is imposed on the commissions earned by PSE registered brokers, which will generally be passed on by the broker to the client.

In the case of a sale or other disposition of shares of stock in a domestic corporation not listed and traded through the PSE by a resident or non-resident seller or transferor, a final tax is imposed at the rates of 5% for the net capital gains not over P100, 000, and 10% on the gain in excess of P100, 000, unless an applicable tax treaty exempts such sale from tax.

AuthorsMichael G. Velten is a Partner with Velten Partners LLP, a boutique Asia tax and transfer pricing consultancy. He can be contacted at [email protected].

Yeoh Lian Chuan is a Tax, Private Wealth & Trusts Partner with Rajah & Tann LLP. Rajah & Tann LLP is a leading Singapore law firm. Lian Chuan can be contacted at [email protected].

Adelene Sung-Pei Wee is a member of the Clyde & Co Hong Kong & China Corporate Commercial Group. Adelene is based in the Hong Kong office of Clyde & Co, a leading international law firm. She can be contacted at [email protected].

Penelope Wong is a Consultant with Velten Partners LLP. Penelope can be contacted at [email protected].

by michael g. velten, yeoh lian chuan, adelene sung-pei · pdf file02-09-2009 · 22...

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